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CIARAN RYAN: Here’s something you may not have heard about – ‘shadow banking’. That comprises non-bank actors that perform banking-type operations but outside of the regulatory net. It’s reckoned to account for more than half of the world’s financial assets or, in raw numbers, $256 trillion. And it’s growing at nearly 10% a year.
So what is shadow banking, and should we welcome it or fear it?
To answer that, we’re joined once again by Adriaan Pask, chief investment officer at PSG Wealth. Hi Adriaan. Thanks again for joining us. Can you put this in perspective for us? What is shadow banking? Define it for us. What does it do and is it something that we should fear?
ADRIAAN PASK: Hi Ciaran, thank you for having me. Shadow banking is a fascinating part of the financial system. The conventional banking system, which has been around for centuries, is what most people are familiar with: if you need money, you go to a bank; if you want to earn interest, you make a deposit.
Over time, however, the financial world has evolved, giving rise to a variety of new vehicles, securities, and institutions. Many of these operate outside the traditional banking framework but still perform bank-like functions, such as lending. This is what we refer to as the shadow banking system – the term ‘shadow’ reflecting how these entities mirror the activities of conventional banks without being regulated in the same way.
But there are some important differences to keep in mind. Unlike commercial banks, these institutions don’t take deposits in the traditional sense and therefore aren’t necessarily subject to the same capital requirements.
Most people are familiar with frameworks like Basel and capital adequacy requirements, which are designed to ensure that banks remain sufficiently liquid in the event of a systemic crisis – such as the global financial crisis.
Historically, this need for liquidity arose because, when investors panicked and rushed to withdraw their funds, banks could run into serious shortfalls.
That’s where the phrase ‘a run on the bank’ comes from – simply too many people demanding their money back at once, leaving the bank unable to meet its obligations.
While these issues have largely been addressed through regulation, such safeguards primarily apply only to large commercial banks.
This gap is where the challenges of the shadow banking system emerge.
You’ve mentioned the scale of these entities and how quickly they are growing – it’s truly remarkable.
Today, the global non-bank financial sector accounts for more than half of the total financial system, having expanded tremendously to over $250 trillion – almost 10 times the size of the entire US economy.
Within this vast system, many of the entities operate under regulatory standards that are not necessarily as stringent as those applied to traditional banks.
Perhaps even more important is that some entities within the shadow banking system are inherently riskier.
The Financial Stability Board in the US monitors these particular institutions. What’s especially concerning is that this segment has also grown substantially – it now holds roughly $76 trillion in assets and is expanding even faster than the 10% growth rate you mentioned.
The shadow banking sector as a whole is growing at nearly 10% per year, but the riskier segments are expanding even faster.
This raises concern because, if a shock were to occur in that part of the system, the usual safeguards that protect conventional banks may not apply.
Many of these entities are relatively new to the financial system and haven’t experienced previous crises, which is why regulators have started paying closer attention and expressing concern.
CIARAN RYAN: What type of institutions or markets make up this shadow-banking ecosystem? There are some fairly familiar names among them, are there not, Blackstone being one of them? Give us a few others.
ADRIAAN PASK: If we look at it from an asset-class perspective, focusing on the riskier subset of the shadow-banking system, the largest component is private credit in particular.
This segment, which I mentioned earlier for its fast growth, was relatively small compared to the broader shadow-banking system. About five years ago, it stood at around $500 billion. While still significant, that was modest relative to total assets in the system. Today, that $500 billion has grown to over $2 trillion, reflecting rapid expansion.
This growth has been driven in part by marketing initiatives from some private credit issuers promoting these products to retail investors, and so on. We are quite concerned, as we don’t think that’s the appropriate type of client for that vehicle – but we can address that component later.
Another point that might surprise people involves conventional money-market funds, which are generally considered quite safe. However, they are not protected under the same regulations as banks.
Regulators have introduced additional rules for money-market funds and have implemented insurance measures similar to those found in the banking system.
With banks, deposits are covered by national insurance – we have the same system in South Africa. Regulators have introduced similar protections for money-market funds.
You can imagine that if investors suddenly panic and withdraw large amounts, it creates a scenario similar to a run on the banks – too many withdrawals at once, with insufficient liquidity to cover them. This can lead to losses, but this risk in money-market funds has largely been addressed through these regulatory measures.
Another component of the system is hedge funds, which represent a substantial part of the market, with about $12.5 trillion in assets globally.
Our concern – especially considering the growth I mentioned earlier – is that risk appetites have also increased. The average leverage in this space is now eight times net asset value, a record high for hedge funds.
Finally, if we look at the crypto market, particularly where investors can buy crypto through platforms that allow leveraged purchases, we see a potentially dangerous combination.
Crypto markets are highly driven by sentiment, and introducing leverage amplifies risk. Unlike the banking system, the safeguards that protect investors in more traditional markets are largely absent here.
We’ve seen some more recent failures in this space. One example is Blue Owl Capital. That name might not be familiar to everyone, but it is one of the more prominent credit players in the US, and it has recently faced liquidity constraints. They had a retail-focused fund where certain credit instruments were sold to retail investors, and significant capital calls could not be met. As a result, the funds had to be ‘gated,’ meaning they were closed to new redemptions.
Other major players in this space include Blackstone Private Capital and KKR. There are quite a few large-scale players in the US, though fewer in South Africa.
Nonetheless, there are consequences for our local environment, particularly in the crypto space. Vulnerabilities in the global system can affect local crypto holders, and any repricing of credit markets resulting from failures in the private-credit space could also impact the capital or valuations of local assets.
CIARAN RYAN: Finally, Adriaan, you’ve touched on some of the risks, one of them being, I guess, a liquidity mismatch. These shadow banks would borrow short term and lend long term. They don’t have the safety nets that traditional banks have, but there are other risks.
What are the key takeaways for investors as a result? They presumably have to know they’re dealing in an unregulated environment, so what other things should they bear in mind?
ADRIAAN PASK: I think it’s important to go back to the first principles of regulation. The rules that exist for banks – designed to address issues like a run on the bank – are fundamentally aimed at managing a material risk: liquidity mismatches. When people demand more capital than a bank can provide, a mismatch arises.
In parts of the shadow-banking system, the lack of comparable regulation means this risk often remains largely unaddressed.
The Blue Owl example illustrates this clearly: redemption freezes occur when an entity says ‘Sorry, we can’t return capital now,’ which can trigger panic in the wider environment and introduce additional risk.
From this perspective, contagion risk – something I alluded to earlier – is largely a product of these liquidity mismatches.
These entities are typically interconnected, so stress at one large player can easily propagate and create problems for similar providers elsewhere.
So this is a typical banking crisis. The banking crisis typically comes in when there’s a handful of players or even one large player experiencing issues, and that contagion risk then spreads into the other environments. This is an interesting one because Jamie Dimon, the CEO at JPMorgan, has spoken quite a bit about this contagion risk that concerns him in the environment.
And then there’s leverage. As I mentioned with hedge funds, leverage is already at record levels, but what concerns me further is how some of these instruments are being positioned or sold, which I believe can be somewhat misleading.
Providers often claim that these instruments are less volatile, but that perceived stability is largely because they are not priced as frequently as, for example, a stock on the stock market.
In many cases, the issuer needs to sell value, and obviously there is a conflict of interest there. The instrument might not be as volatile as measured by the price that’s being determined, but that’s only because the price isn’t accurately determined every day.
So you may feel that it’s not as volatile, but it’s actually just concealing another risk – and that opacity is a risk in itself.
Those are some of the key risks that we think are there. But, largely within that, following the discussion that we’ve touched on so far, it is very clear that there are some regulatory gaps.
Regulators are struggling to keep pace with the size and complexity in areas of the shadow-banking system. And with that stress test, those conducted by the big central banks, for example, [they] aim to identify the vulnerabilities.
But much of the sector remains untested under real crisis conditions. And what we’ve seen historically is those regulations only follow a disaster.
They are not really pre-emptive, and regulation is set into place only once the lessons are learned.
Our fear is that in some of these areas, there are going to be lessons learnt by investors, and only then will regulations follow.
That’s not the situation you want to be in; you would rather be in a situation where you can, with the right advice, evaluate the various risks properly and make sure that you are not overexposed before a crisis actually takes place and regulations will inevitably follow.
CIARAN RYAN: We’ are going to leave it there. Thank you very much. Adriaan Pask is chief investment officer at PSG Wealth.
Brought to you by PSG Wealth.
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