Posted Apr 15, 2023, 11:37 AMUpdated on Apr 15, 2023, 12:11 PM
“There are major players who act as shadow banks.” The Credit Suisse investment boss sounded the alert at the end of 2022, relayed a month later by the president of UBS in Davos, with this new warning: “regulators have taken their eyes off shadow finance”.
On the program of this World Economic Forum, the gratin of world finance spoke about “banks in the eye of the storm”. Are Overregulated Too Safe to Fail Banks Ready to Support the Economic Recovery?
We know the rest of the story, or rather the counter-story: the financial crisis broke out precisely within the walls of the traditional banking industry, American then Swiss.
Le « shadow banking »
To tell the truth, Swiss financiers are not the only ones who have sought to attract attention outside the traditional banking system. “The biggest challenge are the non-banks”, also affirmed that day in Davos the Governor of the Banque de France.
A natural target for bankers to explain the source of their problems, “shadow banking” is this parallel finance into which they throw everything that appears less regulated, from private equity funds, to securitization funds, hedge funds, to financial companies, capable of taking more risks.
Paradoxically, it is this shadow finance that rushed to the bedside of the Californian bank SVB. It is also – the Apollo fund – which lent a hand to Credit Suisse to relieve it of 55 billion dollars of securitization portfolio.
Devoid of the constraints of regulation and the blank check of the supervisor – and the overlays of capital supposed to protect against bankruptcy – it remains invisible to depositors and taxpayers. And above all painless. In recent years, no particular taxpayer or underwriter of Blackstone, KKR or TCI has had to wipe the slate clean. And no central bank has in principle the inclination to fly to their aid.
Notorious tax havens
Since the 2008 financial crisis, non-bank finance has grown 139% to $239 trillion, or 49% of total financial assets, according to the Financial Stability Board (FSB). Strictly speaking, “shadow banking” (whose role is only to provide credit) more than doubled to 68 trillion dollars according to S&P, first in the United States (30% of assets held by banks shadow), then in Europe and China.
Notorious tax havens, the Cayman Islands (57%), Ireland and Luxembourg concentrate the largest share of shadow banks in the world, on the scale of their financial system.
In fact, “in many cases, non-banking finance has played a positive role over the past decade in providing alternative sources of financing to the real economy,” S&P points out in a report.
An activity that has become strategic
After the 2008 crisis, banks were forced to withdraw from financing that was too costly in capital, and debt funds came to take over when they restricted their credit conditions for borrowers who did not show their credentials.
Banks have also been able to derive real benefits from shadow finance. “Some traditional banks derive lucrative revenues from shadow banks, for example by arranging securitizations,” or by providing services to hedge funds, S&P points out. Among others, an institution like BNP Paribas has made prime brokerage one of its strategic axes. The rating agency even believes that “a drop in shadow banking activity would hurt banks’ profits”.
For banks, risk taking, on paper, is minimal: it represents only 2.6% of their total assets.
Putting savers at risk
So what about the explosion of the hedge fund Archegos? The sprawling securitizations of Greensill, which brought down Credit Suisse, recalling the errors of subprime mortgages, these securitizations of real estate loans from populations with poor credit that took the banks away in 2008? What about US bank SVB’s exposure to the tech fund bubble?
In the eyes of politicians and the general public, the problem lies not so much in the existence of shadow finance itself – as long as it serves a population of borrowers outside the banking system. The scandal erupts when, ultimately, the savers that the banks are supposed to protect, and by extension the taxpayers, are put at risk.
In other words, it is the channels that the banks maintain with this parallel finance, both to “de-risk” themselves and to indirectly derive profits from the more aggressive risk-taking of these actors, as well as their control, that make question.
In its report on the Archegos scandal, the auditors commissioned by Credit Suisse highlight “the culture of profit which took priority over risk management”. And in the opinion of even bankers, the Archegos problem and its excessive, even misleading risk-taking, does not reflect the practices of shadow finance.
The threat of rising rates
So why worry more today than yesterday? Because the rise in rates raises fears of extreme pressure on the “shadow banks” and their aggressive refinancing model. Some funds could experience margin call peaks, others withdrawals in the face of illiquid assets, still others using leverage visible through debt or invisible through derivatives, being more tense. Combined with the rise in credit defaults in an uncertain economic environment, the bill could become steep.
S&P warns that in 2023 the rating of banks itself may, due to its interconnections with shadow banking, be affected.
In short, non-banking finance did not experience the crisis. But according to the usual regulatory statement in stock market matters, past performance is not indicative of future performance. One crisis does not preclude the other.