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The rise of shadow banking may pose risks to financial stability, Fitch warns

The rapid growth of global shadow banking since the financial crisis has shifted risks away from banks but kept them within the financial system, which will be affected if there is any stress in the sector, Fitch Ratings said in a new report May 21.

Shadow banking, which Fitch defines as lending or financing done by firms other than banks, central banks, public institutions, insurers, and pension funds, accounted for assets of $52 trillion, or 13.5% of the $381 trillion total global financial assets as of 2017-end.

The two countries with the largest amount were the U.S., with $14.9 trillion of shadow banking assets, and China, with $8.3 trillion. While U.S. shadow banking assets have been roughly stable since 2010, China has seen a sharp increase, with a compound annual growth rate of 58.1% since 2010.

More regulatory scrutiny

The strong growth has drawn more scrutiny from China's national regulators, and authorities elsewhere in the world are also looking to impose more requirements on shadow banking given the lack of transparency and modest regulation in the sector, according to the report.

European Central Bank Vice President Luis de Guindos called for more regulatory oversight of shadow banking at the City Week conference in London on May 21, warning that nonbanks have accumulated more credit and liquidity risks on their balance sheets in their chase for yield.

Although regulators need to make efforts to mitigate potential systemic risks coming from the shadow banking space, they also need to balance these "against their desire to maintain credit availability, particularly for the under-banked," Fitch said.

Regulators in China have focused their efforts on improving transparency and disclosure at shadow banks in an aim to reduce contagion risks rather than trying to shrink the sector itself, according to the report. They need to tread carefully as they want to contain the rapid growth of shadow banking without affecting the ability of Chinese banks to access credit for the domestic economy or financial markets more broadly, the rating agency said.

Banks' exposure modest

On a global level, the banking sector's direct exposure to shadow banks is modest both in terms of lending and borrowing, Fitch said.

Assets lent or borrowed from shadow banks accounted for less than 6% of total bank assets in 2017, having gradually slowed down since 2010, according to Fitch data. However, banks may suffer from indirect hits to the financial system coming from other forms of market connectedness to shadow banking or asset price volatility which may be caused if the latter sector experiences stress.

Likely due to a high dependency on bank lending and the less developed capital markets on the continent, western European banks are more exposed to shadow banking than global peers. Fitch data showed that of the six countries with the largest nonbank lending exposure in 2017, five were located in western Europe.

In the U.S., Goldman Sachs Group Inc. and Morgan Stanley are most exposed to shadow banking among the country's 15 leading banks by asset size. This is because traditional lending is not their core activity and therefore a bigger part of loans in their portfolio are to non-depository financial institutions, Fitch said.

Shadow banking can be positive if it is sufficiently transparent and provides additional sources of credit and liquidity to support economies, the rating agency said. But the performance of shadow banks through the next credit cycle will be needed to determine whether a higher reliance on the sector as a source of financing to the economy is more beneficial than a bank-concentrated model.

Future risks

Three main factors could heighten Fitch's concerns about shadow banking in 2019 and beyond — further rapid growth, credit quality deterioration, and funding and liquidity pressures.

Continued strong growth in the currently competitive underwriting environment would mean shadow banks take higher risks. Credit quality weakness against the benign economic backdrop across most developed economies at the moment would also be a red flag. Furthermore, funding and liquidity pressures may affect the viability of shadow banks, the rating agency said.

"Fitch expects shadow banking to continue to attract incremental regulatory scrutiny at both the country-specific and international levels, as the sector continues to grow in size and potential systemic importance," the agency said. However, barring any marketwide shocks emanating from shadow banking, "more meaningful regulation of shadow banking will be confined to specific countries" such as China and India, it added.