The failure of Credit Suisse prompted the ECB’s vice president, Luis de Guindos, to issue a dire warning: although Europe’s banking sector remains “sound and resilient”, the shadow banking sector is the real source of “problems for the whole financial system”. 

How seriously should we take this alert? These non-banks play an important role in financing the economy, but their light-touch regulation raises concerns over the risks they pose to the financial system.

Look at Ireland, the land of my birth, itself an outlier in non-banking. I no longer live in Ireland which means I can now look at the old country somewhat dispassionately!

Equivalent to just 0.06% of the world’s population, Ireland finds itself home to the world’s fifth largest shadow banking industry with an astonishing €4.6tn in assets under management, according to its own government figures. 

The Irish central bank has cautioned, with some understatement, that “such funds could be subject to ‘bank-run’ like events, in the event of a shock”. 

Ireland’s shadow banking sector is made up largely of investment funds, money market funds and special purpose entities who act mostly on behalf of international investors and hold non-Irish assets. This means that the risks to the Irish domestic economy are limited.  

But this isn’t true for the rest of Europe. In a review of EU investor fund regulation earlier this year, British regulators expressed concern that Europe was not moving fast enough on implementing appropriate safeguards.

Bank of England governor Andrew Bailey hinted at tensions in January, telling MPs that while the UK was working on ways to improve the resilience of money market funds, their cross-border structure meant “we need the EU to do it and they have not done it yet”.

Last week, financial regulators announced a clampdown on shadow banking. Global watchdogs at the Financial Stability Board launched a review that could limit hedge fund leverage and increase transparency on their borrowings. In the US, the Securities and Exchange Commission has brought forward policies on fund transparency so stringent that some are suing in a bid to stop them.

Could the ‘fix’ to the last crisis cause the next crisis? 

To understand where the root of this problem lies, we must of course go back to the global financial crisis of 2007-8. Regulation enacted in the wake of the crash forced banks to reduce their leverage. 

Corporate lending began to move away from the banks towards an array of non-bank lenders that had emerged to fill the void in a classic example of regulatory arbitrage. 

Direct lenders, who raise capital through lightly regulated fund structures, became a significant source of debt financing for private equity buyouts. A 2022 University of Chicago paper showed that 78% of loans made by US private debt funds were for PE buyouts.

Since the global financial crisis, the tables have turned. Growth in the euro area shadow banking sector has far outstripped growth in traditional banking. 

Total shadow bank assets reached $240tn in 2021 according to the Financial Stability Board, having more than tripled in size since 2004. 

FSB data shows that collective investment vehicles with features that make them susceptible to runs grew by 10.6% in 2021 and loan provision that is typically dependent on short-term funding grew by 7.7% in the same year.  

Unlike Ireland, the UK’s exposure to offshore shadow banks was highlighted last year when turmoil at pension fund vehicles, largely based in Ireland and Luxembourg, forced the Bank of England into an emergency intervention to halt a sharp fall in government bond prices.

Liability Driven Investment strategies that help pension schemes hedge against risks from interest rate rises and inflation caused turmoil when UK chancellor Kwasi Kwarteng’s ‘mini’ budget sent gilt prices tumbling.

Pension schemes and LDI managers received margin calls on their derivatives, forcing them to sell gilts, creating a vicious circle. The Bank of England eventually stepped in to calm markets with a £65bn intervention.

The Central Bank of Ireland was reported at the time to have requested LDI fund managers working with UK pension schemes to tell regulators before doing anything that would increase the leverage in their funds.

So, should we worry about the risks posed by the shadow banking sector in Europe?  I think we should, simply because shadow banks have numerous links to the broader financial system. Retirement funds today, for example, have scaled back on investing in bonds and entered the business of making direct loans. They are acting as banks – but without the regulatory oversight or the experience in lending that banks have.

To reduce regulatory arbitrage, policy-makers may need to redraw the boundaries between banks, regulated investment companies, and unregulated investment companies.

There is nothing necessarily shadowy about the activities being discussed.  

But if regulators want to manage the amount of leverage in the financial system and the risk of contagion in the global economy, understanding the business models and choices made by these entities is crucial in the development of suitable monitoring frameworks for this growing part of the financial sector.