The Financial Stability Board (FSB), the global financial regulator, has raised alarms about shadow banking once again. In a recent report, the FSB highlighted the industry’s high leverage and lack of transparency, even to financial regulators.

This report is troubling, as it indicates that the shadow banking sector poses significant risks to overall financial stability.

First, the FSB warns that high leverage can lead to liquidation channels, where position unwinds and asset sales occur. This often happens when an adverse shock triggers unexpected liquidity demands, such as collateral or margin calls.

Procyclical deleveraging can also emerge as investors breach risk limits or strive to maintain target risk levels in their portfolios. Such asset sales, especially in stressed markets, can further depress prices, creating a feedback loop that increases liquidity demands and risk reduction across other market participants involved in the same asset class.

Second, the counterparty channel can lead to defaults or distress among leveraged entities, resulting in direct losses for counterparties and cascading financial stress that forces liquidations.

For instance, a leveraged entity might default if it can’t meet collateral or margin calls, or if market losses wipe out its capital. This initial shock can propagate to the defaulting entity’s counterparties, potentially leading to further financial distress if those counterparties cannot absorb the losses.

The FSB points out that shadow lenders are interconnected with major banks, including those providing them leverage. This means that a default by a shadow lender can transmit stress to systemically important banks through the counterparty default channel. The ongoing opacity of shadow banking even to regulators heightens the risks for banks lending to this sector.

As previously noted, U.S. banks have extended nearly $5 trillion to shadow bankers via both on- and off-balance-sheet exposures, with about 80% of these loans coming from the 25 largest U.S. banks.

The FSB also cites several examples of shadow banking’s impact on global financial stability during recent stress episodes:

• March 2020: The ‘dash for cash’ highlighted rising Treasury market volatility, leading to increased margins on U.S. Treasury futures. Traders unwound positions, exacerbating sales volumes and instability. Lack of supervisory leverage limits for investment funds in non-centrally cleared bond repo markets allowed extreme leverage, revealing gaps in credit risk management.
• March 2021: The collapse of Archegos led to significant repercussions for Credit Suisse, which many had considered a safe institution. This oversight ignored its substantial exposure to shadow lenders like Archegos.
• 2022: Commodities market stress saw position liquidations due to rising margins and counterparty credit risk, affecting CCP clearing members facing increased default risks.
• September 2022: The LDI crisis showed how leverage in GBP-denominated strategies amplified stress in the UK Gilt market, triggering position liquidations due to margin calls and heightened risks.

The potential for a major crisis is real, especially considering the significant exposure U.S. banks have to shadow lenders. Such events could severely impact large U.S. banks.

Bottom Line

While it may be hard to believe, larger banks have more major issues on their balance sheets than smaller ones. The 2008 financial crisis was driven by one major problem, but today, banks face multiple significant risks. These include challenges in commercial real estate, rising consumer debt levels, underwater long-term securities, and high-risk shadow banking. Overall, the current banking landscape may present even greater risks than those seen during the 2008 crisis.