Shadow bank stress lurks, Moody’s warns

The global banking sector has so far weathered the stress of tighter financial conditions and dimming economic prospects. But the high-rate environment is boosting risks for the other half of the financial system — the shadow banking sector — says Moody’s Investors Service in a new report.

While the turmoil that gripped certain U.S. banks earlier this year was seemingly contained thanks to policy-makers’ quick action to fend off contagion risks, “there remain concerns about the risks posed by less regulated and transparent parts of the global financial system,” the report cautioned.

In particular, financial institutions that are carrying “more leverage, less liquidity and weak risk management will find it harder to navigate the cycle,” Moody’s said.

Tighter financial conditions make it tougher to generate strong returns and secure funding, the report noted.

These challenges are particularly acute for shadow banks that “adopted leverage-driven investment strategies or took on maturity risks when funding was inexpensive and abundant,” it said. Also, investment funds “face liquidity risks from redemption runs or margin calls triggered by falling asset values or weaker portfolio performance,” it said.

These issues could also spill over to the real economy, particularly in markets where shadow banks provide a larger share of funding to certain sectors, such as the small business and real estate sectors, which is the case in the U.S., the U.K., Korea and Brazil, Moody’s noted.

“[Shadow banks] cannot directly access central bank liquidity like banks can, and where there is a large degree of interconnectedness among [these firms] or with other sectors, stress in one institution can quickly spread to others,” it said.

“In pockets where regulatory oversight and transparency is low, it is difficult for policy-makers to anticipate and quickly stem risks that could damage market confidence and tighten liquidity,” it said.

James Langton

James is a senior reporter for Advisor.ca and its sister publication, Investment Executive. He has been reporting on regulation, securities law, industry news and more since 1994.