In 1930, coming off the back of a plague of bank runs that plunged the country into the Great Depression, the voice of a then-unknown Orson Welles gripped American audiences: “Who knows what evil lurks in the hearts of men? The Shadow knows…” Nearly 100 years later, history is rhyming amid the second- and third-largest bank failures in U.S. history, as International Monetary Fund researchers warn of the evils that still lurk in the shadows. The shadow banking system, that is.
Nearly 50% of all global assets are now held in shadow banks, according to the IMF. These institutions, also called non-bank financial intermediaries (NBFIs), include pension funds, insurers, hedge funds, private equity funds, structured investment vehicles (SIVs), limited-purpose finance companies (LPFCs), and numerous other entities—each with their own acronym.
Shadow banks are often the under-regulated middlemen of the financial system, and they’re growing in number. For nearly a decade now, Federal Reserve officials have repeatedly warned about the hidden dangers present in these shadow banks. And it’s not just U.S. regulators that have expressed concern—from Ireland to China, the risks inherent in the shadow banking system are well known.
Even JPMorgan Chase CEO Jamie Dimon argued in his 2019 annual shareholder letter that shadow banks need to be “assiduously monitored.” But the IMF says these institutions still have “little regulatory or supervisory oversight” and commonly have “virtually no loss-absorbing capital.”
“NBFI vulnerabilities appear to have increased in the past decade,” the fund’s researchers wrote in a Tuesday article. “Policymakers need appropriate tools to tackle turmoil in the NBFI sector that may adversely affect financial stability.”
The researchers highlighted key risks in the shadow banking system, including elevated leverage and the potential for a liquidity mismatch caused by rising rates. Given their high levels of “interconnectedness” with the traditional banking system, they added, shadow banks present a risk to financial stability.
One poignant example of that risk was seen last October, after concerns about fiscal policy in the U.K. led to a massive selloff in government bonds, called gilts. The selloff meant pension funds, which are a part of the shadow banking system, weren’t able to fund their liability-driven investment funds (LDIs) that guarantee a lifetime income post-retirement based on salary. Ultimately, regulators were forced to step in to save the day. Bank of England Deputy Governor Jon Cunliffe said at the time that multiple LDI funds would have gone bust without the intervention, leading to a “self-reinforcing spiral” and “consequent widespread financial instability.”
“Last year’s U.K. pension fund and liability-driven investment strategies episode underscores the perilous interplay of leverage, liquidity risk, and interconnectedness,” the IMF researchers wrote.
After banks’ recent issues and the U.K. pension fund rescue last year, the fund’s researchers urged banking regulators worldwide to ensure there is “robust surveillance, regulation, and supervision” of shadow banks, arguing that there are “gaps” in the data these institutions share with officials. And they noted that with inflation proving to be a consistent challenge globally, central banks would face “challenging tradeoffs” between fostering financial stability and ensuring price stability if a shadow bank were to fail.
“In a low-inflation environment, central banks can respond to financial stress by easing policy such as cutting interest rates,” they noted, but these days “injecting central bank liquidity for financial stability purposes could complicate the fight against inflation.”
