Shadow Banking Is Again A Great Danger To The Global Financial System

In the shadows (Photo: Twitter)

The shadow banking industry that played a key role in triggering the global financial crisis of 2007 again looms as a threat to global financial stability with its assets had risen to $52 trillion until 2017, or a 75 percent increase since the financial crisis ended.

Shadow bankers or nonbank lenders helped fuel the financial crisis by providing lending to underqualified borrowers. They also bankrolled some of the exotic investment instruments that collapsed when subprime mortgages fell apart.

"The exposure of the global financial system to risk from shadow banking is growing," said Canadian rating agency DBRS citing data from the Financial Stability Board (FSB). "Weaknesses in these shadow banks arising from these activities could result in runs that could instigate or exacerbate financial market stress."

DBRS identified three specific risks posed by shadow banks in times of market stress. Shadow banks are "not structured" to deal with periods of low liquidity and heavy withdrawal.

They lack experience in dealing with periods of weakening credit conditions. They also don't practice earnings diversification and this will hurt them when parts of the markets begin to slide.

FSB is an international body that monitors and makes recommendations about the global financial system. It was established in April 2009 in the wake of the global financial crisis that began in 2007.

The crisis was triggered by a crisis in the subprime mortgage market in the United States. It developed into a full-blown international banking crisis with the collapse of the investment bank Lehman Brothers in September 2008.

In the years since the crisis, global shadow banks have seen their assets grow to $52 trillion, said CBRS. It noted that shadow banking firms in the United States comprise the biggest part of the total sector with 29 percent or $15 trillion in assets.

Shadow banking is doing particularly well in China with its $8 trillion in assets accounting for 16 percent of the total share.

CBRS is worried about a new shadow banking product called "collective investment vehicles." This fund encompasses many bond funds, hedge funds, money markets, and mixed funds.

Collective investment vehicles have seen their assets balloon by 130 percent to $36.7 trillion. It's particularly dangerous because of its volatility and susceptibility to "runs." DBRS see it as part of the "significant risks" from the shadow banking industry.

It warns the sheer size of shadow banking and its peers in the nonbank financial industry poses potential risks should things head south.

J.P. Morgan Chase CEO Jamie Dimon has again warned about the risks of shadow banking.

"The growth in non-bank mortgage lending, student lending, leveraged lending, and some consumer lending is accelerating and needs to be assiduously monitored," said Dimon.

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