Banks are in trouble, but a bigger financial crisis could be brewing

London () — The International Monetary Fund warned this week about the “vulnerability” of so-called non-bank financial institutions, saying global financial stability could depend on their resilience. The Bank of England drew attention to the same issue last month.

And global investors surveyed by Bank of America amid the recent banking collapse pointed to a group of US nonbanks, rather than traditional lenders like the recently defunct Silicon Valley Bank, as the most likely source of a credit crunch.

But what exactly are non-bank entities and what is their level of risk?

The term encompasses financial companies, other than banks, that provide all kinds of financial services, including loans to homes and businesses. It is a diverse cast: non-bank entities range from pension funds and insurers to investment funds and high-risk funds.

And the sector is great. According to the Financial Stability Board (FSB), a body of global regulators and government officials, nonbanks had about $239 trillion on their books in 2021, representing just under half of the world’s total financial assets.

The sector has grown strongly since the 2008 global financial crisis, with an average annual increase in its asset base of 7%, according to FSB data.

When interest rates bottomed out in the years following the crisis, many savers and investors turned to nonbanks for higher yields. Meanwhile, as regulators placed more restrictions on bank lending, certain types of borrowers, such as riskier consumers, were increasingly looking to nonbanks for financing.

Non-bank entities that grant credit are known as “shadow banks”, although the term is often used imprecisely to refer to all non-bank entities. It is these types of institutions that concern investors surveyed by Bank of America.

Shadow banks currently account for around 14% of global financial assets and, like many non-banks, operate without the same level of regulatory oversight and transparency as banks.

What are the risks?

Some of the risks faced by nonbanks increase when interest rates rise, as they do now. The sheer size of the sector means that its problems could, on their own, destabilize the entire financial system, but could also spill over to traditional banks through real and perceived interconnections.

One of the risks is the probability of credit losses. In a November report, the European Central Bank noted the “persistent vulnerabilities” of the non-bank sector, including “the risk of substantial credit losses” if its corporate borrowers were to start defaulting amid the weakening economy.

While economic prospects in Europe have improved since the start of the year, fears of a US recession have grown after the collapse of SVB and Signature Bank and the bailout of First Republic Bank last month.

Economies on both sides of the Atlantic remain fragile as interest rates are expected to continue to rise and energy prices remain high despite recent declines.

The other risk stems from what is known as a “liquidity mismatch,” which exists in open-end funds, a type of investment fund. Open-end funds allow nervous investors to withdraw their money quickly, but often have cash tied up in assets that can’t be sold as quickly to pay clients back.

Pedestrians walk on Wall Street near the New York Stock Exchange. Credit: Michael Nagle/Bloomberg/Getty Images

Rising interest rates and uncertain economic prospects have also made financing more expensive and difficult for some European non-banks, Nicolas Charnay, head of European financial institutions at S&P Global Ratings, told .

Since nonbanks do not take customer deposits, they are mostly exempt from the stringent loss-absorbing capital and liquidity requirements imposed on banks. And most are not subject to regular testing by regulators to ensure they can withstand a host of adverse scenarios.

In a February report, S&P Global Ratings pointed to another alarming characteristic of many nonbanks.

“Shadow banks cannot access emergency funding from central banks in times of stress and we do not expect governments to use taxpayer funds to recapitalize a failing shadow bank,” the firm said.

“This means that public authorities have limited tools to mitigate contagion risks.”

The poor health of a large non-bank or a large part of the sector could rub off on traditional lenders, because non-banks lend to and borrow from banks, and many invest in the same assets as their conventional counterparts.

A notorious example is the collapse of the US fund Archegos Capital Management two years ago, which caused losses of about US$10 billion across the banking sector. More than half corresponded to Credit Suisse, which counted Archegos among its clients. The coup contributed to a series of scandals and compliance failures that have plagued the Swiss lender in recent years, eventually leading to an emergency takeover by rival UBS.

Where are the risks?

Some regulators also worry that certain corners of the sector are particularly exposed to an SVB-style run on assets that, in turn, could lead to losses for traditional lenders.

Open-end funds are especially risky, according to analysts. If dozens of panicked investors call out their holdings at the same time, these funds may have to quickly sell some of their assets to meet the payments.

A sell-off of government bonds, for example, by multiple funds, would depress the value of those bonds, causing losses for other bondholders, which could include banks.

This is what happened last autumn, when British pension funds using the so-called liability-based investment approach had to sell UK government bonds, which were collapsing as a result of the disastrous budget plans of the then Prime Minister Liz Truss. This created “a vicious spiral” in the country’s bond market, in the words of the Bank of England, which nearly brought down the British financial system.

Direct and indirect links between banks and non-banks are not the only sources of risk for the entire system. Trust is very important in banking, and the mere perception that the banking sector might be connected to a troubled non-bank could trigger a broader financial crisis.

“This form of contagion risk, through perceived proximity or reputational risk, should not be underestimated,” S&P Global Ratings states in its report.

Regulators are beginning to play a more active role. In March, the Bank of England said it would carry out a resilience test of the UK financial system, which would include non-banks, although it noted that the exercise would not amount to “a resilience test of individual companies”.

Financial watchdogs in the United States and Europe have also proposed introducing a net asset value adjustment mechanism known as “swing pricing,” which would impose a cost on withdrawing cash from a money market fund, a type of open-ended fund, to avoid diluting the value of other investors’ holdings and discourage mass withdrawals of the fund’s assets.

In a report on nonbanks published this week, the International Monetary Fund welcomed “tighter supervision” of the sector, which should include rules on its capital reserves and access to liquidity.