Luis de Guindos, vice president of the European Central Bank, said the growing shadow banking sector is potentially vulnerable and called for it to be actively monitored.
De Guindos said at the City Week conference in London on May 21 that the nonbank financial sector, or shadow banking, was becoming ever more important to the financial system, but regulation of it is still in its infancy.
Shadow banking is the term used to describe lenders, such as insurance companies, which may be regulated but are not subject to banking regulation. It has grown in size for six consecutive years and at $184.3 trillion accounts for almost half of total global financial assets, the Financial Stability Board said earlier in 2019.
De Guindos said the share of market-based financing is likely to continue to grow, in particular because of the capital markets union — the European Union initiative that aims to deepen and further integrate capital markets in the bloc.
"More integrated and deeper European capital markets will promote a more diversified funding base for the European corporate sector. This, in turn, will help firms weather a possible shock to the banking sector and a resulting decline in the supply of bank credit as they would be able to draw on other, market-based, funding," he said.
Credit, liquidity risks
However, this could only happen if market-based finance remains resilient in the face of such a shock, said de Guindos, and he warned of growing vulnerabilities in the sector.
"In search of higher yields, nonbanks have accumulated more credit and liquidity risks on their balance sheets. This renders them more vulnerable to the low credit quality and high indebtedness in some segments of the corporate and government sector," he said.
De Guindos warned that shadow banks could already be contributing to the current underpricing of risk partly because shadow banks are subject to lighter regulatory constraints that in some cases can allow them to take on more risks. He warned that if these risks were to unwind in a disorderly manner then funding flows could dry up and funding conditions in the real economy could be affected more broadly.
Regulatory oversight needs developing
It is vital to strengthen regulators' risk identification and monitory of the shadow banking sector, while international cooperation was needed to develop tools for stress testing and to look for tipping points, de Guindos said. He said prudential standards must remain solid in the shadow banking sector but he warned that though the prudential standards to which banks are held were well-developed and provided regulators with the tools to address risks, that was not the case with the shadow banking sector.
"The framework for nonbanks is still in its infancy and needs further development," he said.
He also called for the Basel III package of banking reforms to implemented in a timely manner across jurisdictions, including the "output floor," which limits the capital benefit a bank can gain from relying on internal models rather than on standardized models.
This has come to the fore particularly after Metro Bank PLC, which operated on a standardized model, made a serious error in classifying the risks associated with its loans and led to calls for risk-weighted assets to be independently audited in future.