This week's Economist magazine talked about the rise of shadow banking, or rather the continued and growing presence of it. While I have read extensively and will provide some of my views on this, I'm just going to point out something interesting that I've thought of:
Lending to households or consumers who may be not very 'financially-capable' is an action by a bank that can be viewed very differently by different parties at different times. Some will say that doing so is financially irresponsible - these borrowers do not really have the ability to return these loans. Many then conclude that the financial institutions are nothing but liars and cheaters, especially with stories of apparently unsuspecting families accepting loans that would be impossible to repay in the long run.
While the stories have their validity, this opinion however has incomplete reasoning behind it. Why would a profit seeking bank do so? Excluding parties with mandates to do so (like Freddie Mac and co), the banks often do so because these borrowers use collateral (such as real estate) that is deemed stable and growing in value. The accurate pricing of both risk and hence value of these assets is hence a big question - a static analysis of real estate prior to the burst of the 2007-8 bubble may suggest real estate is a fast appreciating and historically fairly stable asset. However a dynamic and perhaps less quantitative look at real estate will reveal that there has been a momentum of speculative demand pushing speculative demand for real estate, and that soon without real demand or with a minor shock, housing prices could just collapse like a pack of cards. While I would say that I'm dissatisfied with the lack of a quantitative and rigorous method to evaluate these assets in a dynamic way such that predictions can be made and a thorough understanding of the forces behind asset prices can be accomplished, it is not an overstatement that current financial models are insufficient in the regard of assessing shifts and changes in the market due to other parties - a bit like game theory - as I suspect that most models simplify the effects of other market players as 'efficient'.
Anyway, the other view of lending to borrowers who are less credit worthy is that it is actually a good policy because the market is inefficient in not providing them the loans because of potential mis pricing of risk and positive externalities such as community benefits from increased house ownership. For me, the arguments about the positive effects of house ownership can only make sense with the tools to weigh the other side of the equation - the pricing of risk and assets.