Despite improved bank credit profiles since the 2008 global financial crisis, shadow banking poses growing systemic risks for financial stability as it exhibits notable post-crisis growth, says Fitch Ratings.
Bank regulations, low interest rates, a favourable economic backdrop and the growth of financial technology are factors driving the growth of shadow banking in spite of increased capital, liquidity and more conservative underwriting standards among financial institutions, said Fitch Ratings.
"Shadow banking's ascent may signal growing systemic risks. These could include direct and indirect exposures faced by banks, insurance companies and pension funds, reduced financing availability for banks and non-financial corporate borrowers, and increased asset price volatility," said Fitch Ratings.
"However, credit intermediation outside of the banking industry, assuming a level of transparency, can be positive if it provides additional sources of credit and liquidity to support economic growth."
The performance of shadow banking entities through the next credit cycle will determine whether this "more diffuse but less transparent and more lightly regulated" construct is more beneficial for the overall financial system versus the prior, more bank-concentrated model, said the international credit rating agency.
Shadow banking, or credit intermediation or liquidity transformation that takes place outside of banks, central banks, public institutions, insurance companies and pension funds, stood at US$52 trillion (1.7 quadrillion baht) globally or 13.6% of total financial assets at year-end 2017, up from $30 trillion at year-end 2010, according to the Financial Stability Board.
The US had the largest, albeit declining, share of shadow banking assets at $14.9 trillion, or 29%. This was down from 48% at year-end 2010, with a compound annual growth rate (CAGR) of 0.8%, trailing the global CAGR of 8.3%.
Investment vehicles including open-end fixed income funds, money market funds and credit hedge funds have been the largest contributor to growth, at $37 trillion, or 71% of total shadow banking assets, as of year-end 2017.
Forced asset sales or outsized redemptions could, however, negatively affect asset prices and the broader financial system, particularly if the underlying assets are less liquid and the funds are materially levered, said Fitch Ratings.
Globally, banks have modest direct lending and borrowing exposure to shadow banking, although they face indirect risks including interconnectedness and asset price volatility, said Fitch Ratings.
For example, Chinese regulators' concerns over shadow banking interconnectedness with banks led to increased oversight in 2018, particularly focused on wealth management and trust products.
In India, the default of an infrastructure finance company in 2018 created broader funding pressures, leading domestic regulators to re-examine liquidity norms for the sector and prod banks to increase lending to, and asset purchases from, such entities.
In the US, the 15 largest banks have low loan exposure to non-depository financial institutions, with Wells Fargo the highest at $104.9 billion or 5.5% of assets at year-end 2018.
Asset-based financing can mitigate bank exposure to non-depository financial institutions, with advance rates offering downside protection to declining asset values, said Fitch Ratings.
"Shadow banking growth rates have been higher in emerging market economies compared to developed market peers, driven by country-specific market developments and smaller asset bases," according to Fitch Ratings.
China and Argentina had the fastest growing shadow banking assets, with five-year CAGRs of 58% and 48%, respectively, at year-end 2017.
Shadow banking growth is attracting increased country-specific and international regulatory scrutiny, but improvement has been incremental.
A more comprehensive regulatory framework most likely will not exist beyond specific countries or sub-sectors, such as consumer finance, unless and until necessitated by a market-wide shock correlated to shadow banking, said Fitch Ratings.
"Reducing shadow banking risk could be achieved through further direct regulation, more transparent financial reporting and limitations on asset and liability mismatches," said Fitch Ratings. "However, regulators would need to balance any such changes against the need for prudent expansion of capital and credit availability, particularly for under-banked and developing economies."
