What is shadow banking? Investing Explained

In this series, we bust the jargon and explain a popular investing term or theme. Here it’s shadow banking.

Sounds spooky

You are right to feel a sense of unease. Shadow banking is the name given to hedge funds, money market funds and private equity funds that operate outside the formal banking system, advancing loans to businesses. These shadow entities may be in the lending arena, 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-time activity?

No. The sector has doubled in size since the global financial crisis of 2007-2008 and is responsible for about half of loans issued to companies. It appears that some businesses cannot get the finance they want from traditional banks.

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

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

Who’s most concerned?

The International Monetary Fund, the European Central Bank and the Bank of England are among the bodies that have voiced their disquiet. Janet Yellen, the US Treasury Secretary, has expressed anxiety about US money market funds, some of which make long-term loans.

This could pose a liquidity mismatch if a fund faced a sudden tide of withdrawals from investors.

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

Why the worry now?

The panic caused by the collapse of Silicon Valley Bank (SVB) and the emergency takeover of Credit Suisse may have abated.

But apprehension persists of a doom loop, the possibility that these events have not yet been contained and could spark further crises.

Like other central banks, the Bank of England stands behind UK institutions in the role of lender of last resort in the event of catastrophe. But there is no such lender of last resort in the shadow banking world. The lack of such a safeguard is why a few observers were rather surprised to find that SVB, a normal sort of bank, was at the centre of the panic, rather than some shadow bank. Indeed, a survey by Bank of America revealed that investors thought a shadow bank would be the cause of a credit crisis.

Are the authorities tackling it?

The Bank of England said that it would be devising stress tests for shadow banking entities in the wake of the mini-Budget.

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

Should we be scared?

There is always the potential for contagion in the financial system, as the fallout from one troubled institution spreads to others that are secure.

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