Opinion
The multitrillion-dollar threat that could spark another financial crisis
Stephen Bartholomeusz
Senior business columnistEver since the 2008 financial crisis, financial regulators have been concerned about the rate of growth in the non-bank, or shadow banking, sector and the risks that growth might pose to financial systems.
Even as regulators have toughened and tightened their regulation of banks, they’ve tended to see the non-bank participants in the system as something quite different and as a sector that distributes risk more widely and therefore lowers systemic risks.
Since 2008, the non-bank financial sector has grown significantly, to the point where it now holds more than 50 per cent of the world’s financial assets.Credit: AP
Last week, the Federal Reserve Bank of New York published a series of blog posts on the interconnections between the regulated banking system and the less regulated (or effectively unregulated) non-banks. They concluded that non-banks pose an increasing risk to America’s big banks.
Since 2008, the non-bank financial sector has grown significantly, to the point where it now holds more than 50 per cent of the world’s financial assets. That’s not surprising, given that the post-2008 prudential regulation of banks intended to drive them out of riskier lending, which pushed a lot of activity that used to be conducted by banks into the shadow banking sector.
It used to be that corporate loans and mortgage loans were held on banks’ balance sheets. Increasingly, however, because of the higher capital requirements of supporting those loans, they are being held by non-banks.
The private credit market, the short-term funding market and the funding of derivatives, where banks used to play the central role, are now dominated by non-banks.
At face value, it might appear that pushing these activities into the non-bank sector lowers systemic risk. The NY Fed economists, however, posit that the risks to banks have been transformed from exposure to loans to exposures to non-bank balance sheets.
Non-banks may have displaced banks as the intermediaries for higher-risk financial activity, but banks have acquired indirect exposures to those same activities by funding the non-banks, whether it’s loans to private credit companies, or collateralised loans to real estate trusts, warehouse financing, credit lines or commercial paper.
Where for, say, mortgages, the risks of mortgage origination and servicing have been shifting to non-banks, the banks are providing the funding for the non-banks to make or buy mortgage loans that are then securitised, or bundled together, and on-sold to investors.
The exposure to the risks in the process has been shifted from a direct exposure to an indirect one but the risks remain.
The Biden administration in the US has, despite fierce opposition from the non-bank sector, reversed some of the Trump-era deregulation to make them subject to prudential standards.Credit: Bloomberg
Before the 2008 financial crisis, most derivative transactions were bilateral deals, with a non-bank on one side and a bank on the other. In response to the crisis, regulators mandated that most derivatives should be centrally cleared, so the non-banks now deal via clearing houses.
To meet the initial and prospective margin calls by those clearing houses, however, the non-banks need contingent liquidity – access to cash – which is provided by banks in the form of lines of credit.
As the NY Fed researchers say, that transforms the risks for the banks from counterparty risk to liquidity risk.
Thus, they say, the activities and related risks of banks and non-banks remain “intimately connected” – they describe the relationship as “symbiotic” – even as banks have withdrawn from direct participation in some financial activities. The risks haven’t migrated from the banking system but have been repackaged.
The core concept behind the post-2008 regulation is that some banks are too big to fail, and therefore the prudential regulation needed to be bulletproof. Conversely, non-banks could – and would be – allowed to fail without any intervention by regulators or taxpayers.
That’s even though there are now a lot of non-banks that look quite similar, in terms of what they do, to banks or, at least, segments of what banks do.
The NY Fed researchers say the correlation of bank and non-bank sector-wide risk has risen from about 65 per cent pre-financial crisis to more than 80 per cent.
The interconnections between banks and non-banks and the similarity of their assets could, the researchers say, turn out to be an important source of severe market disruptions, driven by asset pricing dislocations if non-banks were forced to dump assets to generate liquidity.
If, for instance, an asset manager – a fund manager, hedge fund, large REIT or exchange-traded fund, for instance – were to experience forced sales of its assets, perhaps because of some shock to the real economy, they might have to dump Treasury bonds, and/or corporate bonds or real estate to generate liquidity.
That would have flow-on effects to other non-banks and banks’ balance sheets.
In 2022, when then-UK chancellor Kwasi Kwarteng announced massive unfunded tax cuts and a cap on energy prices, the UK bond market melted down.
The UK pension sector, which was a heavy user of derivatives, was almost destroyed as interest rates spiked and bond prices plummeted and the funds, hit by margin calls, were forced to dump their bond holdings at heavy losses.
That had flow-on on effects to the banking sector, not only because banks were counterparties to the derivate transactions but because the plunge in UK government bond prices impacted their own balance sheets and liquidity.
The growth of shadow banking is a growing risk to some of the world’s biggest banks.Credit: Bloomberg
A major factor in the Bank of England’s intervention, and the UK government’s policy backflip, was a concern that bank lending would dry up and the crisis for pension funds would morph into a banking and economic crisis.
The NY Fed refers to the potential for similar events in future as “spillover risks”.
The increased reliance of non-banks on banks for funding could, the researchers say, result in “vectors of shock transmission and amplification, forcing authorities to intervene and do so en masse”. The extent of market disruptions could be, they say, severe.
They conclude that the systemic risk generated by the increased interdependence of banks and non-banks means that effective regulation and systemic risk surveillance require a holistic approach to the financial system that recognises that interdependence.
The Biden administration in the US has, despite fierce opposition from the non-bank sector, reversed some of the Trump-era deregulation to give itself the ability to identify and investigate non-banks and designate them as systemically important and therefore subject to prudential standards. (That shift towards greater scrutiny of non-banks might not, of course, survive if there’s another Trump administration.)
If it is accepted that the interconnections and exposures of banks and non-banks are significant and growing, then the arguments for limited, if any, regulation of non-banks are quite thin.
At the very least, regulators will need to ensure that those connections and their implications in the event of an economic shock or market disruption are properly recognised and understood so that they can adapt their regulation of banks and, perhaps, extend some level of regulation to the bigger non-banks.
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