Growing Risks from Europe’s Shadow Banking Demand Greater Regulatory Scrutiny

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By Nicholas Larsen, International Banker

The European Central Bank (ECB) is growing increasingly wary of the risks posed to eurozone lenders by the region’s shadow-banking sector, which has grown much faster since the Global Financial Crisis (GFC) than the traditional banking industry. With several spillover channels from this non-bank financial intermediation (NBFI) sector to the region’s banking sector now identified by the financial regulator, it seems likely that authorities will seek to increasingly clamp down on the dealings conducted between traditional financial institutions and the shadow-lending sector.

According to a paper produced by ECB economists Emanuele Franceschi, Maciej Grodzicki, Benedikt Kagerer, Christoph Kaufmann, Francesca Lenoci, Luca Mingarelli, Cosimo Pancaro and Richard Senner, eurozone banks have significant exposures to the NBFI sector—that is, firms that operate as lenders and/or credit intermediaries but are not registered or regulated as banks, including insurance firms, hedge funds, asset managers, financial-vehicle corporations, venture capital (VC) firms, money market funds (MMFs) and pension funds. The combined assets of such entities in Europe have more than doubled since the 2008 Global Financial Crisis from €15 trillion to €31 trillion.

But many shadow institutions have felt the pain of the rising interest-rate environment throughout the eurozone during 2022 and the first half of this year, having invariably engaged in risky activities when ultra-low interest rates prevailed throughout much of the previous decade. Following the rescue of Credit Suisse in March, which involved intervention by the Swiss government and its acquisition by rival UBS, the ECB’s vice-president, Luis de Guindos (Jurado), warned that although European banking remained “sound and resilient”, it was the shadow-lending sector that “could be a source of problems for the whole financial system” due to the risks taken amidst that previous ultra-accommodative monetary environment.

Indeed, regulators worldwide have stepped up their efforts to identify and manage potential sources of financial risk outside the traditional banking sector since the GFC of 2008. And it seems the ECB is gearing up to crack down further on these non-bank funding sources. Although concerns over shadow banking’s risks have steadily grown over the last 15 years or so, fears markedly spiked in 2021, when the collapse of family office Archegos Capital Management incurred $10 billion in losses for its banking counterparties, including a $5.5-billion trading loss for Credit Suisse alone—a significant episode in a long-running saga that ended in the Swiss bank’s failure earlier this year.

In January, the Bank of England (BoE) pressed its leading banking institutions to do more to manage risks pertaining to their business activities with non-bank financial institutions. “During 2022, the market reaction to Russia’s invasion of Ukraine, and volatility in the nickel and long-dated gilt markets, reinforced the importance of a robust risk culture and sound risk management practices at firms,” the BoE’s letters to banking chiefs read. “Despite regular messaging from the PRA (Prudential Regulation Authority) on the subject, these events demonstrated that firms continue to unintentionally accrue large and concentrated exposures to single counterparties, without fully understanding the risks that could arise.”

Eurozone lenders’ main exposure channels to shadow banking are loans, securities, derivatives contracts and funding dependencies, which expose banks to liquidity, market and credit risks, the ECB noted. And it is funding from shadow banks that ECB officials have stated represents the most significant spillover channel, given that they maintain their liquidity buffers primarily as deposits and very short-term repo (repurchase agreement) transactions with banks. The ECB calculated eurozone banks’ asset exposure to NBFI entities at an average of 9 percent of significant institutions’ total assets.

But perhaps more concerning is that any turmoil in the NBFI sector is expected to disproportionately impact larger, more complex and systemically important banks due to the higher concentration of asset exposures, funding linkages and derivative exposures in this group of lenders. “The concentration of banks’ exposure to NBFI entities on the lender side is much higher than the concentration of euro area banking assets,” the paper noted. “The top five banks account for about 50% of total loan and securities exposure and the top 13 banks for over 80%. This group of banks includes the eight euro area G-SIBs [globally systemic important banks: BNP Paribas, Deutsche Bank, Société Générale, Crédit Agricole Group, Banco Santander, UniCredit, ING Bank and Groupe BPCE], as well as several other large universal banks.”

Following a late-2022 “targeted horizontal review” of governance and high-level risk management of counterparty credit risk at 23 banks active in derivatives and securities financing transactions with non-banking counterparties, the chair of the European Central Bank’s Supervisory Board, Andrea Enria, noted that “material shortcomings” in the operations of those banks persisted. “As a general remark, institutions need to go beyond mere compliance with regulatory requirements when designing their approaches, which should be proportionate to the scale and complexity of the business, products offered and the nature of the counterparties, as well as the need to keep pace with the increasingly fast-moving and complex market situation,” Enria stated, whilst also making three crucial recommendations:

1. Client due-diligence procedures at the onboarding stage and on an ongoing basis must be strengthened when dealing with NBFIs and should substantially impact credit decisions and contractual conditions.
2. Banks with material or complex counterparty credit-risk exposures should specify their willingness to accept this risk in their risk-appetite statements rather than capturing it implicitly in credit risks. As such, banks need broad sets of risk metrics encompassing all facets of counterparty credit risks.
3. Banks must do more to develop appropriate stress-testing capabilities for counterparty credit risks across all business lines and ensure that the stress tests’ results influence risk monitoring and limits, focusing on NBFIs.

Such recommendations continue to be voiced not only in Europe but throughout the world across a sector that has more than doubled in size since the 2008 Global Financial Crisis and which, according to the Financial Stability Board (FSB), commanded a whopping $239.3 trillion as of December 2022. And yet it remains subject to much lighter regulations than traditional lenders. “We have seen that an international crisis cannot be responded to by national initiatives alone; it needs a global response,” Marco Zwick, head of funds regulation at Luxembourg’s regulator, the Commission de Surveillance du Secteur Financier (CSSF), told the Financial Timesin early July. Vasileios Madouros, deputy governor of the Central Bank of Ireland, added that Dublin favours shadow-lending risks being contained by an “overarching, comprehensive” framework.

But achieving regulatory harmonisation across Europe, let alone the world, will likely prove challenging. In May, the ECB’s Luis de Guindos proposed a series of “regulatory efforts” needed in the non-bank financial sector:

1. Reducing the risks of mismatches between funds’ asset liquidity and redemption policies. “Funds need to ensure that their redemption policies are closely aligned with the liquidity of their portfolio assets,” de Guindos argued.
2. Renewing efforts to reform the money market fund (MMF) sector in the European Union (EU) by implementing pandemic-era proposals at international and European levels, such as removing regulatory threshold effects, strengthening MMF liquidity requirements and improving the availability and usability of liquidity-management tools.
3. Addressing risks from non-bank leverage through various perspectives, such as improving data quality and coverage and information sharing, as well as identifying gaps in global policy frameworks, especially when financial entities are not subject to adequate leverage rules.
4. Enhancing margining practices and liquidity preparedness to meet margin calls amidst potentially volatile market scenarios. This will help reduce procyclical demands for liquidity.

“Interconnectedness between the banking and the non-bank financial sector remains high, increasing the scope for contagion,” de Guindos noted, adding that growing risks are rendering the policy actions undertaken to date increasingly inadequate. “Indeed, there seems to be a general inertia in the adoption of policy recommendations on non-banks. That has to change,” he added. “The lack of policy action today may mean the materialisation of risks tomorrow. In particular, a more comprehensive macroprudential framework should be a priority to ensure that non-banks are more resilient and able to provide a stable source of funding to the real economy in both good and bad times.”

Regulatory action should be taken swiftly, with Andrea Enria suggesting that risks among NBFIs could intensify in the coming months as monetary policies tighten further to bring inflation back down toward the ECB’s target. In June, Enria noted that risks had built up “profoundly” and leverage among shadow banks had grown sharply, with large mismatches in the durations of their assets and liabilities and growing evidence of insufficient preparedness to meet large demands for liquidity among the most serious concerns.