Global financial regulators are preparing a clampdown on so-called shadow banking as they confront the unintended consequences of previous waves reform that pushed risks into hidden corners of the financial system.
Policymakers have been warning all year — with mounting alarm — about the risks and sizes of bets taken by some hedge funds and private equity houses. But now, fears that rising interest rates could derail some of their mammoth bets is turning that talk in to action.
In recent weeks, the UK’s top financial regulator has drawn up plans for a probe into private capital valuations, while the Bank of England has declared such “non-banks” to be so important that policymakers should create a new facility to lend directly to them in times of crises.
Global watchdogs at the Financial Stability Board have launched a new review that could limit hedge fund leverage and increase transparency on their borrowings. In the US, the Securities and Exchange Commission has brought forward policies on fund transparency so stringent that some are threatening lawsuits.
Together, the non-banks on regulators’ radar — which include hedge funds, pensions and insurers — account for 50 per cent of global financial services assets.
“Clearly there is work we still need to do,” Klaas Knot, chair of the FSB, told the Financial Times. “We are moving from policy development to policy implementation,” he said.
The roots of the latest wave of financial regulatory lie, at least partly, in the era created by regulators following the 2008-09 global financial crisis when there was a rush to dramatically reduce risks in the banking sector.
As banks have stepped back from trading in general and from investing in private assets, others have snapped up their market share. They include hedge funds, private equity houses and others outside the traditional banking sector. But they were not restrained by some rules for banks, especially restrictions on the amount of leverage on their trades, which potentially magnifies the size of their gains or losses.
“We never really thought that we were solving one problem and what would the knock-on be?” said one financial stability policymaker from that crisis era, arguing that regulators are now entering a “new phase”, where they have to ask “where did the risk pop out and how do we deal with that?”
Ashley Alder, a veteran international markets regulator who now chairs the FCA, said the “turning point” in regulators’ thinking around non-bank financial risks was the March 2020 “dash for cash”, when bond markets went into freefall in the early pandemic, forcing central banks to intervene.
Before then, the conversation had focused on whether to designate individual non bank institutions — such as major asset managers — as “too big to fail” as global regulators do with systemically important banks. Now policymakers had shifted to identifying risks across the shadow banking sector as a whole, Alder said.
“There is a question mark about what lurks out there,” he added, because regulators do not have good data on shadow banks’ exposures, something that has inspired the Bank of England’s world first marketwide stress test.
Several other causes for alarm have arisen. One is the spectacular near-death experience of pension fund hedging strategies in the UK one year ago. The implosion of investment house Archegos also bit a hole into several banks’ balance sheets in March 2021. The nickel market malfunctioned in March 2022. And this year, an outsized burst higher in US government bond prices following the demise of Silicon Valley Bank drew regulatory concern over hedge funds’ bets.
The causes of these breakouts were different, but the key protagonists were all part of the shadow banking universe, and each had been a risk lying in plain sight. Debt-funded bets on US government bonds by hedge funds are now under scrutiny.
In recent months, as the dramatic rise in global interest rates has introduced new risks to a sector amped up on a decade of cheap debt, warning bells have reached a peak.
The European Systemic Risk Board, the Bank for International Settlements and global securities regulator Iosco have all called out mounting risks.
“It is impossible to argue that market-based finance cannot threaten stability,” the BoE’s markets boss Andrew Hauser told a conference on Thursday.
In that speech, he noted that policymakers needed to get the balance right between allowing investors to take their own risks, and global stability.
“I think we all need to accept that in markets there are risks and part of the function of markets is to be able to provide funding by taking certain risks,” says Verena Ross, chair of Europe’s securities regulator Esma. “At the same time, I think we still have pockets where there clearly are specific risks that I think we need to look at.”
An overly heavy hand could end up creating yet more uncomfortable and unintended consequences, said a former financial stability policymaker who declined to be identified. “What is the answer?” he said. “Obviously no one wants no market volatility — that’s a bit weird. Also you don’t want the absence of leverage because we wanted that margining for good reason. But what is a blow-up? How much volatility is too much?”
Hedge funds have come under particular scrutiny in recent months for a combination of reasons including their size, their opaque nature and the perception that they must take big risks to justify charging large fees for managing money.
Even prime brokers — the investment banks that lend to hedge funds — have limited visibility on the funds’ overall borrowings, a blind spot that was illustrated by the collapse of Archegos when the true scale of its borrowings from multiple brokers emerged only on its deathbed.
“We ask that question all the time. I’m relying on clients to tell me the truth,” says a senior banker at one prime broker. The FSB is looking at ways for banks to share information, but market sources say that would be a long and complicated effort.
Another senior bond trader active with big investment houses and hedge funds said transparency was only one part of the problem. The other was size. “The dealer community is constrained on its balance sheets, and at the same time . . . our clients now are just so much bigger than us. That shows up in moments of stress like after SVB failed. Liquidity is systematically compromised.”
A short-term fix being looked at by regulators is compelling banks to be more careful about their lending to hedge funds. “We need to increasingly rely on banks’ role as the watchtowers of the sector,” said the ECB’s top banking supervisor Andrea Enria in a recent speech.
For some, action on shadow banks isn’t coming fast enough.
“There have been good reports from the FSB on money market funds for example,” says one financial stability expert who is active in the international debate. “You wonder ‘is anybody paying any attention?’ I don’t know how much of the inaction is due to lobbying, political questions, preoccupation with other issues and so forth. What is clear is that not much is being done.”
“You have to limit [leverage] somehow, rather than just shout about it,” said another.
Increasingly, regulators agree. But Knot, who has framed tackling shadow banking as a key plank of his FSB leadership, admits it is not a quick fix. “The work is in train, but like the reforms on the banking side after the global financial crisis, this is not something you do in one year.”
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