How big a threat is the shadow banking sector to EU?

The rise of shadow banking and other non-bank financing has become one of the major drivers influencing the financial structure of European Union.

During the post-financial-crisis period (after 2008), regulatory authorities focused primarily on stabilising and strengthening traditional banking institutions.

At the same time, another shift has occurred at the same pace as an ever-increasing portion of capital is raised by asset managers, hedge funds, privately held equity firms, and fintech platforms.

These organisations have a more dominant impact on the European economy than they used to have before.

This change was the fabrication of the post-crisis rules which curtailed the lending by the banks; as a result, investors and firms found other aids of financing that could provide them better returns.

The availability of credit by non-bank financial institutions has been facilitated by financial technology. Thus, fintechs, funds, and other private lenders have taken an even larger role in funding the economy.

The capital-markets union was one of the efforts created by the EU to promote investment across borders, as well as allow the EU not to become too dependent on banks.

Ideally, the transformation would make the financial system more resilient as it would spread the risk and tap more into the private savings. That said, the highly-selected, less-regulated actors are now exposed to fresh cracks the very construct of stability that the EU had built in the years after 2008.

Large volumes of funding are now flowing through entities whose balance sheets are opaque, leverage difficult to measure, and activities capable of amplifying shocks when liquidity becomes scarcer. Taken together, asset managers and investment funds hold trillions in assets across the EU, with wide variations in leverage ratios across jurisdictions.

In times of market stress, simultaneous attempts to sell assets in order to meet redemptions could create sudden price collapses that feed back into the banking system through shared exposures.

Without harmonised EU standards, the existence of national differences creates regulatory arbitrage, which can lead to the rebirth of shadow intermediation in an online form.

Regulatory arbitrage

The industry of asset management and investment fund, in totality, possesses trillions in assets in the European Union. There is a high degree of leverage variance in these assets across the member states.

During stressful periods of the market, efforts to sell off such assets to settle redemption requirements, within the stipulated period, can result in sharp price falls that could spread out into the banking industry, via standard exposures.

Some systemic spillovers remain to be unresolved as responses to the advisories issued by ESMA (European Securities and Markets Authority) have been slow and uneven. Supervision of the non-bank entities proves difficult because some of them are regulated nationally, whereas some of them are regulated by cross-border fund models, which are flexible, e.g., Luxembourg's UCITS (Undertaking for Collective Investment in Transferable Securities) and AIF (Alternative Investment Fund).

As much as this operates to attract foreign capital, the flexibility presents a challenge to the regulators to oversee the mismatch of liquidities, leverage, and off-balance sheet risks.

The banking tools that are developed as macro-prudential are not easily transferred to funds and fintech lenders and the EU still lack the necessary information, coordination and legal certainty to offer such devices.

The rapid growth of digital finance has presented new non-bank practices which regulators are striving to understand.

Typically marketed through lax licensing regimes, peer-to-peer lending, buy-now-pay-later services and tokenised investment products tend to be more dependent on data and market sentiment than capital buffers. Without harmonised EU standards, the existence of national differences creates regulatory arbitrage, which can lead to the rebirth of shadow intermediation in an online form.

As private credit grows, central banks lose some control over monetary transmission because more firms borrow from non-bank lenders instead of traditional banks.

European companies rely heavily on investors from the US and the UK for corporate bonds and private debt. This dependence exposes Europe to shifts in global liquidity and sentiment, weakening its financial autonomy during periods of stress.

The fast-spreading of shock by the non-bank sector has been proven by recent stresses in liability-driven investment funds in the UK and the liquidity crunch in bond markets undergone within the pandemic.  

Predicted future crises may compel the European Central Bank to provide market-backing assistance, further blurring the boundary between monetary and fiscal responsibilities and raising concerns about accountability, distributive effects, and moral hazard.

The main idea is that non-bank finance now is crucial in the development of the whole economy and green transition in Europe, but it is not unaccompanied by risks.

A total crackdown cannot be done or is not desirable.

Hence, the issue is to ensure that innovation does not outpace regulation.

Europe needs more oversight, better cross-border data transmission, and new macroprudential instruments specific to the funds and fintech, as stability can match the growth of the market.

Provided that the EU is fast and united in action, non-bank finance might continue to be the source of strength, and it enables strategic independence instead of a weakness that endangers financial autonomy. 

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