The agency cited particular risks from the practice of borrowing short-term and lending long-term, a practice called “maturity intermediation” that helped doom Lehman Brothers and shook Wall Street to its core. In addition, it identified issues with liquidity, leverage and credit transformation, or investing in high-risk high-return vehicles, which can include leveraged loans.
“The exposure of the global financial system to risk from shadow banking is growing,” DBRS said. “Weaknesses in these shadow banks arising from these activities could result in runs that could instigate or exacerbate financial market stress.”
To be sure, industry advocates stress that its institutions still face substantial regulation and have become better capitalized in the days since the crisis. They cite the importance of the industry in providing financing to borrowers who can’t go to traditional banks.
In its analysis, DBRS noted as well that the collective investment vehicles actually help provide buffers against market stress so long as outflows are contained. Moreover, the low interest rate climate that has pervaded the world as central banks look to keep financial conditions accommodative has helped mitigate downside risks.
Still, the sheer size of shadow banking and its peers in the nonbank financial industry poses potential risks should those ttideal conditions change.
Nonbank financials, which also include insurance companies, pension funds and the like, have grown 61% to $185 trillion. Traditional bank assets have increased 35% to $148 trillion during the same period.
DBRS identified three specific risks that shadow banks pose under times of market stress: That they are “not structured” to deal with periods of low liquidity and heavy withdrawals; a lack of experience in dealing with periods of weakening credit conditions, and a lack of earnings diversification that would hurt them when parts of the markets deteriorate.
Fixed income is at particular risk within the collective investment vehicle space, with its $10.6 trillion in assets.
“A sharp rise in rates would impose sizable mark-to-market losses and diminish fund returns,” DBRS said. “In some circumstances, this deterioration in performance might result in large investor outlows and greater potential for forced asset sales. Such outflows might spill over into other funds and the markets more broadly.”