As rising interest rates shake financial markets, dangers are growing in what is known as the shadow banking system of largely unregulated institutions that provide more than half of all U.S. consumer and business credit.

The Federal Reserve has lifted its benchmark lending rate this year to its highest level in 15 years, triggering a sharp decline in speculative cryptocurrencies, technology stocks and housing prices.

Now, if the economy plunges into a recession next year as rates continue rising, some regulators fear that problems at unpoliced “shadow banks” could ricochet through the financial system or increase the number of lost jobs.

The Fed hopes to bring inflation under control without causing a recession. And so far, traditional banks like JPMorgan Chase and Goldman Sachs are weathering the storm, thanks to regulations imposed following the 2008 financial crisis that required them to hold more capital in reserve to absorb losses.

But financial risks have not gone away; they have just moved out of the spotlight.

While those regulations made the big banks safer, they did nothing to prevent other institutions, such as hedge funds, insurance companies, asset managers, money market funds and fintech companies, from taking risks. Facing few of the disclosure requirements of deposit-taking banks, these shadow banks binged on borrowed money and acquired assets that could be hard to sell in rocky markets, analysts said.

“We need to worry, a lot, about non-bank risks to financial stability,” Michael Barr, the Fed’s vice chair for supervision, said in a speech earlier this month.

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One area that has some analysts concerned is the roughly $1.5 trillion market in private lending, which has more than doubled in size over the past several years and now rivals junk bonds as a source of corporate funds. Among the largest investors in the private credit funds that provide these loans are state pension plans, including those in California, New York and Arizona.

Desperate to earn higher returns when interest rates were low, these plans invested in funds that make loans to risky midsize companies and corporate takeover artists.

Private equity companies use much of that borrowed money in leveraged buyouts. Some of the deals are sizable: Blackstone Credit, Ares Capital and a Canadian pension fund last year provided a combined $2.6 billion to help finance Thoma Bravo’s buyout of, which took the company private.

Borrowers are attracted to private credit, rather than commercial banks, by the ability to borrow more relative to their earnings and the ease of negotiating terms with a smaller number of lenders.

In 2013, the Fed discouraged banks from lending to companies if the loan would push total debt to more than six times earnings. Some private credit funds, however, will exceed that limit, according to Ana Arsov, managing director at Moody’s, the credit rating agency.

Most private loans carry a floating interest rate. So the Fed’s higher rates are good for the loan-making funds’ profits. But they make it harder for the heavily indebted borrowers to make their payments, Arsov said.

The financial pressure on companies could lead to a wave of cost-cutting, including layoffs.

“There is a significant piece of the underlying employment of the U.S. economy that is linked to this,” she added.

Financial institutions other than banks now provide nearly 60 percent of total consumer and business credit, twice the 1980 share, according to Barr. Non-bank mortgage providers such as Quicken Loans last year wrote more than 7 out of every 10 home loans.

These institutions are vital to the economy. But they have a habit of getting into trouble.

In March 2020, amid the pandemic’s first panicky weeks, hedge funds sold massive amounts of Treasury securities to raise cash. With sellers greatly outnumbering buyers, trading in the normally liquid market — which influences the value of all financial assets — broke down. Only after the Fed took emergency action by buying $1 trillion worth of Treasurys did markets return to normal.

Likewise, it was non-banks such as the failed investment bank Lehman Brothers and the giant insurer AIG, which required a $182 billion federal bailout, that fueled the 2008 financial crisis.

The Financial Stability Oversight Council, created by the 2010 Dodd-Frank legislation, initially designated four non-banks as “systemically important,” requiring them to face tighter regulations because their failure could cause a broader crisis. But the Trump administration made it harder to issue such “too big to fail” verdicts and freed the last non-bank from that special scrutiny in 2018.

Under Treasury Secretary Janet L. Yellen, the council next year is expected to rewrite the Trump-era regulations. “The 2019 non-bank designation guidance undercuts the Council’s ability to address risks to financial stability,” said John Rizzo, a Treasury spokesman. “Secretary Yellen expressed her concerns about the 2019 guidance when it was issued and continues to believe it should be reassessed.”

On Friday, the council’s annual report said non-bank institutions represented a potential weak spot for the financial system, adding that “rising interest rates or a broader economic downturn could further amplify these vulnerabilities.” The report warned of a possible “deterioration in credit quality” in non-bank lending as borrowers made “optimistic” projections of their prospects for increasing revenue and cutting costs.

The Fed’s multiple rate hikes since March threaten to hurt investors who took on too much risk when money was inexpensive. Higher interest rates increase the cost of repaying debt. But they also affect investment flows, by making it possible to earn a better return on safe assets, like bonds, and making risky stocks, such as those of high-tech companies that won’t post substantial profits for years, less attractive.

An early sign of how hard the adjustment to a higher-rate environment could be came in October, when the British government bond market was rocked after bond traders rejected the new government’s tax-and-spending plan as inflationary. The frenzied trading rattled pension funds that had bet on interest rates staying low.

After the 2008 crisis, persistently low rates encouraged companies to load up on borrowed funds. Business debt this year rose to almost $20 trillion, equal to more than 78 percent of the economy, up from about 66 percent, or $9.5 trillion, in mid-2007, according to the Fed.

“Risk is definitely building up, unseen and unmonitored, and it’s going to surprise regulators just like AIG surprised regulators in 2008,” said Dennis Kelleher, president of Better Markets, a nonprofit that promotes tighter regulation of the financial industry.

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Still, some analysts play down the likelihood of any contagion, noting that the regulated banks at the core of the financial system remain healthy and that the rate hikes so far have not caused widespread financial problems.

“So far, this seems to be a controlled burn, much as the Fed intended,” said Steven Kelly, senior research associate at the Yale Program on Financial Stability.

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Though there is no sign of an imminent crisis, some parts of the private markets have shown cracks. Blackstone earlier this month restricted investors’ withdrawals from a $69 billion private-real-estate investment trust, after requests for cash exceeded preset quarterly limits.

The fund has gained more than 8 percent so far this year by investing in Sun Belt rental housing and warehouses, outperforming the stock market. But higher interest rates have hurt real estate values, prompting some investors to cash in. Those redemptions fueled the equivalent of a bank run and caused Blackstone to bar blanket withdrawals.

Former Fed chair Ben S. Bernanke said in a Dec. 8 lecture, while accepting the Nobel Prize for economics, that regulation of non-banks following the 2008 crisis had been insufficient.

“My concern is that the shadow banks, which were the original source of the crisis — there’s been some regulatory change, but not nearly enough in my opinion. And that, I think, is a problem that is still there,” Bernanke said. “We need to do something about that regulatory area.”

On the same day, the Financial Stability Board, a global watchdog established by the Group of 20 leaders, said that regulators must develop more robust plans for winding down failing non-bank institutions like insurance companies. “The largest cross-border resolution challenges that need to be addressed with some urgency remain in the non-bank sector,” the group said.

Private credit funds, run by asset managers like Ares Capital, are regulated by the Securities and Exchange Commission as securities. But unlike banks, the funds are not judged on their potential impact on the entire financial system, which regulators call the “macro prudential” perspective.

Regulated banks, however, are increasingly involved with the shadow banks. In 2021, deposit-taking banks increased their lending to non-bank institutions such as mortgage providers by 22 percent, even as other types of loans declined amid the pandemic, according to the Fed. Those links “could increase [the] risk to banks,” the Fed said, noting non-banks’ “limited transparency.”

There has been little regulation of private credit markets largely because the investors involved are sophisticated institutions rather than individuals.

Indeed, regulators have little information about private market transactions, including borrowers’ financial details, how sensitive the loans are to higher rates, or the risk that problems in one private credit fund could have spillover effects elsewhere. The combination of fast growth, opaque markets and debt has some analysts worried.

“It’s all completely opaque. If I was looking for a shoe to drop, that’s one I’d be worried about,” said Jeff Meli, head of research for Barclays in New York. “We’ve been lucky so far that higher rates have not been associated with a decline in economic activity.”

That’s because even after nine months of repeated Fed rate hikes, inflation-adjusted interest rates are still negative. Karen Petrou, managing partner of Federal Financial Analytics, said the stress will grow once rates move higher and really begin to slow the economy. After Thursday’s increase, the Fed now expects rates to peak next year above 5 percent and to remain there through 2023.

“It’s a very tricky situation. As rates rise, even in a mild recession, then it gets ugly,” she said.


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