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How the Shadow Banking System Became the Reference Market

The total amount of credit provided by non-banks already exceeds $100 trillion and poses some overlooked systemic risks. This has real consequences for long-term investors.

Myret Zaki
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Within a decade, the «shadow banking system», which refers to credit activities provided by non-bank financial intermediaries, has become the norm in the financial world. Non-banks have largely taken over lending activities from banks. Today, players such as investment funds (fixed income funds), private equity firms and structured finance vehicles play the role of banks by extending loans directly to companies, except with much less regulatory oversight than banks.

The Covid-19 crisis is accelerating this trend. According to the «Wall Street Journal», the giant fund Apollo Global Management has created a $12 billion platform that will grant loans of around 1 billion directly to firms.

About 80% of credit is now provided by non-bank players in the U.S. While this can be a welcome source of alternative funding and liquidity, we increasingly tend to forget that shadow banks or the shadow banking system carry considerable systemic risks. It is much less regulated than banks, and with even more crash transmission channels.

The taming of the Financial Stability Board

These risks have been duly pointed out every year by the G20 Financial Stability Board (FSB). Initially, the tone of the report was risk-averse, laden with heavy regulatory and surveillance language, as the traces of the 2008 financial crisis were still present. But in recent years, the tone of the report has softened, and the focus is more on narrowing definitions and euphemizing risks.

The real deal was spelled out in the first 2011 report. The FSB back then was quite ambitious in terms of regulating shadow banking entities. It estimated the size of global shadow banking at $67 trillion, 35% of which based in the U.S. The size then went to $89 trillion in 2014, which surpassed the world’s GDP.

After that, the report started undergoing some tidying up. In 2015, the FSB came out with a new «narrow measure», explaining that this one only took into account credit which directly involved systemic risks, and placing its size at $34 trillion (even this narrow measure today exceeds $50 trillion). The FSB report has since put forward the narrow measure almost exclusively, and the figure based on the initial (wider) measure is more difficult to find in the 2019 report.

A mountain of more than $114 trillion

I still tracked it year by year, because in the FSB’s own definition, it is the one representing «credit intermediation involving entities and activities outside the regular banking system», involving maturity and liquidity transformation, leverage, imperfect credit risk transfer, and typically relying on short-term funding from markets, such as through repurchase agreements (repo) and asset-backed commercial paper.

That measure went from $89 trillion in 2014 to $114 trillion in the latest 2019 report. Of course this volume of non-bank debt has been sustainable only because interest rates have been close to zero percent ever since.

In 2018 came some further embellishment. The FSB report started by praising non-bank financial intermediation as a «valuable system», before pointing out the risks. The pejorative term «Shadow Banking System» disappeared completely from the title and was replaced by «Non-bank financial intermediation».

After that, at venues such as the World Economic Forum in Davos, as well as in the financial press, the term «shadow banking» became only reserved for China, although the bulk of these activities takes place in the U.S.

But changing a name won’t change the rapidly growing amount of risks involved. How did we get to that point?

Bankers profess a bubble logic

After 2008, U.S. and European banks became subject to higher capital requirements. Their balance sheets could no longer bear the cost of as much credit risk as before the 2008 crisis. So credit activity quickly migrated to the shadow banking system. It was largely taken over by less regulated financial intermediaries, such as investment funds, private equity, hedge funds, all kinds of non-bank vehicles, non-regulated structures of regulated banks, as well as peer-to-peer platforms, all the way to today’s blockchain-based decentralized finance (DeFi).

It was a kind of political compromise in which authorities had to strike hard against banks but stopped short of stifling the giant market-based credit business. The latter does represent a good alternative to banks, but it comes at a high cost: permanent 0% interest rates and central bank refinancing, to prevent the system from toppling.

In 2016, I wrote a book titled «The Shadow Banking System Takes Control» (published in French), in which I described – what was then $89 trillion – an «Everest of systemic risk»: Speculative debt of the subprime kind, now mainstreamed. I compared the strict regulation of banks versus the light regulation of non-banks to a three-sided swimming pool, from which all the water (i.e. credit activity) would obviously escape through the non existent fourth wall.

I predicted that this time around, interest rates wouldn’t ever normalize upward again (like they did in 2004 when they reached 5,25%), because of the uncontrollable credit and leverage bubble.

Not only did this happen, but central banks had to activate even more levers than the short term interest rate: they must now permanently administer the financial system and act as a market-making printing press in order to prevent a crash of the credit bubble.

Several experts from the banking sector with which I spoke find this perfectly suitable and are grateful for this state of affairs, in which central banks offer a permanent guarantee. They just don’t look at the costs of such a guarantee, as long as they don’t have to.

A bubble logic, in short. But the record rise in the price of gold seems to tell a different story. Investors are seeking protection from inflation more than ever since 2011.

Myret Zaki

Myret Zaki started in 1997 as a junior analyst in a Geneva private bank where she learnt the basics of equity research, before joining the daily newspaper «Le Temps» in 2001, where she was in charge of the finance section for 9 years. When the financial crisis broke in 2008, she wrote the investigative book «UBS, am Rande des Abgrunds» (originally published in French as «UBS, les dessous d'un scandale»), for which she received the Schweizer Journalist prize. She joined «Bilan» magazine in 2010 where she became Chief Editor from 2014 to 2019. Between 2010 and 2016, she wrote three other bestselling books, about Swiss banking secrecy, the end of the Dollar reserve status, and the rise of the shadow banking system. She has a Political Science Bachelor from the American University in Cairo and an MBA from the Business School of Lausanne. She is now head of the Communication faculty at the School of Journalism and Media in Lausanne.
Myret Zaki started in 1997 as a junior analyst in a Geneva private bank where she learnt the basics of equity research, before joining the daily newspaper «Le Temps» in 2001, where she was in charge of the finance section for 9 years. When the financial crisis broke in 2008, she wrote the investigative book «UBS, am Rande des Abgrunds» (originally published in French as «UBS, les dessous d'un scandale»), for which she received the Schweizer Journalist prize. She joined «Bilan» magazine in 2010 where she became Chief Editor from 2014 to 2019. Between 2010 and 2016, she wrote three other bestselling books, about Swiss banking secrecy, the end of the Dollar reserve status, and the rise of the shadow banking system. She has a Political Science Bachelor from the American University in Cairo and an MBA from the Business School of Lausanne. She is now head of the Communication faculty at the School of Journalism and Media in Lausanne.