Top financial watchdog says shadow bank vulnerabilities yet to be fixed

Stay informed with free updates

Simply sign up to the Financial & markets regulation myFT Digest — delivered directly to your inbox.

The world’s financial stability watchdog has urged regulators to maintain their clampdown on the “underlying vulnerabilities” building up outside the formal banking system in fast-growing and often heavily indebted areas such as private equity and hedge funds.

Klaas Knot, chair of the Financial Stability Board, told the world’s top finance ministers and central bank governors in a letter on Monday that geopolitical tensions, rising debt levels and elevated asset prices heightened the risk of a potential financial crisis.

“While the memory of past turmoil fades and optimism over a soft landing for the global economy grows, it is important to emphasise that tail risks remain,” said Knot, who is also head of the Dutch central bank. 

He said regulators had still not done enough to tackle the dangers created by the vast shift of financing activity outside of the closely supervised banking system into an area known as non-bank financial intermediation (NBFI).

This sprawling “shadow bank” sector includes money market funds, asset managers, pension funds, insurers, hedge funds, private equity, credit funds and real estate investment trusts. It has built a stockpile of assets worth $218tn — nearly half of all global financial assets.

Knot said in his letter to G20 officials ahead of their meeting in Rio de Janeiro on Thursday and Friday that “key underlying financial system vulnerabilities have not gone away, so we must maintain our focus on building resilience”.

The FSB has been focused on the risks stemming from non-bank financing since a “dash for cash” by heavily indebted hedge funds in March 2020 was blamed for a sharp-sell off in bond markets. 

These concerns intensified after the collapse of family office Archegos Capital Management three years ago, leaving investment banks with $10bn of losses, and the crisis in UK debt markets two years ago due to problems from derivative-linked strategies in pension funds.

“Recent incidents of market stress and liquidity strains have demonstrated that NBFI can create or amplify systemic risk,” Knot said. “Many of the underlying vulnerabilities that contributed to these incidents are still largely in place, leaving the global financial system susceptible to further shocks.”

Knot said some progress had been made in addressing these risks, but he warned “the pace of implementation of agreed NBFI policies has been uneven across jurisdictions and we may already be losing momentum”.

He said some non-banks, such as hedge funds, broker-dealers and finance companies had been “taking on additional leverage through off-balance sheet exposures, including foreign exchange swaps and forwards”, which had “grown significantly over the past decade”. 

The FSB said it planned to publish a report “with proposed policy approaches for authorities to address system risk” from the build-up of leverage at non-banks, and warned this extra debt could “propagate strains through the financial system, amplify stress and lead to system disruption”.

The warning echoes the comments of Elizabeth McCaul, a member of the European Central Bank’s supervisory board, who told the Financial Times this month that the “remarkable” growth of non-banks was the biggest threat to the stability of the Eurozone’s financial system.

The FSB has no legally binding powers of its own but brings together the world’s top central bankers, finance ministers and regulators to agree on a common global framework for financial regulation.

It has agreed for investment funds to have more liquid assets and to carry out stress tests to better withstand market shocks. It has also called for a tightening of redemption rules at money market funds, including penalising investors who pull their money out in a crisis.

Policies to tackle vulnerabilities in money market funds had been introduced or changed in several countries, including the US, Switzerland, South Korea, Japan, India and Indonesia, the FSB said. But it added that others “are still in the process of developing or finalising their reforms”, such as the UK, the EU and South Africa.

“Given the vulnerabilities reported in individual jurisdictions,” the FSB said more progress was required in implementing the agreed policies on money markets to “limit the need for extraordinary central bank interventions during times of stress”.