What is shadow banking? Investing Explained

In this series, we break down the jargon and explain a popular investment term or theme. Here’s shadow banking.

Sounds spooky

You are right to feel uncomfortable. Shadow banking is the name given to hedge funds, money market funds and private equity funds that operate outside the formal banking system and provide loans to companies. These shadow entities may be in the credit world, but they do not take deposits in the same way as a regular bank and are not subject to the same level of regulatory oversight.

Is this a small-scale activity?

No. The sector has doubled in size since the global financial crisis of 2007-2008 and accounts for about half of corporate lending. It seems that some companies cannot get the financing they want from traditional banks.

The Financial Stability Board, a global watchdog, estimates that shadow banks have $239 billion in assets on their books.

This highlights how diligently these entities have been lending and why it has been suggested that they could pose a risk to global financial stability, especially at a time of rising interest rates.

Who is most concerned?

The International Monetary Fund, the European Central Bank and the Bank of England are among those who have expressed concern. Janet Yellen, the US Treasury Secretary, has expressed concern about US money market funds, some of which provide long-term loans.

This can create a liquidity mismatch if a fund experiences a sudden wave of investor withdrawals.

The Republic of Ireland is home to the world’s fifth largest shadow banking sector – worth nine times its economy.

Why worry now?

The panic surrounding the collapse of Silicon Valley Bank (SVB) and the emergency takeover of Credit Suisse may have cooled.

But fears remain of a doomsday loop, the possibility that these events are not yet under control and could trigger further crises.

Like other central banks, the Bank of England stands with British institutions in the role of lender of last resort in the event of a catastrophe. But there is no lender of last resort in the world of shadow banking. The lack of such security is why some observers were quite surprised to find that SVB, a normal kind of bank, was at the center of the panic, rather than a shadow bank. Indeed, a survey by Bank of America found that investors believed that a shadow bank would be the cause of a credit crunch.

Will the authorities deal with it?

The Bank of England said it would develop stress tests for shadow banking entities in the wake of the mini budget.

At that point, the Bank had to intervene when some pension funds struggled to meet margin calls on Liability Driven Investments (LDIs) in which they had invested. This episode raised suspicions of other possible hidden weaknesses in the system that had the potential to wreak havoc.

Should we be afraid?

There is always a chance of contagion in the financial system as the fallout from one troubled institution spreads to others that are safe.

The regulators are aware of the threat of shadow banking and we expect them to do their job to mitigate this threat.