Shadow banks: S&P warns higher borrowing costs risk contagion of ‘financial instability’
Risks to financial stability “could emerge from the shadows”, according to a report from S&P Global Ratings.
The report found that higher interest rates may put pressure on the highly leveraged shadow banking sector.
While traditional banks have limited exposure to shadow banks, the wider financial system could face “indirect” risks of contagion if large shadow banks were to rapidly deleverage, the report warned.
“Shadow banks operating with high leverage, running structural liquidity mismatches, or taking significant asset-quality risk could face financial pressure, particularly if their economies enter recessions,” S&P Global Ratings credit analyst Nicolas Charnay said.
The report found that some shadow banks continued to operate with limited transparency and oversight compared to traditional banks. This can mean less prudent risk-management practices and large losses at times of market volatility.
Additionally, shadow banks cannot access emergency central bank funding in times of stress and it is unlikely governments will use public money to bail out a shadow bank.
The report argues public authorities have “limited tools to mitigate contagion risks”.
Assets in shadow banking have increased to $68trn from about $30trn in the immediate aftermath of the financial crisis, representing 14 per cent of global assets.
But the report also highlights that the sector is set to slow as higher interest rates make it more difficult for financial institutions to access capital.
“Tighter funding conditions and weaker macroeconomic conditions will likely undermine shadow banks’ competitive advantages over traditional banks in 2023, ending several years of robust growth,” Charnay added.
Shadow banks have increasingly become an area of concern among regulators with risk migrating from the more stringently regulated traditional financial sector.
At Davos last month, Colm Kelleher, chair of banking giant UBS, said regulators had “taken their eye off the ball” when it came to shadow banks.
At the same event François Villeroy de Galhau, governor of the Bank of France said “the greatest challenge today is non-banks” and that on shadow banks, the world’s regulators “lag behind”.
What are shadow banks?
Shadow banks include a variety of financial institutions which provide similar services to banks but without equivalent regulation.
They do not take deposits, instead generally relying on short-term funding. However, they still perform the same intermediary function between borrowers and lenders that banks do.
Examples include hedge funds, private equity firms, money market funds and special purpose entities.
Backers say shadow banks have contributed to a more diverse financial system. Critics allege they have have increased risk in the system because they are not required to hold the same ratio as capital against their lending as traditional banks have to.