Growth in global financial assets held outside the banking system in nonbank financial institutions (NBFIs) has been a key feature of the past decade. Shadow banks, a subset of institutions within the NBFI sector, held about $63 trillion in financial assets in major global jurisdictions at end-2022, representing 78% of global GDP, up from $28 trillion and 68% of global GDP in 2009.

As shadow banks are involved in credit intermediation in a similar way to banks, they may pose a bank-like threat to financial stability. Moreover, S&P Global Ratings believes that the risks facing shadow banks are on the rise amid tighter financing conditions. This is fueling additional scrutiny by banks and regulators globally.

Shadow banks provide a meaningful source of alternative finance in several countries, for instance, by offering solutions to fund long-term assets with matching liabilities. They can also improve the efficiency and depth of a financial system by holding assets with maturity structures and credit characteristics that may be unattractive to traditional banks.

At their best, shadow banks can do this without adding significant incremental risk. Yet some shadow banks have elevated leverage, structural liquidity mismatches, and/or heavy credit exposures to specific economic segments such as real estate financing. This makes some hedge funds or financing companies (fincos) particularly vulnerable to a potential loss of investor confidence.

At first glance, direct financial linkages between traditional banks and shadow banks appear limited, but we believe that there is more to this than meets the eye. First, global aggregates hide potential concentrations of risk exposures at certain banks. Second, linkages can take less easily observable forms, such as exposures to derivatives. More broadly, shadow banks' significant presence in certain economic sectors or countries can make them systemically relevant. Under stress, they could create a problem for global banks simply by spreading or exacerbating financial risks.

Unlike traditional banks, shadow banks can't access emergency central bank funding in times of stress. Regulators now have a better understanding of the direct and indirect risks that the nonbank sector poses to the financial system, but they have limited tools to mitigate contagion risk should it arise.

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. In particular, we will monitor how banks manage their direct exposures to shadow banks, and how regulators implement the various recommendations that global standard-setting bodies have issued to mitigate NBFI-related risks.

NBFIs Account For Around Half Of The Global Financial System

NBFIs slightly contracted on a global level in 2022, with assets down by 5.5% in nominal terms, the first such decline since 2009. Despite this, NBFIs continue to account for about 47% of total financial assets (2021: 49%) in the major economies reporting to the Financial Stability Board (FSB; see chart 1). These economies account for about 80% of global GDP in aggregate.

Chart 1

The decrease in 2022 was mainly driven by a fall in equity and debt securities prices that year. NBFIs tend to account for such securities at fair value, contrary to banks, whose assets mainly comprise loans held at amortized cost. As such, we believe that the reported relative decline is primarily due to accounting inconsistencies or cyclical equity-market valuation effects. In contrast, credit assets probably continued to rise as certain segments within the NBFI sector saw continued growth in 2022, including fincos, broker-dealers, and money market funds (see chart 2).

Chart 2

In 2023, we consider that NBFIs will likely have benefited from the rebound in market values, and therefore the 2022 decline should prove short-lived. In 2024, the lagged effects of past rates hikes are likely to constrain economic growth and tighten funding conditions, clouding the outlooks for both banks and NBFIs. That said, S&P Global Ratings' economists expect policy rates in major jurisdictions to trend down from mid-2024, which should support financing conditions both generally and for NBFIs in particular.

Ratings on NBFIs vary

We rate 233 entities that fall under the broad umbrella of NBFIs (see chart 3). Financial market infrastructures (FMIs) tend to sit at the higher end of the rating scale, while many securities firms and fincos have either low investment-grade or speculative-grade ratings. Our outlooks for the various NBFI subsectors reflect their differing exposures to the economic and rates cycles.

Chart 3

FMIs.   We expect rated FMIs to repeat their generally solid 2023 performance in 2024. Treasury income on reinvested client margins and deposits is likely to fall in 2024, but many FMIs should benefit from continued volatility across asset classes. FMIs' earnings are broadly resilient to cycles and have become more diverse and repeatable for most (see "FMIs' All-Weather Business Models Support Stability In 2024," published Jan. 25, 2024).

Asset managers.   The traditional asset management sector is likely to continue experiencing challenges in 2024, while the alternative asset management and wealth management sectors should be more resilient. That said, the full effects of monetary tightening may not have materialized yet, and market volatility and a slowing economy could put pressure on both the debt (public and private) and equity markets in 2024.

Of the three subsectors, traditional asset managers are the most exposed to market volatility. Net outflows and continued fee pressure for some issuers may compound the impact of this volatility. While wealth managers are also vulnerable to market movements, their asset base is stickier, resulting in more stable earnings. Alternative asset managers are in the best position of the three as their assets under management are locked up (see "Stabilizing Interest Rates Ease Pressure On Asset Managers, Despite Headwinds," published Jan. 22, 2024).

Fincos.   Many fincos proved resilient in 2023, repricing their asset bases, securing funding, and increasing their liquidity. However, the significant risks to the economic outlook mean that funding and liquidity stability could collapse quickly if economic shocks spill into the real economy and weaken investor confidence (see "Downside Risks Abound For Financing Companies In 2024," published Feb. 19, 2024).

In the U.S., we think that a slowing economy, declining household savings, and stresses in areas like commercial real estate will likely weigh on many fincos' asset quality this year. And we believe that high interest rates will continue to limit many of these companies' ability to issue debt--at least in the first half of the year (see "Declining Asset Quality And Funding Obstacles Follow U.S. Finance Companies Into 2024," published Jan. 23, 2024).

Securities firms.   The potential for lower inflation and Federal Reserve rate cuts in the second half of 2024 could spur underwriting activity and reduce market volatility. It would also reduce the margin that retail securities firms earn on their clients' cash balances, but it would likely reverse the decline in these balances due to clients' cash migrating to higher-rate products. Despite potential headwinds, we expect ratings to remain largely stable, with most firms maintaining solid capital and liquidity (see "Industry Credit Outlook: U.S. Securities Firms 2024 Outlook: Ratings Largely Stable Despite Potential Headwinds," published Jan. 18, 2024).

Shadow Banks Are A Meaningful Source Of Credit In Some Countries

Overall, shadow banks had $63 trillion in total assets at end-2022 in the jurisdictions reporting to the FSB, representing around 29% of total NBFI assets or 14% of total global financial assets. Banks, in comparison, accounted for 40%. Within shadow banks, fixed-income funds account for the majority of assets, followed by fincos, broker-dealers, and structured finance vehicles (see chart 4).

Chart 4

Shadow banks saw a 2.9% decrease in their asset base in 2022

This decrease was entirely due to investment funds, while the asset volumes of fincos, broker-dealers, and securitization vehicles slightly increased (see chart 5). Within the investment fund category, much of the decline in 2022 occurred in traditional fixed-income funds and related to falling market valuations. Money market funds, on the other hand, saw continued growth, with assets under management increasing from $5.2 trillion to $6.4 trillion from February 2023 to February 2024.

The regional bank turmoil in the U.S. and rising interest rates drove U.S. money market fund inflows since February 2023. In Europe, money market funds remain a relatively limited sector, with assets under management of €1.7 trillion at the end of 2023. Despite the rise in interest rates and banks' limited pass-through to depositors, growth in money market funds has not been significant in Europe. In addition, private credit has seen rapid growth of its market share, especially in the U.S. and in certain subsegments of corporate lending (see box below).

Chart 5

Chart 6

Shadow banks' relative importance and composition differ across jurisdictions

On the one hand, we see some relatively small open economies where shadow banks represent a significant share of financial assets, such as the Cayman Islands, Luxembourg, and Ireland. This largely corresponds to investment funds located in these countries for tax and other regulatory reasons.

In most major European jurisdictions, shadow banks tend to represent less than 10% of total assets, reflecting the dominance of bank funding (see chart 7). In North America, we see more financial diversification, with shadow banks representing more than 10% of financial assets in the U.S. and Canada. In these jurisdictions, fincos and securitization vehicles represent a meaningful share of assets (see chart 8).

In Asia-Pacific and Latin America, we see a more mixed picture. Shadow banks are relatively important sources of funding to the economy in Brazil, Mexico, China, India, and Korea. In these countries, investment funds tend to dominate less, and fincos or broker-dealers play a significant role. In Japan, broker-dealers represent a material share of shadow banks' assets, and their activities have expanded recently, mainly reflecting the increase in short-term repurchase agreement (repo) transactions on both the asset and liability sides.

These repos reflect an increase in the brokerage of arbitrage transactions (by Japanese securities companies and money market brokers) between the short-term money market and current account deposits at the central bank. These transactions typically do not have any duration mismatch between their assets and liabilities. However, when brokering trades between the participants and nonparticipants of central counterparties (CCPs), Japanese broker-dealers could bear a liquidity burden due to the margin requirements that CCP participants face until the nonparticipants of CCPs post margins. They may also face ad hoc margin calls in case of large price fluctuations in intraday market transactions.

Chart 7

Chart 8

Risks To Shadow Banks Are On The Rise, Leading To Increased Regulatory Scrutiny

Shadow banks are exposed to bank-like risks through credit intermediation. These risks fall into three main categories: credit, liquidity, and leverage. Shadow banks' relative exposures to these three risk categories varies significantly due to the diversity of their business models (see chart 9).

Chart 9

At one extreme, money market funds typically have limited liquidity and leverage risks, while their exposure to credit risk varies depending on their asset allocation between government and nongovernment bonds. At the other extreme, credit hedge funds typically operate with high leverage (mostly in synthetic form) and face elevated liquidity risks from their derivative positions and/or their open-ended nature.

Between these two extremes, fincos tend to be exposed to credit and refinancing risks stemming from their financial leverage. Their reliance on wholesale markets makes them vulnerable to occasional capital squeezes due to a generalized loss in confidence, with the risk of contagion to other fincos or banks. The fate of several Mexican nonbank lenders is a prime example of how these risks can materialize (see box on Mexican nonbank lenders below).

Another example is Korea, where fincos face difficulties following rapid growth in their exposure to real estate project financing. Real estate projects represent 6% of their total assets, and the delinquency ratios on these portfolios more than doubled to 4.4% over the year to end-September 2023. Positively, many Korean fincos are affiliates of major banking groups or large corporate conglomerates, and potential support from these parent entities helps mitigate financial stress.

Finally, investment funds face liquidity risks when they operate with a structural mismatch between their assets and liabilities, for instance, open-ended funds offering rapid redemption and investing in potentially less liquid assets such as real estate. The Chinese shadow banking sector exemplifies this risk. It grew rapidly up until 2017, prompting regulatory efforts to reign it in over subsequent years (see box on China below).

Chart 10

The Global Regulatory Agenda For 2024 Will Largely Focus On NBFIs' Excessive Leverage

According to FSB estimates, total financial leverage for NBFIs in the U.S., the euro area, Japan, and the U.K. stands at around 50% of total GDP, a proportion roughly equivalent to that of household debt. Financial leverage has increased rapidly in recent years and takes various forms, including bonds, bank loans, and short-term repo funding.

However, leverage is highly uneven across the NBFI subsectors, with investment funds and broker-dealers largely accounting for 90% of this total debt. The most leveraged subsectors are broker-dealers and hedge funds, which make use of significant amounts of repo funding and short-term debt.

Adding to this financial leverage are other synthetic forms of leverage that are difficult to measure reliably. The notional amount of nonbank investors' over-the-counter derivatives increased from less than $10 trillion at the turn of the millennium to almost $90 trillion in 2022, above the previous peak use of derivatives on the eve of the global financial crisis in 2007. Such derivative positions increase liquidity demands due to potential margin calls, as we saw with certain U.K. pension funds during the September 2022 gilt crisis.

Global regulators recognize growing leverage, coupled with certain players' use of short-term and synthetic forms of leverage, as a policy issue. This will likely lead to some policy recommendations that seek to reduce excessive leverage in 2024. Bodies such as the FSB and the International Organization of Securities Commissions (IOSCO) have already put risks in investment funds at top of their policy-making agenda. In 2023, these bodies adopted two important policy recommendations relating to the micro-prudential treatment of liquidity risks in open-ended investment funds.

In particular, the FSB recommended that open-ended investment funds be categorized by the type of assets that they hold, from less to more liquid, and be subject to specific expectations in terms of their redemption terms and conditions, depending on the liquidity of the assets. This will mitigate the risk of structural liquidity mismatches between open-ended investment funds' assets and liabilities.

Complementary to that, the IOSCO recommended that open-ended investment funds use appropriate liquidity management tools to mitigate investor dilution and potential first-mover advantages, that is, situations where investors have a financial incentive to exit a fund first in stressed conditions. These recommendations will now need to become national regulations.

Financial Links Between Banks And Shadow Banks Appear Deceptively Limited

Overall, banks' balance sheet exposures to shadow banks appear limited, representing 1.8% of total bank assets at end-2022, versus 2.6% at end-2021 (see chart 11). Similarly, funding from shadow banks accounted for only 2% of banks' total assets in 2022 (2021: 2.2%). We believe that the small year-on-year evolutions likely reflect accounting discrepancies and other statistical effects rather than meaningful trends. The numbers are for the major jurisdictions reporting to the FSB.

Chart 11

We see a more direct balance sheet connection between shadow banks and traditional banks in a handful of countries (see chart 12). In Luxembourg, this reliance is mainly due to many investment funds operating in the country and depositing some of their funds with various custodian banks legally based there. As such, these funds are not a meaningful source of funding for local banks and the real economy.

Chart 12

Traditional banks' exposures to shadow banks are more meaningful in countries where shadow banks play a prominent role in financing the real economy, such as Korea or India (see chart 13).

Chart 13

That said, we believe that these balance sheet exposure figures only tell part of the story, and that the linkages between banks and shadow banks are more complex and potentially riskier than they appear. A good example is prime brokerage activities, namely, services that banks provide to hedge funds and other nonbank entities, including custody, clearing, securities lending, financing, and reporting. Prime brokers can also provide leverage via cash financing--mainly via secured deals such as margin loans or securities financing transactions--or via synthetic financing in the case of derivative transactions (for example, equity total return swaps).

The prime brokerage sector is heavily concentrated, with the top 10 prime brokers serving the largest proportion of hedge funds globally (see chart 14). In France, two prime brokers account for 82% of brokers' total gross notional exposures to nonbank entities.

Chart 14

Prime brokers typically aim to run a matched book, meaning that they conduct repurchase and reverse repurchase transactions to collect and repledge collateral, with differing haircuts to generate net funding positions and profits. As for derivative positions, prime brokers typically try to offset trades with various counterparties, and hedge the remaining risks directly with the market. For these reasons, economies of scale matter greatly to the efficiency of the risk management process and ultimately lead to concentration.

Beyond the complexity of these financial connections, prime brokers may not be aware of hedge funds' linkages with other banks, creating potential contagion channels between institutions. In addition, prime brokers' exposures are subject to wrong-way risk, namely, the risk that a credit exposure could increase precisely at the time when the counterparty is most likely to default.

Supervisors across the globe have increased their scrutiny of banks' counterparty credit risk management practices in recent years, especially following the default of Archegos Capital Management in 2021, but still acknowledge some deficiencies and data gaps.

Another example of the indirect though very real connection between banks and shadow banks is the implicit guarantees that some Chinese banks have provided to the wealth management products issued by shadow banks. Chinese regulators have since sought to limit or remove such guarantees to avoid contagion between shadow banks and banks.

As Their Assets Increase, NBFIs Can Intensify Or Spread Financial Stress

Aside from the micro-financial risks that individual NBFIs face, macro-financial vulnerabilities arise from the growth of the NBFI sector as a whole. These include:

Concentration effects in certain economic sectors.   Although they account for only 14% of total financial assets globally, shadow banks can have particular relevance in certain regions or economic sectors. Chinese shadow banks and their involvement in financing real estate projects are a prime example. Another is the role of private credit funds in the speculative-grade corporate credit sector in the U.S. Difficulties and/or deleveraging at shadow banks can have an outsized impact on these specific economic sectors, with ripple effects in the broader economy and financial system.

A systemic impact on financial markets.   Certain NBFIs can be meaningful actors in specific corners of the financial markets. These include liability-driven investment (LDI) funds run by U.K. pension funds, which were major buyers of long-dated and index-linked gilts. When yields spiked following the U.K. government's mini-budget announcement in September 2022, these funds faced margin calls on their derivative positions and proceeded to sell part of their holdings in this segment of the gilt market, where the supply of buyers was insufficient. The Bank of England eventually needed to step in as a buyer to allow the LDI funds to generate the liquidity they needed.

Contagion via perceived or real interconnectedness between shadow banks and traditional banks.   Illustrating this risk is the spillover to money market funds of the liquidity squeeze that some pension funds faced due to their derivative positions (margin calls) in March 2020. In Europe, European Central Bank estimates suggest that these long-term investors paid a total of €50 billion in variation margins to their derivative counterparties between March 11 and March 23, 2020. The pension funds did not have sufficient cash in bank deposits available to meet the margin calls and therefore generated liquidity through sales of short-term debt instruments, repo transactions, and redemptions from money market funds. Such outflows could lead money market funds to pull back from the commercial paper markets, creating funding strains for banks and corporates that use these markets as a source of short-term funding.

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.

Financial supervisors are acutely aware of these potential vulnerabilities. In 2024, the Bank of England will run a system-wide exploratory scenario exercise to better understand the behavior of banks and nonbanks under stress conditions. With more than 50 participants including banks, insurers, central counterparties, pension funds, and investments, the results of this analysis will an important source of intelligence for regulators and may lead to further regulatory action.

Unlike traditional banks, shadow banks cannot access emergency central bank funding in a stress scenario. Should contagion occur, central banks could still intervene in the financial markets, but we expect the bar for such intervention to be very high, meaning that contagion risks to banking systems would need to be imminent and severe. We do not see the failure of most shadow banks, or a broad deleveraging of the shadow banking sector, as likely to meet that bar.

For traditional banks, this means that they need to carefully manage the risks emanating from their business with shadow banks, in keeping with supervisory authorities' insistence on the need for banks to manage their counterparty credit risks carefully.

Although we are mindful of the contagion risks that shadow banks pose to traditional banks, we don't see them as a major negative rating driver for traditional banks, but rather a source of risk. We consider that banks have increased their financial resilience to shocks, including those potentially stemming from shadow banks.

Related Research

• An Update On Securities Firm Anchors By Country (February 2024), Feb. 20, 2024
• Downside Risks Abound For Financing Companies In 2024, Feb. 19, 2024
• When Rates Rise: Risks To Global Banks Could Emerge From The Shadows, Feb. 16, 2023
• Japan Nonbank Sector Eyes Greater Resilience, Profitability, Feb. 2, 2024
• China's Distressed AMCs: Government Support Will Be There, Feb. 2, 2024
• FMIs' All-Weather Business Models Support Stability In 2024, Jan. 25, 2024
• Declining Asset Quality And Funding Obstacles Follow U.S. Finance Companies Into 2024, Jan. 23, 2024
• Stabilizing Interest Rates Ease Pressure On Asset Managers, Despite Headwinds, Jan. 22, 2024
• Industry Credit Outlook: U.S. Securities Firms 2024 Outlook: Ratings Largely Stable Despite Potential Headwinds, Jan. 18, 2024
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