Until last September, few people beyond the close-knit world of pension asset managers had heard of ‘liability-driven investment’ (LDI), a trading strategy deployed by many pension funds. When the then UK Chancellor Kwasi Kwarteng announced a mini-budget that included unfunded tax cuts, markets went into a wild tailspin. The pound plunged into depths not seen since the global financial crisis of 2008, while the yield of gilts, as UK government bonds are known, shot up precipitously. LDI would become the fuse that would set markets on fire, eventually burning Kwarteng and Liz Truss’s government.

Beyond the political mayhem, the crisis highlighted the risks engulfing the so-called ‘shadow’ financial sector: non-bank institutions acting as lenders or intermediaries. These include institutional investors that are not prone to speculation, such as pension funds. It is risk aversion that forces pension funds to hold gilts. However, in a low interest rate environment, even institutional investors have been tempted to experiment with riskier ventures. Based on derivative hedging, LDI strategies have allowed pension funds to tap into the gilt market without necessarily holding the bonds, with some estimating that before the crisis around £500bn held by UK pension funds had been turned into over £1.5trn in investment.

When gilts started losing value the day Kwarteng announced his ill-fated budget, pension fund managers were forced into a massive sell-off to meet long-term liabilities. The result was a flurry of margin calls, as counterparties demanded more cash as collateral, creating a vicious circle of illiquidity.

Given that pension funds are the main buyers of long-dated gilts, this was an idiosyncratic demand shock. Effectively, the market had run out of buyers. It was only the £65bn intervention of the Bank of England (BoE) that saved the day by providing extra liquidity. “If the BoE had not intervened, a doom loop would have started with gilt and other asset prices crashing in an attempt to meet the margin calls,” says Professor David Blake, an expert on pensions who teaches at City, University of London.

This would have possibly spiralled out of control, affecting banks and insurance companies holding gilts, says Jonathan McMahon, chairman of UK wealth management firm Parallel Wealth Management and former Head of Financial Institutions at the Central Bank of Ireland: “They must have judged that the downstream consequences of not intervening would have led to a run on gilts, and possibly insolvency events in other areas.”

That 2008 feeling
A strict definition of ‘shadow banking’ includes only financial institutions that carry out credit intermediation, such as collective investment vehicles, broker-dealers and structured finance vehicles.

But once a broader set of ‘market-based finance’ intermediaries are included, the sector becomes a broad church that encompasses all non-bank financial institutions involved in lending: insurance firms, mutual funds, hedge funds, payday lending services, pension funds, currency exchanges and microloan organisations. Many finance practitioners avoid the term altogether, dismissing its dark connotations that echo the credit crunch in 2008. Non-bank lending played an important role in the global financial crisis, with insurance providers and mortgage associations like the US government-sponsored enterprise Fannie Mae being at the centre of the subprime mortgage storm. However, it was the traditional banking sector that attracted the attention of regulators and the ire of protesters; there was no ‘Occupy Wall Street’ movement for little-known hedge funds and insurance providers. The sector escaped the crisis relatively unscathed, while regulators imposed higher capital requirements on banks, restricting their ability to lend.

As the banks retreated, shadow banks filled the gap by offering riskier credit options, while facing little supervision and enjoying low-interest rate liquidity through quantitative easing in Europe and the US. Since the crisis, non-bank lending has almost doubled in size. Currently, it accounts for almost half of the global financial sector, according to the Bank for International Settlements (BIS), up from 42 percent in 2008, controlling $226.6trn by 2021. Across the EU, shadow banking institutions hold the majority of total assets, while non-bank institutions in the US match traditional banks in lending numbers. In the UK, ‘market-based’ finance accounts for almost half of all lending activities.

“This time round the search for yield was fuelled by persistent overreliance on monetary policy to stimulate economic recovery,” says Sir Paul Tucker, a veteran banker who served as deputy governor of the Bank of England in the aftermath of the global financial crisis (GFC), adding: “Post-GFC reregulation of banking incentivised that to happen outside of de jure banks. There is no surprise in the regulatory arbitrage, which is why the G20 agreed a decade ago to develop policies to contain the problem.”

One reason for that precipitous growth has been the idle, growing savings of the Western middle classes, seeking profitable investment opportunities, says Matthias Thiemann, a political economist and expert on shadow banking who teaches at Sciences Po, Paris. “These savings lead to large cash pools, which in turn seek to invest in profitable opportunities.” The post-crisis withdrawal of banks also provided ample opportunity for non-deposit taking lenders who rushed to deliver customer-orientated solutions, with managers promising quick lending decisions in towns where high street banks were shutting down branches, says Andy Copsey, non-executive director at ABL Business, a UK commercial finance consultancy: “Gone are the days that SMEs could only trot along, cap in hand, to their local bank manager when they wanted a loan.” One reason why micro-lending in particular has skyrocketed is the increasing number of people who find it difficult to get larger loans, says Tommy Gallagher, founder of Top Mobile Banks, a UK website dedicated to digital banking.

Proponents of shadow banking highlight its advantages, notably the fact that it offers borrowers a wide range of options. This also means that risks are more spread out; few non-bank institutions are too big to fail, like banks back in 2008. The smaller ones, like peer-to-peer lenders and fintech firms, offer financial services to those traditionally excluded from the mainstream banking system. “It would be very difficult for capitalism to work in the 2020s if banks were the only source of capital,” McMahon says, adding: “Banks are very good at one thing, which is typically lending to property, but not at providing cash flow-based financing to businesses.”

The flip side is that the non-bank sector has increased in complexity, making it harder to discern the nature and scale of risk embedded in the system. High leverage can cause uncontrollable ripple effects. Unlike banks, which have to meet capital requirements set by regulators, shadow banks hold collateral set by their counterparties, which thus creates a complex network of interconnected parties. The system worked well in the pre-pandemic era of historically low interest rates and unlimited liquidity, but now many non-bank institutions need to have access to substantial collateral, as shown during the LDI crisis. Flexibility and innovation prowess are two of the greatest advantages of non-bank financial intermediaries (NBFI), but they can also turn into disadvantages when markets turn south, says Professor Barbara Casu, Director of the Centre for Banking Research at Bayes Business School: “These structures are inherently fragile and they lack an official backstop, such as a central bank. Regulators intervene because of the interconnectedness between banks and the NBFI and the potential risk of spillovers to the banking sector.”

More worryingly, the sector shows signs reminiscent of the credit crunch, as low interest rates have encouraged asset managers to beef up portfolios with leverage. Critics claim that non-banks are not prepared to deal with tighter credit conditions, a problem that will be further exposed by higher interest rates. “The shadow banking system is an unstable system of leverage, asset bubbles and crashes, and then the regulator and the central bank have to step in to prevent the whole financial system – and after that the economy – from collapsing,” says Blake from City University.

Since the crisis, non-bank lending has almost doubled in size

The lack of transparency makes it more difficult to identify potential sources of systemic risk in the non-bank sector, although finance linked to real estate seems to be in a particularly perilous state in the advanced economies. In the US, rising interest rates have already shaken mortgage lenders, which have seen refinancing activity plummet.

Mortgages could also be a problem for many UK households that borrowed at low interest rates, according to Blake: “As these fixed rate deals are coming to an end, mortgage rates are rising rapidly and house prices are falling – so we could get a doom loop developing as people are forced to sell their houses because they cannot pay higher mortgage rates.”

China’s message to the world
For those raising the alarm about the perils of unbridled shadow banking, one case study stands out: the world’s largest economy. Following the global financial crisis, the Chinese government fuelled growth through fiscal stimulus and easy credit, largely channelled to the economy through shadow banks that in many cases were associated with traditional banks. In 2009, the non-bank sector accounted for eight percent of the country’s financial sector; by 2016 this had grown to a third (see Fig 1). The Chinese government tacitly abetted, and for some even encouraged this trend. “Shadow banking expanded rapidly based on a combination of regulatory arbitrage by banks trying to channel credit to restricted sectors, along with a widespread perception that government guarantees at some level, central or local, would ultimately backstop any losses,” says Logan Wright, Director of China Markets Research at Rhodium Group, a research firm.

As the system built leverage, problematic loans were gradually burdening Chinese financial markets with dangerously high levels of credit risk, while many inexperienced retail investors were entering the local stock market. Its crash in 2015, which caused major shares to lose up to a third of their value within a month, convinced the authorities that the non-bank sector’s growth posed a threat to financial stability. In response, regulators implemented reforms constraining the lending abilities of shadow banks, mainly by cutting down the interest rates they could charge. As a result, the country’s shadow banking assets dropped from over 100 percent of GDP to around 80 percent, shrinking by RMB11.5trn ($1.6trn) from 2017 to 2020.

Although the reforms were successful in reducing the size of the sector and limiting risks on the liability side, they also had negative side effects. “The result was that credit risk rose sharply on the asset side of the balance sheet as more defaults occurred, because many institutions were cut off from financing,” says Wright. Effectively, the crackdown reversed the deepening of the financial system that had benefitted underserviced borrowers, such as lower-income households, while undermining the government’s plan to build a more equitable growth model, known as ‘common prosperity.’ SMEs, traditionally shunned by banks that prefer to lend to large state-run firms, were particularly hit, although their reliance on shadow banks increased during the pandemic.

The shadow banking system is an unstable system of leverage, asset bubbles and crashes

One sector that has also been hit hard is real estate, as some of the main users of shadow banking channels are property developers. Currently, the sector, which represents up to 30 percent of the country’s economy, is embroiled in an acute crisis, with some of China’s largest property developers facing the possibility of bankruptcy. “The deleveraging campaign contributed to the property market crisis by encouraging property developers to rely more heavily on pre-construction sales as a primary mode of financing,” says Wright, adding: “Presales effectively became a substitute form of credit for shadow financing channels, which were contracting under the deleveraging campaign. This process also produced a significant expansion of housing supply and new construction at a time when fundamental demand among owner-occupiers was slowing.”

The crisis is now coming back to bite the financial sector, as falling property sales test the solvency of many non-bank institutions. Chinese trusts defaulted on roughly $9bn in financial products linked to real estate in the second half of 2022, according to data provider Use Trust. One possible response would be further deepening of the country’s bond and stock markets, according to professor Sara Hsu, an expert on China’s shadow banking system who teaches at the University of Tennessee. Although the West doesn’t have an exact parallel to China’s shadow banking system, there are lessons to be learned, Hsu says: “The Chinese shadow banking system underscores the need to provide finance to SMEs and early regulation, as well as the need for market-based solutions.”

Shadows all over the world
Shadow banking has rapidly grown in many other emerging economies where small businesses remain unbanked. A case in point is Mexico, where the banking sector’s small size and limited trust in SMEs has fuelled their appetite for alternative funding sources. The bubble burst last winter, with loan provider AlphaCredit defaulting first, followed by Credito Real and Unifin. Since then, contagion has shaken many other non-banks, currently funding themselves at increasingly high interest rates. Overall, the three bankrupt companies had lent about $6bn, on top of issuing around $4bn of unsecured bonds and foreign bank debt. The crisis has spilled over into the real economy, as thousands of smaller businesses face the prospect of running out of credit. “Contagion has already set in, and it is very difficult for all remaining players to obtain funding and refinance maturities,” says Victor Herrera, Partner at Miranda Ratings Advisory, a Mexican financial services firm, and former CEO of S&P Global Ratings in Mexico.

Default on shadow bank bonds has a broader impact on the country’s economy. “Normal Chapter 11 procedures have not been followed and bond holders feel they have been mistreated because of Mexican debt restructuring practices,” Herrera says, adding: “All bond issuers in Mexico, regardless of the sector they are in, will suffer the reputational effect.” The overarching problem, according to Herrera, is the lack of regulation and supervision. “One questions why a $100 deposit in the bank benefits from ample regulatory supervision, but if a doctor or teacher buys a $100 bond, no government body monitors the risk the retail investor is undertaking, many times without knowing it.”

The next crisis
As dark clouds gather over the global financial system, many analysts fear that regulators will soon find out that they have even less control and understanding of the non-bank financial sector than they thought. “The problem with ‘shadows’ is that they do not foster transparency – so the size of the correction is difficult to predict,” says Copsey from ABL Business. Higher interest rates may shrink asset valuations that were previously inflated due to cheap debt, leading to liquidity challenges and even insolvencies. The energy crisis and the war in Ukraine also pose problems for the financial sector, but perhaps the biggest one is complexity, McMahon from Parallel Wealth Management says: “We just don’t know what the trigger event will be.”

Capital-based pension funds are a major reason why we are in this mess

One particular problem is the lack of co-ordination between regulators. In the case of the LDI crisis, the pensions regulator was monitoring individual pension funds, but not systemic risks across the sector, while the central bank lost sight of pension funds altogether. “Capital-based pension funds are a major reason why we are in this mess: they invest a lot in shadow banking. We need to go back to a pay-as-you-go system,” says Thiemann from Sciences Po. Other proposed solutions include conducting rigorous stress tests for non-banks and setting up special regulators, or expanding the remit of existing ones, such as the US Financial Stability Oversight Council, to monitor the shadow banking system and detect potential threats.

“Where they can, the authorities should quietly be encouraging very careful deleveraging in some places,” says Sir Paul Tucker, adding: “They should be much less reluctant to use their powers to get providers of leverage, including clearing houses, to set higher minimum margin and excess collateral (haircut) requirements. That might have been done from around 2016-17, if not earlier.”

Optimists believe that the financial sector is better prepared to face a crisis, compared to its pre-2008 naivety. Data coverage of the shadow banking sector has dramatically improved since the crisis, according to Martin Hodula, Head of the Financial Research Coordination Unit at the Czech central bank. One way forward, he suggests, is broadening the regulatory framework covering traditional banking to encompass the shadow banking sector on a global scale, and thus create a level playing field: “A unified global regulatory framework seems vital because local financial regulation is subject to the prisoner’s dilemma and cross-country regulatory arbitrage.” Alternatively, policymakers and regulators could completely separate traditional and shadow banking, while pledging that they will never bail out a non-bank institution. “The real solution would probably lie somewhere in between,” Hodula says. If a crisis does erupt, however, governments across the world may have to face the same dilemmas that haunted them during previous financial crises, McMahon believes: “Ultimately governments will have to stand behind the banking sector and corporations, but with government balance sheets under stress, how is all that going to be financed?”