August 9, 2017    6 minute read

Should UK Shadow Banking Be Regulated?

Potentially Shady    August 9, 2017    6 minute read

Should UK Shadow Banking Be Regulated?

‘Shadow banking’ globally has increased after a liquidity crunch following the financial crisis in 2008. The contagion caused by the collapse of Lehman Brothers, led to traditional banks around the globe pulling back their credit lines, resulting in small and medium sized businesses turning to ‘Other Financial Institutions’ or OFIs in order to meet their funding and liquidity needs.

The vacuum in available credit led to a number of unregulated entities stepping in to fill the void left behind by the banks. The shadow banking problem in China has been extensively covered, which is unsurprising given the approximate $8trn estimated size of shadow bank liabilities according to Bloomberg, but to what extent is there a problem in the UK?

What Is Shadow Banking?

While there are inconsistencies between regulating bodies as to what constitutes a shadow bank, a broad generally all-catching term for a shadow bank is an institution that fills the role of an investment bank; replicating banking services such as lending and securitisation, without actually operating in the same regulatory environment as banks. These institutions include, but are not limited to, insurance corporations, brokerage firms, pension funds, hedge funds, investment companies and trusts, and asset management firms.

Figure 1 demonstrates the largest bank service providers’ intuitions in a select Financial Stability Board (FSB) sample comprising of G20 countries, as well as some smaller EU countries and systematically important financial districts, including the Cayman Islands, Hong Kong, Singapore and Switzerland. The FSB is an international body that monitors the global financial system, and coordinates financial regulation chiefly for the G20 economies.

Figure 1: Largest OFI Subsectors

Source: FSB

Why Is Shadow Banking a Problem?

Non-bank financing provided by OFIs is an alternative to bank funding, which helps to foster growth in the private sector. This is especially important in an environment where bank funding lines have virtually dried up, as was seen in the subsequent years following the collapse of Lehman Brothers. This source of funding also provides a diversification in the sources of credit supply, which is beneficial for the overall economy, so long as adequate controls are put in place to prevent creating additional systematic risks.

However risks arise when unregulated OFI’s borrow from regulated banks, and then go out and lend to other third parties. As OFIs do not have to undertake as rigorous compliance and KYC checks, the overall risk in the system exponentially increases. Figure 2 simply explores the relationship between three entities; a bank, an OFI and a third party.

Figure 2: Risk analysis of the relationship between Banks and OFIs

Source: FSB

In one scenario, the bank lends to the OFI, taking credit risk to the OFI; while the OFI takes funding risk to the bank. If the OFI then goes out and lends those funds to a third party, and that third party subsequently defaults; the OFI becomes unable to pay the bank. This is an example of just one relationship.

The interrelationships between bank and non-bank entities highlights the crucial need for an overarching regulatory environment, which is not currently in place to monitor these transactions. If there was an economic downturn, and many counterparties started to default, then this would threaten the overall financial stability of the system (please refer to Figure 3).

Figure 3: Interrelationship of the global financial system

Source: FSB

UK Shadow Banking Impact

According to the FSB’s data analysis, the Eurozone as a whole had the largest OFI sector in 2015, with assets of $30trn, followed by the US ($26trn), the UK ($8 trn), China ($8trn), the Cayman Islands ($6trn), Canada ($4trn) and Japan ($4trn). If these statistics are accurate, then the OFI sector in the UK is the same size as that of Chinas. So why hasn’t there been greater uproar in the UK? OFI lending is not inherently risky in itself, but rather only constitutes a threat when those entities pose a sizeable financial stability risk – for example, a highly leveraged hedge fund is more risky than a lowly geared pension fund.

On a larger scale, non-bank financial institutions’ assets in the FSB’s sample rose to $149trn in 2015, of which, an estimated $35trn represented assets from risky ‘shadow banking’ activities. This amounts to roughly just under a quarter of the total assets – a worrying prospect. In addition, according to the FSB, shadow banking activities increased 3.2% on 2014 to reach $34trn. So not only does shadow banking represent a significant chunk of the financial system, it has been growing in relative size.

Therefore it can be assumed that shadow banking in all countries, including the UK, has increased. While it is impossible to know the size of the shadow banking sector in the UK, it is possible to roughly estimate.  The FSB states that over 10% of total bank assets in the UK were exposures to OFIs in 2015. Assuming a quarter of all non-bank financial institutions’ assets are risk assets; banks in the UK are on average 2% exposed to shadow banking activities. So there is no need to panic just yet.

The Future

While the impact of shadow banking in the UK is not of great concern currently; the uncertainty over Brexit negotiations and the effect this will have on the financial services industry remains to be seen in the future. If banks fail to retain their passporting rights, and in a worst case scenario move all their operations to mainland Europe, there may be a significant increase in the role of OFIs in the UK.

BlackRock’s 2016 Insurance Research report indicates that over 50% of insurers’ surveyed at the end of 2016 planned to increase their exposure to direct commercial mortgage lending in 2017. A willingness to lend and a potential funding vacuum created by Brexit, creates the perfect conditions for OFI’s to increase their importance in British financial services. Therefore it is imperative that regulators begin to include these entities within their regulatory scope now, in order to prevent weakening the financial system in the UK in the future.

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