This week, researchers from the International Monetary Fund (IMF) have voiced new concerns over the risks posed to the global economy by shadow banking, this time, specifically the private credit market. In an article published on the fund’s website (based on the IMF’s Global Financial Stability Report 2024), researchers discuss emerging vulnerabilities in this “opaque and highly interconnected segment of the financial system” with “limited oversight.”
A perfect storm brewing
About thirty years ago, the private credit market surfaced as an alternative form of financing for companies that were too big or too risky for traditional banks, or too small to access public debt markets. Over recent years, it has experienced substantial growth, with attributes such as speed and flexibility appealing to borrowers.
Institutional investors, including pension funds and insurance companies, have shown keen interest in these types of funds, attracted by the potential for higher returns and reduced volatility. “Private corporate credit has created significant economic benefits by providing long-term financing to corporate borrowers. However, the migration of this lending from regulated banks and more transparent public markets to the more opaque world of private credit creates potential risks,” warns the IMF.
An article published by the IMF this time last year pointed to recent stress to the US and European banking sectors as indicators of built-up financial risks and warned of the importance of understanding and safeguarding the shadow banking or NBFI sector, which comprises institutions outside of traditional banking, such as pension funds, insurers and hedge funds – and plays a significant role in the global financial system.
NBFI vulnerabilities have increased over the past decade due to factors such as elevated leverage, liquidity mismatches, and interconnectedness among NBFIs and traditional banks.
The IMF has repeatedly urged policymakers to enhance surveillance, regulation, and supervision, as well as improve private sector risk management and disclose relevant data to manage NBFI risks effectively.
Shining a light on the shadows
The IMF argues that the shadow banking sector can’t be sufficiently supervised without giving adequate power to regulators and improving the quality of risk-related data. “Policymakers need appropriate tools to tackle turmoil in the NBFI sector that may adversely affect financial stability,” it says, adding that policymakers must also “narrow or eliminate gaps in regulatory reporting of key data,” including details of risky activity such as derivatives trading.
“The rapid growth of private credit has recently spurred increased competition from banks on large transactions. This in turn has put pressure on private credit providers to deploy capital, leading to weaker underwriting standards and looser loan covenants – some signs of which have already been noted by supervisory authorities,” says the IMF.
Why isn’t shadow banking regulated like the banking sector?
In October 2022, concerns over UK fiscal policy under Liz Truss’ government led to a rapid selloff of government bonds. This meant pension funds (part of the shadow banking system) were unable to fund their liability-driven investment funds (LDIs) which are designed to guarantee a lifetime income for investors upon retirement. Regulators were forced to step in and bail out the LDI funds. This event demonstrated just how connected the shadow banking sector is to the rest of the financial system.
The global private credit market is now worth more than US$2.1tn globally. While providing essential long-term financing, this market’s opacity and rapid growth pose potential risks. Limited oversight means valuation can be infrequent and credit quality unclear, raising concerns about systemic risks. The IMF has previously said shadow banking symbolises “one of the many failings of the financial system leading up to the global financial crisis.” So why isn’t it better regulated?
It’s complicated
Shadow banking refers to a system of credit intermediation that involves entities and activities outside the traditional banking sector. These include hedge funds, money market funds, structured investment vehicles (SIVs), and other non-bank financial institutions. After the 2008 financial crisis, there were efforts to regulate shadow banking more effectively. However, several challenges have hindered comprehensive regulation:
Complexity: Shadow banking activities are often complex and interconnected with various parts of the financial system. Regulating them effectively requires understanding these complexities and potential systemic risks. Regulating them in isolation without considering these interconnections could lead to unintended consequences or regulatory blind spots.
Exploitation of regulatory loopholes: Shadow banking entities may exploit regulatory loopholes or operate in jurisdictions with lax regulations to avoid oversight. This regulatory arbitrage makes it difficult to enforce rules uniformly across the global financial system.
Rapid change/growth: The shadow banking sector is quickly evolving. Financial innovation constantly creates new products and structures, many of which fall under the umbrella of shadow banking. Regulators often struggle to keep pace with these innovations and may not fully understand the risks they pose until they materialise during a crisis.
Political and industry resistance: There may be resistance from the financial industry and political stakeholders against tighter regulation of shadow banking. Powerful lobbying efforts and concerns about stifling innovation or impeding economic growth can impede regulatory reforms.
Coordination challenges: Regulating shadow banking effectively requires coordination among various regulatory bodies, both domestically and internationally. Coordination challenges among different jurisdictions can hinder the development of consistent and cohesive regulatory frameworks.
Measures such as enhanced disclosure requirements, stricter capital and liquidity standards, and efforts to strengthen oversight and monitoring have been implemented since 2008, but the IMF is arguing that more needs to be done in order to avoid another financial crisis.
“Authorities should consider a more active supervisory and regulatory approach to private credit, focusing on monitoring and risk management, leverage, interconnectedness, and concentration of exposures…Regulators should improve reporting standards and data collection to better monitor private credit’s growth and its implications for financial stability.
Securities regulators should pay close attention to liquidity and conduct risk in private credit funds, especially retail, that may face higher redemption risks,” recommends the report.
Further reading:
Global Financial Stability Report 2024
Fast-Growing $2 Trillion Private Credit Market Warrants Closer Watch
Shadow Banks: Out of the Eyes of Regulators
Nonbank Financial Sector Vulnerabilities Surface as Financial Conditions Tighten
