The world’s so-called “shadow banks” survived the onset of the Covid-19 crisis, but they remain a risk to the global financial system, DBRS Morningstar warns.
In a new report, the rating agency said that extraordinary efforts to inject liquidity into the global financial system by central banks helped shadow banks weather the disruptions inflicted by the pandemic.
These measures generally helped calm markets, shoring up credit spreads and bond prices, which helped stem the redemption and funding pressures facing collective investment vehicles (CIVs) — such as fixed income funds and money market funds.
However, the risk that the large and growing shadow banking segment poses hasn’t gone away, the report warned.
“We see significant risk in shadow banks due to their increasing size, lack of robust global regulation and inconsistent reporting/lack of transparency,” DBRS said.
The growth of the sector has been driven, in part, by traditional banks shedding risk from their balance sheets in the wake of the global financial crisis, as well as robust investor demand for yield amid rock-bottom interest rates, the report said.
In particular, investment fund vehicles have come to represent “a significant component of shadow banking assets,” it said, noting that these funds can pose a risk to the broader financial system.
“These funds may be susceptible to runs on liquidity, especially in a stressed environment,” the report said, adding, “High leverage at these funds can also add a layer of complexity, particularly if assets need to be sold to meet fund redemptions.”
That kind of activity can, in turn, rebound on the traditional, regulated banks, as recently happened when a hedge fund suffered large losses that spilled over to several major investment banks.
“This highlights the interconnected nature of financial markets, and how this substantial and growing shadow banking market can have a sizable impact on the highly regulated banking sector,” DBRS said.