The shadow banking system, a less-regulated sector of the financial industry, has been a topic of increasing concern in recent years. It has been described as a ticking time bomb by many experts and as a potential threat that could have far-reaching implications for the global financial system. To this effect, the European Central Bank (ECB) has been warning about the risks of shadow banking since 2021, with the latest warning issued in July 2024.
What is shadow banking?
Shadow banking is a part of the financial world that includes credit and lending activities by institutions that aren’t traditional banks. These institutions aren’t regulated like traditional banks and don’t have access to central bank funding or public sector credit guarantees. They are often known as non-bank financial companies (NBFCs) and can operate with little to no oversight from regulators.
They play a key role in the economy by providing credit to those who may not have access to traditional banking services.
Some examples of shadow banks include hedge funds like UK-based Capula Investment Management and Man Group, and Bridgewater Associates, private equity funds, such as Aleph Capital Partners and Alteri Investors, mortgage lenders, such as Barclays and Nationwide in the UK, and Bank of America and Wells Fargo in the USA, large investment banks, including HSBC, JPMorgan Chase, and Goldman Sachs, and finance companies, such as Lloyds, Visa, and Mastercard. To name but a few.
It’s important to note that while these activities are not inherently bad, the lack of regulation and oversight can lead to risky financial practices.
The ECB’s warnings
The ECB has handpicked shadow banking as a credible risk due to its potential to destabilize the financial system.
The latest warning was issued by Elizabeth McCaul, a member of the ECB’s Supervisory Board, in an interview on July 10.
The ECB is concerned about the growing size of the shadow banking sector, which held assets worth $46 trillion in 2022, compared to $41.1 trillion for traditional lenders. The industry’s growth since the global financial crisis had been “remarkable” and “something that always worries us,” McCaul told the FT.
One of the main worries of the ECB about the shadow banking sector, besides its growing assets, is that financial information is not transparent enough, creating gaps in data that hide potential risks — like ‘black holes’ that make it hard for regulators to monitor and control financial dangers. This lack of transparency can lead to situations like the 2008 financial crisis, where hidden risks suddenly surfaced and caused widespread damage.
The ECB also cited, among others, that shadow banks, as unregulated financial intermediaries that operate outside the traditional banking system, can exploit regulatory gaps. This exploitation can lead to excessive credit creation and high-risk lending, posing significant risks to the financial system.
Just a day before McCaul’s comments, on July 9, Jose Manuel Campa, the Chairman of the European Banking Authority (EBA), sounded some similar warnings, expressing his concern over the swift growth of the shadow banking sector, highlighting that it lacked transparency. This, he warned, could lead to issues that might spill over into the wider financial markets. He mentioned that the regulatory body is contemplating the introduction of reporting requirements for non-bank financial institutions.
Notably, too, the Financial Stability Board (FSB) and IMF have—at different times recently—equally lent their voices to this blossoming ‘threat’ to financial stability vis-a-vis shadow banks.
The shadow banking system could affect the stability of the global financial system in several ways, as two recent failures in shadow banking show.
The collapse of Bank of Credit & Commerce International (BCCI), the seventh largest private bank in the world with over 400 branches in 78 countries with assets in excess of US$ 20 billion, was unarguably one of the largest shadow banking failures in human history. The Bank of England announced that BCCI might never have been profitable and closed it down in July 1991, with liabilities of $14 billion, later reduced to $10 billion. Its collapse caused over 6,500 depositors to lose their money.
In March 2023, Silicon Valley Bank and Signature Bank collapsed, marking the second and third-largest bank failures in U.S. history. A third bank failure occurred in October 2023: that of Almena State Bank. Three more banks failed in 2023 but have since been reacquired in an auction: First Republic Bank in May, Heartland Tri-State Bank in July, and Citizens Bank of Sac City in November.
Note that, although these banks had some characteristics of shadow banking, they were regulated entities. Still, these examples point straight to the systemic risks posed by the shadow banking system.
If shadow banking keeps growing, it could make it more expensive for banks to borrow money, which would cut into their profits and limit the credit they can offer to businesses and individuals. This could reduce the availability of financing for both banks and companies, making it harder for them to operate. Shadow banking activities could also lead to bigger swings in asset prices, making the financial system more unstable.
Furthermore, if the financial system becomes more fragmented, it could increase volatility and make it harder for investors to spread risk across borders. And if risks aren’t properly separated, it could slip under the radar of managers and regulators, forcing banks to cut back or even stop lending altogether.
Above all, these all stress the urgent need for increased regulation and oversight to prevent future crises. The shadow banking system’s potential to destabilize the financial system calls for a comprehensive review of existing regulations and the development of new ones to address these risks effectively.
What’s the way forward?
While the shadow banking system poses significant risks, it also plays a crucial role in the financial system by providing credit to those who may not have access to traditional banking services. Therefore, the goal should not be to eliminate shadow banking but to effectively manage its risks.
Regulators, therefore, need to strike a balance between ensuring financial stability and fostering financial innovation.
Like a double-edged sword, over-regulation could stifle innovation and limit the benefits of shadow banking, while under-regulation could lead to financial instability.
Andrea Enria, the ECB’s top banking supervisor, warned that non-bank financial institutions’ activity could pose a risk to the financial system, saying “The rapid expansion of these entities’ activities raises the question of how some should be regulated and supervised.”
Technology has supercharged the growth of shadow banking by enabling fintech companies to offer alternative lending platforms that operate outside the traditional banking system. However, technology can also be a part of the solution by making shadow banking more transparent and secure, particularly through blockchain technology. By using a decentralized ledger, blockchain can help track and verify transactions, reducing the risk of fraud and bringing much-needed clarity to the shadow banking world.
Educating consumers about the risks of shadow banking is also important. Consumers need to understand that while shadow banking can offer higher returns, it also comes with higher risks.
Overall, these measures require concerted efforts from regulators and policymakers worldwide to ensure the stability of the global financial system.
The future of shadow banking is uncertain. On one hand, it provides a valuable service by offering credit to those who may not have access to traditional banking services. On the other hand, the lack of regulation and transparency poses significant risks to the global financial system.
In the end, the goal should be to create a financial system that is inclusive, transparent, and stable. A system that serves the needs of the people, without putting the global economy at risk. And that, indeed, is a challenge worth taking on.
Author: Richardson Chinonyerem
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