S&P Global Ratings will monitor how global banks manage their direct exposures to the shadow banking sector where risks are on the rise amid tighter financing conditions.
"Although the state of the shadow banking sector is not a source of rating pressure for global traditional banks right now, it is an area to watch in 2024," the agency said in a March 20 report.
The agency categorizes shadow banks as a subset of the non-bank financial institutions (NBFIs) sector comprising investment funds, structured finance vehicles, financial companies and broker-dealers, among others. Shadow banks held $63 trillion of financial assets across major global jurisdictions, accounting for 78% of global GDP, as of the end of 2022. As their role in credit intermediation is similar to that of banks, shadow banks could "pose a bank-like threat to financial stability," Ratings said.
Economic slowdown and tighter funding conditions expected in 2024 as markets absorb the lagged impact of the prior year's interest rate hikes have increased the risk of stress in the shadow banking sector where financial leverage — in the form of bonds, bank loans and short-term repo funding — has risen rapidly in recent years, Ratings said. The latest estimates of the Financial Stability Board (FSB) show total financial leverage for NBFIs in the US, the euro area, the UK and Japan stands at roughly 50% of total GDP, which is close to the proportion of household debt in those economies, the agency said.
Investment funds and broker-dealers account for about 90% of the total debt in the NBFI sector, with hedge funds and broker-dealers identified as the most leveraged subsectors, Ratings noted.
Banks' exposures 'deceptively limited'
Although banks' direct balance sheet exposures to the shadow banking sector appear "deceptively limited" — accounting for only 1.8% of total bank assets at the end of 2022 — they "only tell part of the story" and "the linkages between banks and shadow banks are more complex and potentially riskier than they appear," Ratings said.
Some of the largest global traditional banks are highly exposed to hedge funds through their prime brokerage businesses with roughly 80% of hedge funds as of June 30, 2022, being serviced by the prime broking units of Goldman Sachs Group Inc., Morgan Stanley JPMorgan Chase & Co., Bank of America Corp., Citigroup Inc., UBS Group AG, BNP Paribas SA, Barclays PLC and Credit Suisse Group AG, which was still operating independently at that time, Ratings data shows.
Prime brokers "may not be aware of hedge funds' linkages with other banks, creating potential contagion channels between institutions," and their exposures are also subject to wrong-way risk, which is the "risk that a credit exposure could increase precisely at the time when the counterparty is most likely to default," Ratings noted.
A recent study from the Bank for International Settlements (BIS) also warned about hedge fund-related risks to global banks. It gave as an example the collapse of hedge fund Archegos Capital in early 2021, which caused over $10 billion of losses for global banks and has been largely linked to Credit Suisse's troubles, eventually leading to the Swiss group's rescue merger with UBS in March 2023.
Global regulators are well aware of the potential risks linked to the NBFI sector and are taking steps to limit them. The Bank of England, for example, plans a systemwide stress test in 2024 to explore the interaction between banks and nonbanks during a downturn, Ratings said.
Systemic risks
Concentration risk in shadow banking goes beyond the traditional banking sector as "shadow banks can have particular relevance in certain regions or economic sectors," with Chinese shadow banks' active involvement in the real estate sector being a prime example, Ratings said. Chinese authorities have already moved to constrain the growth in shadow banking assets in the country, which peaked in 2017, according to Ratings.
"As they increase, the assets of shadow banks and NBFIs more broadly can strain financial systems and lead to systemic disruptions in ways that are hard to measure before the event. Beyond the risk of individual failures, it is NBFIs' collective reactions to changing market conditions and financial stress that can amplify shocks and cause them to reverberate through the economy," Ratings said.
While regulators' understanding of the potential systemic risks posed by the NBFI sector has improved over time, they still have "limited tools to mitigate contagion risk should it arise," the agency said. "Unlike traditional banks, shadow banks can't access emergency central bank funding in times of stress."
