The financial crisis lurking in the shadows: Why regulators must now turn their attention to shadow banking
Some would argue that predicting the next financial crisis is a near impossible task. But Nobel-prize winning economist Douglas Diamond said in October last year: “The last [financial crisis] started in the banks, it stayed in the banks. This one’s going to start in the shadow banks and the companies.”
Shadow banking encompasses a variety of financial institutions that provide similar services to banks but without equivalent regulation. They do not take deposits. Instead they generally rely on short-term funding, which can often leave them facing liquidity troubles if something goes wrong.
Over the past few years, a series of major financial blow-ups in the shadow banking sector, such as the collapse of Archegos Capital and implosion of Greensill Capital, have sparked calls for stricter regulations to be imposed on the sector.
Near the end of last year the Bank of International Settlements said the sector had “the potential to cause financial stability concerns”, while the Financial Stability Board (FSB) identified non-banks as a “key priority” for regulators to focus on in 2023.
On the lookout
Despite these concerns, some financial watchdogs have been criticised for falling behind on regulating the shadow banking sector.
At Davos last month, Colm Kelleher, chair of banking giant UBS, said regulators had “taken their eye off the ball” when it came to shadow banks, while François Villeroy de Galhau, governor of the Bank of France, said the world’s regulators “lag behind” when it comes to keeping up with the sector.
Regulators in the UK have not been idle, however. Following the LDI crisis, the UK introduced stress testing for private equity funds and hedge funds, the first country in the world to do so.
‘Market-based finance’ (MBF), the term most regulators use for shadow banking, was a prominent topic in the Bank of England’s financial stability report too. MBF is the system of markets, non-bank market participants and infrastructure which provides credit alongside the traditional financial sector.
At the end of 2021, MBF accounted for £776bn, about 55 per cent of all lending to UK businesses.
The Bank said “international and domestic regulators urgently need to develop and implement appropriate policy reforms to address the risks from MBF”.
“Until this policy work is complete… the underlying risks remain significant and could resurface.”
Despite the mostly peripheral nature of shadow banks, experts are concerned that the traditional financial sector will still face risks of contagion if large shadow banks were to collapse.
While it is difficult to predict where the pressure points are in the sector, the FSB identified the commodities market as a potential flashpoint due to the widespread use of leverage in the sector.
The surge in oil prices after Russia’s invasion of Ukraine last year led to a spike in margin calls on commodities derivatives contracts, particularly in Europe, resulting in an increased demand for liquidity to meet those calls. A similar shock in the near future could have impacts throughout the sector.
Analysts at S&P Global, however, pointed out it’s “hard to match deeper stress” in the commodities market than last year and, in the end, “liquidity was found where it was needed”.
The analysts identified credit hedge funds and broker dealers as amongst the most risky shadow banks due to their higher level of leverage. Other institutions, such as money market funds, are much less risky according to S&P Global.
A tricky task
But experts told City A.M. that rushing into shadow banking regulation wasn’t a straight-forward task.
“Regulators can’t use a one size fits all policy for regulating non- banks,” S&P Global Ratings’ analyst Alexandre Birry said.
Birry said that regulators need to be “really cognizant of the type of activities” that various shadow banks and non-banks perform “because the nature of the risks they take will be different.”
Kate Troup, a partner at law firm Fladgate who specialises in financial services regulation, noted that the variety of shadow banking makes it a difficult target for regulators.
There is no “easy way” to regulate shadow banking, Troup suggested, because it “covers a wide range of activities”.
Shadow banks have played an important role in diversifying the financial sector as the stricter regulatory framework has pushed traditional banks away from riskier forms of lending.
Nick Smith, managing director at the Alternative Credit Council, an affiliate of the Alternative Investment Management Association, drew attention to private credit funds and the role they play in lending to SMEs.
“Reform of the banking sector means that big banks have reduced their lending activity to SMEs and mid-market businesses. Private credit funds have stepped into the gap,” Smith said.
Private credit funds maintained or even increased lending during periods of market uncertainty such as the Covid-19 pandemic and the invasion of Ukraine.
“This counter-cyclical lending activity is a good example of how the sector supports the resilience of the financial system and economy more generally,” he continued.
Additionally, Smith suggested hedge funds make it easier for banks to offer fixed-rate mortgages by trading interest rate derivatives.
“Without commodity derivatives trading by hedge funds, airlines would find it more difficult to control the costs related to their fuel consumption,” he said.
James Barrett, director of Burges Salmon’s banking and finance team, even suggested that the label ‘shadow banking’ is a “misnomer” given the “increasingly prominent and legitimate role of non-bank provided financial services”.
But Barrett admitted that recent events like the collapse of Archegos have raised legitimate concerns around “the dangers of hidden leverage and maturity mismatches” in the non-bank sector and showed “potential for serious and systemic amplification risk”.
Too big to fail
Global assets in shadow banking have increased to $68 trillion from about $30 trillion in the immediate aftermath of the financial crisis, representing 14 per cent of global assets.
However, at just three per cent of banks’ total assets, S&P Global’s report suggests traditional banks are relatively well insulated from dangers in the sector.
The report also suggested that the growth of the shadow banking sector may slow over the coming year as higher interest rates will reduce shadow banks’ competitive advantage over traditional banks.
“If some of these smaller shadow banks fail, that’s okay”, Birry said, although he did caution that there are big discrepancies across countries and that some areas might require different forms of regulation.
But whether it be in commodities, the gilt market or somewhere completely unexpected, regulators will have to keep an eye on the shadows in 2023.
It seems they’ve got a tricky task on their hands.