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Shadow banking is now a $52 trillion industry, posing a big risk to the financial system

Nonbank lenders, often called “shadow banks,” now have $52 trillion in assets, a 75% increase since the financial crisis ended.

  • The industry was at the center of the financial crisis when the subprime mortgage market collapsed.

  • Industry officials say shadow banks still face considerable regulation and can help provide buffers in times of stress.

 

Nonbank lending, an industry that played a central role in the financial crisis, has been expanding rapidly and is still posing risks should credit conditions deteriorate.

Often called “shadow banking” — a term the industry does not embrace — these institutions helped fuel the crisis by providing lending to underqualified borrowers and by financing some of the exotic investment instruments that collapsed when subprime mortgages fell apart.

The companies face less regulation than traditional banks and thus have been associated with higher levels of risk.

In the years since the crisis, global shadow banks have seen their assets grow to $52 trillion, a 75% jump from the level in 2010, the year after the crisis ended. The asset level is through 2017, according to bond ratings agency DBRS, citing data from the Financial Stability Board.

The U.S. still makes up the biggest part of the sector with 29% or $15 trillion in assets, though its share of the global pie has fallen. China has seen particularly strong growth, with its $8 trillion in assets good for 16% of the total share.

Within shadow banking, the biggest growth area has been “collective investment vehicles,” a term that encompasses many bond funds, hedge funds, money markets and mixed funds. The group has seen its assets explode by 130% to $36.7 trillion. It poses particular danger because of its volatility and susceptibility to “runs” and is part of the “significant risks” DBRS sees from the industry.

In his annual letter to investors, J.P. Morgan Chase CEO Jamie Dimon warned about the risks of shadow banking, though he said he does not see a systemic threat yet.

“The growth in non-bank mortgage lending, student lending, leveraged lending and some consumer lending is accelerating and needs to be assiduously monitored,” Dimon wrote in his letter.

Echoes of the crisis

The agency cited particular risks from the practice of borrowing short-term and lending long-term, a practice called “maturity intermediation” that helped doom Lehman Brothers and shook Wall Street to its core. In addition, it identified issues with liquidity, leverage and credit transformation, or investing in high-risk high-return vehicles, which can include leveraged loans.

“The exposure of the global financial system to risk from shadow banking is growing,” DBRS said. “Weaknesses in these shadow banks arising from these activities could result in runs that could instigate or exacerbate financial market stress.”

To be sure, industry advocates stress that its institutions still face substantial regulation and have become better capitalized in the days since the crisis. They cite the importance of the industry in providing financing to borrowers who can’t go to traditional banks.

In its analysis, DBRS noted as well that the collective investment vehicles actually help provide buffers against market stress so long as outflows are contained. Moreover, the low interest rate climate that has pervaded the world as central banks look to keep financial conditions accommodative has helped mitigate downside risks.

Still, the sheer size of shadow banking and its peers in the nonbank financial industry poses potential risks should those ideal conditions change.

Nonbank financials, which also include insurance companies, pension funds and the like, have grown 61% to $185 trillion. Traditional bank assets have increased 35% to $148 trillion during the same period.

DBRS identified three specific risks that shadow banks pose under times of market stress: That they are “not structured” to deal with periods of low liquidity and heavy withdrawals; a lack of experience in dealing with periods of weakening credit conditions, and a lack of earnings diversification that would hurt them when parts of the markets deteriorate.

Fixed income is at particular risk within the collective investment vehicle space, with its $10.6 trillion in assets.

“A sharp rise in rates would impose sizable mark-to-market losses and diminish fund returns,” DBRS said. “In some circumstances, this deterioration in performance might result in large investor outflows and greater potential for forced asset sales. Such outflows might spill over into other funds and the markets more broadly.”

Courtesy : CNBC

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