In the 2008 crash, unregulated financial institutions—structured investment vehicles, asset-backed commercial paper issuers, securitisation structures, money market and hedge funds—contributed to global instability. In the aftermath, regulators promised to control these ‘shadow banks’, which themselves prefer to be known by the less pejorative terms market-based finance or non-bank financial institutions. But it didn’t happen.
Shadow banks’ share of global financial assets in 2022 was around 47 percent, up from 25 percent in 2007-08, compared to conventional banks’ 40 percent. And the phenomenon is global.
While some structures have declined or disappeared, others have prospered and new ones appeared. Today, the shadow banking complex is dominated by asset managers such as insurance companies, pension funds, non-bank financial companies, and collective investment vehicles (funds, investment companies or partnerships, hedge funds) who invest client funds in public and private equity, debt, or hybrid securities. Other examples include securitisation vehicles which repackage existing obligations into new securities with different characteristics and various quantitative or multi-strategy trading firms. There are also specialised microloan organisations, trade financiers, asset based lenders (providing leasing, secured loans or receivable finance), payday lenders as well as pawn shops and loan sharks. China has a particularly wide range of shadow banks providing wealth management products, trust loans, entrusted loans, and undiscounted bank acceptance bills.
There are commonalities within these disparate operations. They intermediate capital flows between investors (retail, high-networth individuals, family offices, institutions, and sovereign investment vehicles) and businesses. They trade in financial markets using a variety of strategies to profit from buying and selling financial instruments. Most importantly, there is limited regulation relative to that applicable to banks, because they theoretically do not take deposits from the general public and are not part of the payments system.
The current regulatory concerns about the sector are disingenuous as policymakers’ actions underlie their growing role. Stricter bank regulations, such as the Basle 3 accord agreed after 2008, restricted or raised the cost of certain types of lending, especially to smaller enterprises, real estate companies, and projects. This allowed shadow banks to expand to meet the credit needs. The prolonged period of low rates between 2008 and 2021 simultaneously encouraged investors to seek better returns in an ever-mutating investment universe. In Asia, non-performing loans of banks made it difficult for them to meet loan demand. Differences in capital, leverage, and liquidity requirements drove regulatory arbitrage.
The effects of policy are subtle. Securitisation thrives, in part, because the US Federal Reserve, the Bank of Japan, the Bank of England, and the European Central Bank hold 16, 53, around 27, and over 30 percent of their outstanding government debts. Highly-rated securitised debt meets the demand for safe assets and as collateral for secured loans.
Interestingly, regulated banks have benefitted from the growth of the shadow banks. They have refocused their business models on the ‘moving’ rather than the ‘storage’ business. Banks can now ‘sweat their capital’ more effectively, increasing return on shareholder funds by underwriting and distributing loans assets to funds and insurers. For central banks, this increases the velocity of money within the economy.
Circumventing limitations on proprietary position taking, many banks now set up former star in-house traders in external hedge funds. The primary benefit is income from trading financial instruments with the now off-balance-sheet operation and supplying services such as clearing and custody. Banks also provide significant leverage to these vehicles in the form of loans secured by assets or unfunded derivative structures. The substantial profits from prime broking (the terms for these services) testify to the opportunity.
Banks sometimes receive returns on their investments in these funds. Their wealth management or private banking units can offer investments in or products structured by these external entities.
Shadow banks have profoundly altered the financial system and pose poorly understood risks. They allow difficult-to-measure increases in debt levels, which can exacerbate price bubbles across multiple asset classes.
The higher returns offered to investors suggest that shadow banks take greater risks. With bank lending concentrated on more secure borrowers, non-banks maybe extending credit to lower-rated debtors or against riskier assets. Shadow banks frequently enhance yield using leverage at levels higher than that by regulated institutions. There is also heavy reliance on the flawed system of collateral to support credit risk. All this creates potential problems in the event of an economic or financial downturn.
The difficulties are exacerbated by the lack of permanent loss-absorbing capital, because many shadow banks are funds which pass-through investors’ money. There are concerns around liquidity and redemption risks. To maintain returns, most shadow banks must remain fully invested, leaving limited cash buffers. Given the significant asset-liability maturity mismatches and holdings of illiquid assets that offer higher yield, unexpected large investor withdrawals can lead to sudden pressures to raise cash.
Policymakers ignore the connections between regulated entities and their shadow counterparts. They believe that problems in the non-bank sector can be isolated and prevented from infecting banks, thus avoiding unpopular interventions and bailouts using public funds. The failures of Greensill Capital and Archegos, which were factors in the demise of Credit Suisse, demonstrate a different reality. Risks are compounded by the opacity and complexity of these entities.
The most draconian regulatory response would be to strictly quarantine shadow banks. Regulated entities’ dealings with them would be covered with 100 percent cash collateral to minimise exposure. Rigorously enforced prohibitions on bailouts would minimise moral hazard.
A less onerous approach would be oversight and regulation based around function rather than legal form. It would allow greater nuance and flexibility in dealing with differences between entities, their activities, and risk profiles. Based on the type of activity, minimum capital requirements, maximum leverage, and maintenance of enough liquidity to meet potential redemptions would be mandated. Reliance on short-term funding would be constrained. Vetted sponsors would need to meet prescribed standards of capital, skill, and governance. Bank exposures to non-bank institutions, either for lending or other dealings, would be controlled. Appropriate protection and disclosure would be instituted.
But the fear of a large contraction of credit availability and the lobbying strength of the financial sector mean any meaningful regulation is unlikely. It highlights the lack of appetite for reducing debt or changing a borrowing-driven economic model. In the next financial crisis, shadow banks will again exaggerate asset price falls, increase volatility, and be a source of financial instability.
Satyajit Das | Former banker and author
(Views are personal)
