S
OME would argue that predicting the next financial crisis is a near impossible task. But Nobelprize winning economist
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
Near the end of last year the
ON THE LOOKOUT Despite these concerns, some financial watchdogs have been criticised for falling behind on regulating the shadow banking sector.
At
Regulators in the
'Market-based finance' (MBF), the term most regulators use for shadow banking, was a prominent topic in the
At the end of 2021, MBF accounted for £776bn, about 55 per cent of all lending to
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."
RISKY BUSINESS 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
Analysts at
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
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
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."
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.
"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," Nicol said.
Private credit funds maintained or even increased lending during periods of market uncertainty such as the Covid-19 pandemic and the invasion of
"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, Nicol 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.
But Barratt 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
However, at just three per cent of banks' total assets,
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.
Regulators can't use a one size fits all policy for regulating non-banks
(c) 2023 City A.M., source