Shadow banks made the US vulnerable to a crisis. Then they reaped the profits.

April 29, 2021

"Shadow banks" profited off the pandemic and then made it worse. (AP Photo/Elise Amendola)

Shadow banks have made a killing on the market during the coronavirus pandemic, perpetuating and intensifying the economic status quo in a system working well for the ultra-rich while destabilizing the lives of everyday people, a new paper argues.

Because politicians have left shadow banks — private credit intermediaries including private equity, venture capital and hedge fund firms — out of much of the regulatory framework created for traditional banking, the speculative and opaque nature of shadow banks prevents an economic crisis from acting as a shock to inequality, say the authors of the paper, published March 24 in American Behavioral Scientist. Rather than leveling out inequality, as the Great Depression did, the coronavirus crisis is exacerbating it, making the rich richer as millions struggle. 

The authors wrote that in mid-2020, private capital had $2.4 trillion in dry powder on hand, $100 billion more than at the end of 2019, suggesting that shadow banks saw the pandemic as an investment opportunity from the very beginning. 

The stock market has become so divorced from the real economy that, "It can make money even when there is widespread turmoil and devastation and hardship for people in the labor force and companies," said Megan Tobias Neely, the lead author of the paper and an assistant professor at the Copenhagen Business School. In fact, shadow banks have been making money not just in spite of turmoil, but because of it, speculating on flailing industries and rising insurance premiums. And health care, grocery and distribution workers were some of the hardest hit by private equity even before the crisis, leaving them less prepared to safely deal with the pandemic, she said.

Private equity firms own companies that staff more than a third of emergency rooms in the U.S., and between 2004 and 2016, they acquired 1,674 health care and elder care facilities in the U.S., according to a study published by New York University's Stern School of Business. The same study also found that private equity-owned nursing home buyouts led to more staff reductions and lower quality of care for residents. These trends left frontline health care workers less prepared for a pandemic — staff were overburdened and had a weaker bargaining position even before COVID-19.

Similarly, private equity has taken over 50 major grocery chains and, in the past five years, seven of those chains employing at least 125,000 people filed for bankruptcy, wrote Neely and her co-author, Donna Carmichael, a researcher at the London School of Economics and Political Science. Cutting costs — including labor costs — and shutting down grocery stores may have helped investors turn a quick profit, but it harmed workers.

"What makes [firms] profitable in the short term may not make them sustainable in the long term," Neely told The Academic Times. But since the 1980s, as politicians allowed massive deregulation of the financial sphere, firms were increasingly emphasizing shareholder profit at the expense of using earnings to develop workers and products. 

Furthermore, the management style of shadow banks ripples out to other companies, including those looking to attract investment. There is an assumption, Neely said, that people with more money have expertise and thus must have made smart choices; in reality, venture capitalists or hedge fund managers likely have no special insight into one business or another, and yet their management ideas tend to hold more weight. Shadow banking goals also fan out to other companies: Private equity in particular aims to exit companies it invests in within three to five years, making it "impractical ... to invest in technology, workers' skills and quality improvements, all of which require a longer time frame to pay off," as economist Eileen Appelbaum has argued.

Meanwhile, years of investor campaigns against labor organizing left workers in a weakened position to insist on safer conditions when their frontline jobs became life-threatening. Notably, a study in the Journal of Labor Economics found that after private equity acquisition, workers who performed routine or offshorable work were significantly more likely to lose their jobs if they were represented by an aggressive union; and research published in the Socio-Economic Review has shown that weakened unions drive income inequality.

In response to the Great Depression, politicians passed significant federal legislation to make banks more responsible and created a new watchdog agency, the U.S. Securities and Exchange Commission. But subsequently, politicians have undermined that project. Provisions of the 1933 Glass-Steagall Act that restricted banks from dealing with securities firms were formally repealed in the 1990s; the SEC and the Department of Justice under multiple presidential administrations have rarely prosecuted big institutions; and in 2008, the banks that created the subprime mortgage crisis were bailed out by the federal government. 

And while politicians did tighten some banking regulations in response to the Great Recession, shadow banks were overlooked — meaning that investors were actually incentivized to move their money into shadow banks "less encumbered by regulators," Neely and Carmichael wrote. 

This climate of deregulation and impunity, Neely said, has allowed shadow banking to thrive.

Neely pointed out that stock markets have rallied "even though, at the same time, the real economy is struggling in a number of ways — many workers have been laid off or furloughed, entire economic sectors have been devastated, especially in travel and leisure and food and services. What it captures is the fact that, because of the kind of investments being done, the stock market doesn't necessarily represent those economic fundamentals in the ways that we tend to, as a society, assume that it does."

Neely and Carmichael also describe a system of increasing wealth concentration among the richest people. According to research by Greta R. Krippner in Socio-Economic Review and Donald Tomaskovic-Devey and Ken-Hou Lin in American Sociological Review, the finance industry's share of corporate profits over the last 60 years went from an average of 15% to a peak of 45% before 2008. But, as Krippner pointed out, the percentage of people in those jobs barely increased at all: 4% of workers worked in finance in 1950, while only 7% worked in finance in 2001. 

Shadow banking self-perpetuates, Neely said. "Historically speaking, large jolts to our system can be levelers that make people more equal in their response to it," she explained, referencing the Great Depression, the New Deal and rebuilding after World War I and World War II. 

In contrast, "What we find is both the financial crisis of 2008 ... and in this current crisis as well, we don't see the same destruction of physical capital, or the chance for inequality to be alleviated," Neely said. The financial schemes relied on by shadow banks "enable people to profit even during downturns," which hurts the potential for real change. In 2008, politicians' major policy response was to inject liquidity into the economy — which went right back "to the people who were best equipped to rally the fastest."

Neely said she's hopeful that a different policy response to the current crisis could change these dynamics, which she described as anti-democratic. 

"There's a number of things that we could do to rein in on the power of these investors," Neely said. "A really basic change could be to tax [shadow banks] at higher income tax rates, rather than capital gains taxes. … But I also think at the same time, what we need to do is think about how to bolster and empower workers and their demands, so that they're better supported in these situations."

She added, "You have to approach both what's going on at the top and the bottom in order to address the issue of inequality."

The paper, "Profiting on crisis: How predatory financial investors have worsened inequality in the coronavirus crisis," published March 24 in American Behavioral Scientist, was authored by Megan Tobias Neely, Copenhagen Business School; and Donna Carmichael, London School of Economics and Political Science.

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