Home Banking Global Shadow Banks Face Scrutiny as Risks Rise

Global Shadow Banks Face Scrutiny as Risks Rise

by internationalbanker

By Nicolas Charnay, Managing Director & Sector Lead for European FIs, and Mehdi El Mrabet, Associate Director, Financial Services Ratings, S&P Global Ratings

 

 

 

In this article, we will examine three key takeaways regarding the contributions of shadow banks to economies and the risks they pose to traditional banks:

  • Shadow banks play an important role in credit intermediation in many countries, enhancing financial markets’ efficiency and depth but also bringing meaningful risks.
  • Shadow banks’ concentration in certain economic sectors, among other characteristics, means they are not immune to economic and interest-rate cycles. We, therefore, expect their financial positions to come under stress periodically.
  • Traditional banks’ exposures to shadow banks are not as limited as they first appear. How banks and regulators review and manage their direct and indirect exposures to shadow banks is an area to watch in 2024.

Growth in global financial assets held outside the banking system in nonbank financial institutions (NBFIs) has been a key feature of the past decade. Shadow banks, a subset of institutions within the NBFI sector, held about $63 trillion in financial assets in major global jurisdictions at end-2022 according to the Financial Stability Board (FSB), representing 78 percent of global gross domestic product (GDP), up from $28 trillion and 68 percent of global GDP in 2009. In 2024, the lagged effects of past rate hikes will likely constrain economic growth and tighten funding conditions, clouding the outlooks for both banks and NBFIs. That said, S&P Global Ratings’ economists expect policy rates in major jurisdictions to trend down from mid-2024, which should support financing conditions generally and NBFIs specifically.

We rate 233 entities that fall under the broad umbrella of NBFIs globally. Financial market infrastructures (FMIs) tend to sit at the higher end of the rating scale, while many securities firms and financing companies (fincos) have either low investment-grade or speculative-grade ratings. Our outlooks for the various NBFI subsectors reflect their differing exposures to economic and rate cycles.

Shadow banks are a meaningful source of credit in some countries 

Within shadow banks, fixed-income funds account for the majority of assets, followed by fincos, broker-dealers and structured-finance vehicles. In most major European jurisdictions, shadow banks tend to represent less than 10 percent of total assets, reflecting the dominance of bank funding. In North America, we see more financial diversification, with shadow banks representing more than 10 percent of financial assets. In Asia-Pacific (APAC) and Latin America (LATAM), we see a more mixed picture, with shadow banks being relatively important funding sources for economies. In these countries, investment funds tend to dominate less, and fincos or broker-dealers play a significant role. In Japan, broker-dealers represent a material share of shadow banks’ assets, and their activities have expanded recently, mainly reflecting the increases in short-term repo transactions on both the asset and liability sides.

Shadow banks provide meaningful sources of alternative finance in several countries—for instance, by offering solutions to fund long-term assets with matching liabilities. They can also improve the efficiency and depth of a financial system by holding assets with maturity structures and credit characteristics that may be unattractive to traditional banks.

Private credit is a relatively small but fast-growing segment of the shadow-banking sector

With an estimated size of $1.3 trillion globally, private credit is growing quickly, mostly in the United States and certain segments of corporate lending. Alternative-asset managers, through the private credit funds they raise, and business-development companies, which are mostly under external management, have become significant and growing competitors in recent years, particularly for commercial speculative-grade and structured credit. They have brought liquidity and customized solutions to credit markets, but they have also helped fuel high leverage among many US businesses.

These institutions have increasingly positioned themselves as alternatives to other funding sources—most notably, the broadly syndicated loan market and high-yield debt markets. Facing limited prudential regulations, they compete on terms, structure and execution, offering one-stop solutions to many borrowers. They have taken on a variety of assets, most notably leveraged loans, but also various types of senior and subordinated, secured and unsecured, unitranche, distressed, and highly structured and complex assets.

Risks to shadow banks are on the rise, leading to increased regulatory scrutiny

As shadow banks are involved in credit intermediation in a similar way to banks, they are exposed to bank-like risks through this intermediation. These risks fall into three main categories: credit, liquidity and leverage. Shadow banks’ relative exposures to these three risk categories vary significantly due to the diversity of their business models. Moreover, we believe the risks facing shadow banks are on the rise amid tighter financing conditions.

Global regulators recognize growing leverage, coupled with certain players’ use of short-term and synthetic forms of leverage, as a policy issue. This will likely lead to some policy recommendations that seek to reduce excessive leverage in 2024. Bodies such as the FSB and the International Organization of Securities Commissions (IOSCO) have already put the risks in investment funds at the top of their policy-making agendas. In 2023, these bodies adopted two important policy recommendations relating to the micro-prudential treatment of liquidity risks in open-ended investment funds.

In particular, the FSB recommended that open-ended investment funds be categorized by the types of assets they hold, from less to more liquid, and be subject to specific expectations regarding their redemption terms and conditions, depending on the assets’ liquidity. This will mitigate the risks of structural liquidity mismatches between open-ended investment funds’ assets and liabilities.

Complementary to that, the IOSCO recommended that open-ended investment funds use appropriate liquidity-management tools to mitigate investor dilution and potential first-mover advantages—that is, situations in which investors have a financial incentive to exit a fund first in stressed conditions. These recommendations will now need to become national regulations.

In China, the size of the shadow-banking sector as a proportion of the system peaked in 2017 and has declined ever since due to a continuing regulatory crackdown. These regulatory efforts include an extensive overhaul of the asset-management sector, banning NBFIs from serving as banks’ lending channels and significantly reining in loan-like products issued by NBFIs. For example, the trust industry’s property exposure dropped to 4.5 percent of trust assets under management (AUM), or RMB1.0 trillion, as of the third quarter of 2023, from its 2019 peak of RMB2.9 trillion, or 13 percent of assets under management.

Financial linkages between banks and shadow banks appear deceptively limited

Banks’ balance-sheet exposures to shadow banks appear limited, representing 1.8 percent of total bank assets at end-2022. Similarly, funding from shadow banks accounted for only 2 percent of banks’ total assets in 2022, according to the FSB. But we believe that there is more to this than meets the eye. First, global aggregates hide potential concentrations of risk exposures at certain banks. Second, linkages can take less easily observable forms, such as exposures to derivatives. More broadly, shadow banks’ significant presences in certain economic sectors or countries can make them systemically relevant.

In 2024, the Bank of England (BoE) will run a system-wide exploratory scenario exercise to better understand the behaviors of banks and nonbanks under stress conditions and how these financial linkages could play out in a crisis. With more than 50 participants, including banks, insurers, central counterparties, pension funds and investments, the results of this analysis will be an important source of intelligence for regulators and may lead to further regulatory actions.

Unlike traditional banks, shadow banks cannot access emergency central-bank funding. Should contagion occur, central banks could still intervene in financial markets, but we expect the bar for such intervention to be very high, meaning that contagion risks to banking systems would need to be imminent and severe. We do not see the failures of most shadow banks or the broad deleveraging of the shadow-banking sector as likely to meet that bar. For traditional banks, this means they must carefully manage the risks emanating from their business dealings with shadow banks, in keeping with supervisory authorities’ insistence on the need for banks to manage their counterparty credit risks carefully.

Although we are mindful of the contagion risks that shadow banks pose to traditional banks, we don’t see them as a major negative-rating driver for traditional banks but rather as a source of risk. We believe banks have increased their financial resilience to shocks, including those potentially stemming from shadow banks.

This report does not constitute a rating action.

 

 

ABOUT THE AUTHORS
Nicolas Charnay is a Managing Director and Sector Lead in S&P Global Ratings’ Financial Services Ratings team. As the Chair of rating committees, he also oversees the analytical activities for major European banks. Before joining S&P Global Ratings in January 2022, Nicolas was an Advisor in banking supervision at the European Central Bank.

Mehdi El Mrabet is an Associate Director on S&P Global Ratings’ Financial Services team. He joined S&P Global Ratings in 2015 and has contributed to several research commentaries on global trends and industry-related topics. Mehdi holds a Master’s degree in Economics and Finance from Paris Dauphine University.

 

 

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