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Shadow banking ‘increasing systemic risk’

Bank credit profiles have generally improved since the 2008-09 financial crisis, with increased capital and liquidity and more conservative underwriting standards. However, system-wide risk has not necessarily been reduced, warns Fitch Ratings.

In its newly-published report, Shadow Banking Implications for Financial Stability, the ratings agency cites shadow banking exhibiting notable post-crisis growth, driven by bank regulation, low interest rates, the favourable economic backdrop and the growth of financial technology.

The report warns that shadow banking’s ascension may signal growing systemic risks. These could include direct and indirect exposures faced by banks, insurance companies and pension funds, reduced financing availability for banks and non-financial corporate borrowers, and increased asset price volatility.

However, credit intermediation outside of the banking industry, assuming a level of transparency, can be positive if it provides additional sources of credit and liquidity to support economic growth. How shadow banking entities perform through the next credit cycle will determine whether this more diffuse – but less transparent and more lightly regulated – construct is more beneficial for the overall financial system versus the prior, more bank-concentrated model.

Recent growth

Shadow banking, or credit intermediation or liquidity transformation that takes place outside of banks, central banks, public institutions, insurance companies and pension funds, stood at US$52 trillion globally or 13.6% of total financial assets at year-end 2017, up from $30 trillion at YE 2010, according to the Financial Stability Board (FSB).

The US had the largest, albeit declining, share of shadow banking assets at $14.9 trillion, or 29%. This was down from 48% at YE 2010, with a compound annual growth rate (CAGR) of 0.8%, trailing the global CAGR of 8.3%.

Investment vehicles including open-end fixed income funds, money market funds (MMFs) and credit hedge funds have been the largest contributor to growth, at $37 trillion, or 71% of total shadow banking assets, as of YE 2017. However, forced asset sales or outsized redemptions could negatively affect asset prices and the broader financial system, particularly if the underlying assets are less liquid and/or the funds are materially levered.

Increased oversight

Fitch reports that globally, banks have modest direct lending and borrowing exposure to shadow banking, although they face indirect risks including interconnectedness and asset price volatility.

For example, Chinese regulators’ concerns over shadow banking interconnectedness with banks led to increased oversight in 2018, particularly focused on wealth management and trust products. In India, last September’s default of IL&FS Group, a major conglomerate that financed infrastructure projects, created broader funding pressures, leading domestic regulators to re-examine liquidity norms for the sector and prod banks to increase lending to, and asset purchases from, such entities.

In the US, the 15 largest banks have low loan exposure to non-depository financial institutions, with Wells Fargo the highest at $104.9 billion or 5.5% of assets at YE 2018. Asset-based financing can mitigate bank exposure to non-depository financial institutions, with advance rates offering downside protection to declining asset values.

Shadow banking growth rates have been higher in emerging market economies compared to developed market peers, driven by country-specific market developments and smaller asset bases. China and Argentina had the fastest growing shadow banking assets, with five-year CAGRs of 58% and 48%, respectively at YE 2017. 

The report notes that shadow banking growth is attracting increased country-specific and international regulatory scrutiny, but improvement has been incremental. A more comprehensive regulatory framework probably won’t exist beyond specific countries (for example China or India) or sub-sectors (such as consumer finance) unless and until necessitated by a market-wide shock correlated to shadow banking.

Fitch concludes that reducing shadow bank risk could be achieved through further direct regulation, more transparent financial reporting and limitations on asset/liability mismatches, among others. However, regulators would need to balance any such changes against the need for prudent expansion of capital and credit availability, particularly for under-banked and developing economies.

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