Top ECB official sounds alarm on rising risks from shadow banking

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A senior European Central Bank official has said the “remarkable” growth of private funds and other sources of finance outside the regulated banks is the biggest threat to the stability of the Eurozone’s financial system.

“There are certainly caution lights in front of us,” Elizabeth McCaul, an ECB supervisory board member, told the Financial Times.

“The most prevalent one is the area into which we likely have the least visibility and where things can move faster than . . . the normal credit dynamics — that is the non-bank financial intermediaries market.”

Non-bank financial intermediaries, often dubbed “shadow banks”, in the EU held assets worth €42.9tn in the third quarter of last year, against €38tn held by traditional lenders, according to the European Commission.

The sector’s growth since the global financial crisis had been “remarkable” and “something that always worries us”, McCaul said.

“It is outside of the banking supervisory and regulatory perimeter,” she added, stressing that opaque links between the sector and banks via repurchase agreements, lines of credit or derivatives raise concerns about what this “translates into for systemic risks”.

Column chart of Total global financial assets ($tn) showing Shadow banks have become an increasingly important source of finance

McCaul said there had been warning signs of how these risks could materialise suddenly, including the collapse of family office Archegos Capital Management three years ago, which resulted in $10bn of losses for investment banks including Credit Suisse and Nomura.

“We’ve had blips. Maybe even more than blips,” she said, adding that the sell-off in UK debt markets two years ago driven by losses from complex derivative-linked strategies in pension funds was “another warning light”. 

McCaul is the only US citizen to sit on the ECB’s supervisory board since its creation a decade ago to oversee the biggest Eurozone banks.

She said Europe’s banking sector had “proven quite resilient in the face of some very significant challenges in the last few years,” after capital levels rose almost a quarter and non-performing loans shrank by two-thirds in the past decade.

But the rise of shadow lenders reminded her of the collapse of US hedge fund Long-Term Capital Management in 1998 when she was superintendent of banks in New York.

“You learn your lessons on the job,” she said. “I suspect correlation risk is occurring again.” 

“Some of these funds, especially certain hedge funds, are becoming so big that they can partially move the market by themselves and are not likely to act as shock absorbers in the same way banks have sometimes,” she said.

US-based hedge funds Citadel and Millennium both manage over $60bn of assets apiece.

The ECB was “placing particular focus on the private equity and private credit markets,” she said, warning their exposures could be closely correlated with those of banks.

McCaul dismissed the assertion by some private equity executives that they are reducing risks by shifting activities off the balance sheets of banks and diversifying them among investors.

McCaul said their arguments had echoes of the claims made by those packaging up and selling subprime mortgage loans as collateralised debt obligations before that market imploded and caused the 2008 financial crash. “I’m reminded of the subprime crisis,” she said.

The world’s top financial watchdogs are working on ways to bring more transparency and reduce risks in lightly regulated areas outside the traditional banking sector. But they have so far been hesitant to bring non-banks under their direct supervision.

McCaul, who will leave the ECB in November, said it was checking if the 113 Eurozone banks it oversees have a full view of their exposure to non-banks.

“If an institution has lending arrangements, trading arrangements or hedging strategies connected to the NBFI market, we are asking what line of sight and due diligence they are conducting,” she said.

The rise of ‘shadow banking’

Since the 2008 banking meltdown, credit creation has shifted from banks’ balance sheets towards other firms that behave like traditional lenders but are more lightly regulated. These firms are often referred to as “shadow banks”.

The Financial Stability Board — an international group of watchdogs formed after the 2008 crash — monitors these “non-bank financial intermediaries”, which it defines as any financial entity other than a commercial bank, central bank or public finance institution.

This sprawling sector includes money market funds, asset managers, pension funds, insurers, hedge funds, private equity, credit funds and real estate investment trusts. It has built a stockpile of assets worth $218tn — nearly half of all global financial assets.

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