I spent a lot of time discussing interest rates and unsustainable debt levels in my previous post here, but another threat to the financial system that may be lurking below the surface lies in the shadow banking system, which essentially acts as a private credit market that exists OUTSIDE of the realm of red-tape and regulatory checks and balances of traditional banking.
Within this private credit market, borrowers in need of capital seek out non-bank financial institutions (NBFI’s) like pension funds, hedge funds, private equity firms or insurance companies to borrow money and receive loans.
The issue here is that these NBFI’s aren’t regulated the same as normal banks so nobody truly knows how much credit is out there, what the financing terms are or how much leverage is in the system. If several key borrowers find themselves unable to meet their loan repayment obligations there is no telling what the ripple effects might be. There is no transparency, no reporting requirements, NO REGULATORY OVERSIGHT and absolutely no way to calculate how catastrophic things could be if borrowers start defaulting on their loans. With higher interest rates already here - and likely staying elevated for at least the next 18-24 months - it is a near certainty that somebody won’t be able to pay their bills at some point in the near future.
“The enormous size and high leverage levels of the nonbank financial-institutions sector, along with the more lax reporting and regulatory standards applied to this sector relative to banks make it a potential tinderbox,” - Dr. Eswar Prasad, Cornell University and senior fellow at The Brookings Institution
The rotten cherry on top is that these NBFI’s also can’t borrow from the Federal Reserve in the event of an emergency like traditional banks can, so authorities and policy makers’ ability to reduce contagion is severely limited.
In traditional banking, a bank takes customers deposits and in turn is allowed to create new money in the form of loans. If a customer deposits $1 the bank can now lend out $10 (this is essentially fractional reserve banking in a nutshell) and if the bank ever goes bust, the original deposits are still insured. However, NBFI’s aren’t banks and don’t take customer deposits, so if a bunch of borrowers can’t repay their loans and an NBFI ends up going bust, there is no backstop for investors. Just imagine a pension fund losing people’s retirement money because they made a bunch of risky loans to some reckless and injudicious hedge funds.
The shadow banking sector now accounts for nearly half of the assets of the global financial system, so without the backstop of The Fed, you can see how risky things could be below the surface and how interconnected this web might be. If you’re keeping score at home, that’s about $240 TRILLION DOLLARS worth of assets that are operating in the shadows and away from the scrutiny that comes with responsible risk management. It’s complete insanity.
***If you want to read more about shadow banking you can check out this link posted by the International Monetary Fund
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