Shadow Banks pose significant risk to the future stability of the global financial system
20 April 2017 Press Release
Sleep walking into the next financial crisis is not a viable option
TORONTO, Apr. 20, 2017
Shadow banks - non-bank lenders and other financial intermediaries that operate outside the realm of banking regulation - are putting consumers, investors and the overall financial system at risk, warns a paper published today by the Global Risk Institute.
The study notes that despite regulatory reforms in the wake of the 2007-2009 financial crisis, or perhaps because of them, non-bank entities continue to grow and innovate.
Growth in the non-bank sector has been significant. The Financial Stability Board estimates that shadow banks around the globe had US$36 trillion in assets at the end of 2014, or more than a quarter of the traditional banking industry.
The paper, Shadow Banking: Non-bank Credit Intermediation Heightens Risks for Global Financial System, is authored by Sheila Judd, executive-in-residence at the Global Risk Institute. It examines the world’s shadow banking sector in terms of both the benefits and risks it presents to the global financial system.
The study acknowledges that shadow banks provide more sources of liquidity, thereby supporting economic growth and diversifying risk across the financial system. However, because these entities are not subject to the same regulatory standards and safeguards for capital, liquidity or leverage that protect the banking system, they can take on much higher levels of risk.
The paper highlights concerns about non-bank consumer lending and auto finance, where innovative lenders are providing loans that make already stretched consumers more vulnerable to interest rate increases and any disruption in their incomes. Many borrowers have sub-prime credit ratings, putting them at even greater risk.
In addition, the lenders themselves can also take on more debt, making them more vulnerable to a rise in borrower default rates. The paper questions whether borrowers are sufficiently aware of the risks, including the risk of a forced asset sale if they default, or if their lender goes under and they cannot find financing from other sources.
The paper also raises concerns about the growing array of credit-related investment products on offer. Enticed by the promise of relatively high returns, unsophisticated investors may not understand that their capital is at risk, or that some of these products are not readily redeemable.
On a broader front, the study draws attention to specific markets where shadow banking activities are concentrated.
China is one area to watch. The country’s seemingly insatiable demand for credit, together with stringent controls on traditional banks, has fueled the growth of the shadow banking sector. China’s shadow banking assets have soared from 2% of the global total in 2010 to 7.7% in 2014, giving it the third largest shadow banking sector after the U.S. and the U.K. Observers have raised concerns about the quality of the loans and the value of underlying assets. If asset values fall and the loans go bad, lenders and investors could suffer material losses, with a ripple effect on non-bank activities around the globe. Such a setback would also dampen China’s economic growth, with contagion effects for the global economy.
The study notes that in the U.S., which is home to about 40% of the world’s shadow banking assets and some of the largest non-bank financial firms, the Federal Reserve no longer has the legal authority to act as lender of last resort to firms outside the banking system. Other reforms that would loosen financial regulation are also being considered.
Sheila Judd, the study’s author, says that while regulators are keeping an eye on the sector, the breadth and innovative nature of shadow banking presents numerous challenges. Regulators may be reluctant to impose the same rules on banks and non-banks, fearing that such a move will stifle the shadow banks’ contribution to credit liquidity and risk diversification, and perhaps even sound their death-knell. On the other hand, she cautions that we should not ignore the threat that shadow banks pose to borrowers, investors and the broader financial system.
“At a minimum, we need transparency standards that shine a brighter light on the risks facing consumers who borrow from non-bank lenders, and better disclosure for those investing in the growing array of credit-based investment products.” says Ms. Judd. “And a basic liquidity requirement that would apply to shadow banking entities over a designated size would be a good starting point to mitigate the broader systemic risks.”
The study calls for regulators around the globe to adopt basic protections without delay while they consider a more complete, consistent and robust framework. After all, no one wants to be caught sleep-walking into another financial crisis caused by the shadow banks.
The full study can be found on the GRI website.
About GRI: The Global Risk Institute is the leading forum for ideas, engagement and building capacity for the management of risks in financial services. We are a non-profit, public and private partnership with 32 government and corporate members from asset management, banking, insurance and pension management. The institute’s goal is to develop fresh perspectives on emerging risks, to engage members, and to enhance risk-management skills. Our activities support academics, corporations, policy makers and regulators. We take a global view of the risks facing the financial services industry from our base in Toronto, Canada.