Will shadow bank contagion impact traditional banks?

The challenging operating environment for shadow banks, including increasing interest rates, a tighter funding environment and a potential global recession, will likely slow down global shadow banking activity. Those operating with high leverage or taking significant credit risk could face financial pressure.

But could their problems spill over into the traditional banking sector?

S&P Global Ratings argues that the contagion risks are manageable. In its report entitled ‘When rates rise: risks to global banks could emerge from the shadows’, the rating agency said that it doesn’t currently see such risks as having a major impact on traditional banks’ ratings. However, it believes that a slowdown in shadow banking activity would have a negative effect on banks’ profits, and on their capacity to source funding from shadow banking clients and counterparties.

The shadow banking sector, which is defined as a subset of non-bank financial institutions performing credit intermediation activities, has grown rapidly in recent years, with assets climbing to $68tn at end-2021, or 14% of global financial assets, according to the report. Investment funds were the fastest-growing subsector among shadow banks in the past decade, reaching almost 80% of all shadow banks’ assets.

Despite the sector’s rapid expansion, S&P Global Ratings estimates that traditional banks’ direct exposure to shadow banks is limited, at 2.6% of total bank assets. However, as highlighted by the report, traditional banks’ business relationships with shadow banks are varied and complex. For traditional banks, shadow banks can be either competitors, partners or clients.

For example, traditional banks may compete with shadow banks for certain lending segments (financial companies), certain market-making activities (broker-dealers) or customer savings (investment funds). However, they also partner with several shadow banks to offload risks that they originate but are unable or unwilling to carry and/or to manage their liquidity needs.

In addition, traditional banks provide key services and market-making solutions to several investment funds, for example, prime brokerage services to hedge funds or securities firms. These activities result in both fee generation and balance-sheet exposures. “While they can be a lucrative profit source, they require prudent management of counterparty credit risks,” said S&P Global Ratings.

Therefore, a reduction in shadow bank activity would have an impact on traditional banks’ profits, but only a limited impact on their balance sheet exposures, according to the report.

Beyond direct exposure via the balance sheet, S&P Global Ratings sees three main indirect contagion channels through which a large shadow bank’s failure or a broad deleveraging of the shadow banking sector could affect traditional banks:

• Contagion via shared exposures to end clients;
• Contagion via financial market losses; and
• Contagion via perceived interconnectedness and reputational risk.

However, a series of global regulatory initiatives have been brought in following the global financial crisis in 2007–09. Although considered to be a work in progress, these initiatives have improved transparency and mitigated shadow banking risks for traditional banks.

As such, S&P Global Ratings stated: “We believe traditional banks are now more aware of and able to manage counterparty credit risk, having learnt lessons from previous crises. Traditional banks are also more resilient, with higher capital and liquidity ratios, and therefore are generally better prepared to resist financial shocks, including those potentially stemming from shadow banks.”

Joy Macknight is editor of The Banker. Follow her on Twitter @joymacknight

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