Growing shadow bank risks reveal ‘insufficient’ EU rules, warns ECB

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The European Central Bank has warned that growing risks from so-called shadow banks have made EU regulation “increasingly insufficient” to prevent further financial market shocks from triggering a broader liquidity crisis.

Luis de Guindos, vice president of the ECB, said that there are “increased risks to the financial system” from shadow banks, such as hedge funds, asset managers, pension funds and insurerswhich have grown rapidly over the last decade but remain more lightly regulated than banks.

“The interconnectedness between the banking and non-bank financial sectors remains high, increasing the scale of contagion,” de Guindos he said at a financial conference in Frankfurt on Tuesday, adding that the sector it was particularly exposed to rising interest rates and falling asset prices.

His comments indicate that despite the recent banking turmoil in the US and Switzerland, the ECB he is more concerned about the risks of shadow banks. With many nonbanks offering daily redemptions, de Guindos called on nonbanks to build up liquid assets to address a potential outflow of investor funds.

The non-banking sector has grown rapidly over the past decade, providing 26% of credit to non-financial corporations in the Eurozone last year, up from 15% in 2008, de Guindos said. Total assets of eurozone shadow banks have more than doubled in the past 14 years to €31bn.

This alternative funding source benefits corporate borrowers by allowing them to “diversify their funding sources and facilitates an increase in cross-border funding,” de Guindos added. But he warned that regulation hasn’t kept pace with the industry’s growing risks.

There has been some “de-risk” among non-banks in recent months, such as switching from high-yield corporate debt to safer government bonds, he said. However, their exposure to real estate markets had “increased substantially . . . making institutions vulnerable to ongoing price corrections in the real estate sector”.

Many non-banks are exposed to a “liquidity mismatch” between holding high levels of illiquid assets, such as property or corporate debt, allowing investors to withdraw funds on a daily basis without warning. THE liquidity crisis in the UK pension sector after a sell-off in gilt markets last year highlighted the risk of “insufficient preparation to meet the large demand for liquidity, especially from margin calls,” de Guindos said.

He added that the ECB was also concerned about levels of “synthetic debt” — leverage created using derivatives or other complex financial instruments — at non-bank entities. Family office Archegos Capital Management collapsed in 2021 after taking heavy losses on total return swaps it used to place risky bets on stocks.

De Guindos proposed four ways to address these risks to EU policymakers. First, he said non-bank firms that offer daily redemptions to investors should hold high enough levels of liquid assets to weather a potential barrage of withdrawals.

Second, EU efforts to tighten regulation of money market funds “should be pursued as a matter of priority” to catch up with international initiatives launched after the sector’s liquidity shock in March 2020. said he could implement globally agreed reforms only after the next mandate of the European Commission, which starts in 2025. Bank of England governor Andrew Bailey has publicly called for the EU to move faster.

Third, de Guindos called for improvements in “data quality, coverage and information sharing” to assess the risks of “synthetic leverage” at shadow banks. This is an area that UK authorities are looking into as part of a debut stress test of the financial system, and the US Securities and Exchange Commission has also marked as a concern, especially for hedge funds. Finally, he said non-banks need to “improve margin practices and liquidity preparedness to meet margin calls.”

The Basel-based Financial Stability Board, which brings together key policy makers, called in December for “urgent work” to address holes in regimes to deal with failing non-banks, such as clearing houses and insurers, whose operations extend beyond borders.

Pablo Hernández de Cos, Chairman of the Basel Committee on Banking Supervision, She said in March that the recent financial market shocks had highlighted the need for a tightening of rules that protect the banking system from a relapse of problems at the non-bank level.