Monsters in the Closet
After serial failures in the regulated banking system – Signature Bank, Credit Suisse, Silicon Valley Bank, First Republic – it's reasonable to ask: What other systemic risk monsters are hiding in the closet of our financial system?
Most fingers are pointed at lightly regulated (or unregulated) segments of the financial markets known as the “shadow banking system.” That’s certainly where train wrecks have happened in the past – the most devastating of which were the derivatives-laced mortgage-backed securities excesses that led to the global financial crisis of 2007–2009. But let’s not forget hedge fund Long Term Capital’s leveraged fixed income convergence trading bets in 1998, the Reserve Money Market Fund “breaking the buck” in 2008 or Archegos Capital’s total return swaps in 2021, which resulted in billions in losses for its counterparties. Not to mention the UK pension fund’s use of leveraged Gilt LDI strategies last year as well as FTX and other crypto meltdowns.
In its 2022 annual report, the Financial Stability Oversight Council (FSOC) declared its top priority was addressing the risks of nonbank financial intermediation. Regulators have been working on proposals to do just that, such as the U.S. Treasury Department considering a “systemically important financial institution” designation for nonbanks, the SEC adopting a Form PF regulation that requires private funds to provide more robust disclosures, and new liquidity management rules for open end funds.
Two key factors are driving this fear over what might be lurking in the closet:
- The enormous growth of activity and assets in the nonbank segment of the financial markets. Increased capital requirements and tighter regulation have made certain activities unattractive to banks, leading to an explosion of growth in the nonbank segment. The private credit industry alone has grown six-fold over the past decade to over $850 billion. Gross assets managed by hedge funds and other private funds have grown to $21 trillion, just slightly less than assets in the commercial banking sector. As a whole, nonbanks ended 2021 controlling more than $293 trillion in global financial assets, according to the Financial Stability Board – nearly 47% of the world’s wealth.
- Fundamental shifts in the market and monetary policy. The transition from decades of easy-money monetary policy and the end of a decades-long bull market in strategies driven by low interest rates have sent shockwaves throughout the economy. As Gillian Tett put it in the Financial Times, “Quantitative Easing has distorted things so deeply that there will be unexpected chain reactions, if not in banks, then in other corners of finance.”
Inadequate risk management around rising interest rates rattled the regional banks – and the signs that similar problems still await us are everywhere. In addition to asset/liability mismatches, higher interest rates will mean increased debt service costs for borrowers, threatening the credit quality and solvency of lenders. (For example, two auto finance companies just recently went out of business.) Baird Global Investment Banking reports the leveraged loan distress ratio reached 8.75% in March, compared to 1.87% just one year earlier. More than 200 fund managers in a recent Bank of America survey cited a potential “credit event” as the biggest economic risk right now. On the eve of Berkshire Hathaway’s annual meeting, Charlie Munger warned of “a brewing storm in the U.S. commercial property market.”
With all these monsters in the closet, why worry about shadow banking? After all, U.S. taxpayer money is not directly on the line, as it is with banks, whose deposits are insured by the FDIC. The answer is contagion risk.
Moving risks out of the regulated banking system doesn’t eliminate them: As the International Monetary Fund noted in its 2023 Global Financial Stability Report, “risk adheres to any institution engaged in financial intermediation in financial volume.” As I wrote in a 2021 post about systemic risk, the extraordinary complexity and interconnectedness of the modern financial system means that a shock anywhere in the system goes deeper, travels faster and affects other players around the world far more quickly and dramatically than ever before. Historically, when push came to shove and the risk of systemwide conflagration was imminent, the U.S. government has chosen to intervene. For example, during the global financial crisis and the COVID-19 pandemic, it deployed “shock and awe” levels of monetary and fiscal support. But those were disinflationary times, when there was less concern those actions would spark inflation. Today, the Fed seems much more reluctant to protect investors from losses by flooding the market with liquidity because of its efforts to wage war against stubborn inflation.
Instead it seems like the Fed is trying to thread the needle: My colleagues at Baird Advisors believe their remedies would be more surgical in nature, like its recent Bank Term Funding Program, which provided much needed cash to regional banks by allowing them to borrow and post underwater Treasury issues at face or par value as collateral. Such remedies provide relief to affected institutions and help prevent the spread of a contagion, but they will not prevent losses to some investors. Indeed, in the cases of Silicon Valley Bank, Credit Suisse and First Republic, we’ve seen equity holders and some bondholders experience total wipeouts.
While we agree that the Fed will take necessary action to prevent contagious failures in the banking system, we believe their rescue plans could be much more limited going forward. Investors should be mindful of exposure to – and potential losses from – higher risk financial assets in the shadow banking system.
For more on the perils in shadow banking, I highly recommend reading Reshma Kapadia’s recent article in Barron’s, “‘Shadow Banks’ Account for Half of the World’s Assets – and Pose Growing Risks.”