In a joint report published Thursday, the European Central Bank (ECB) and the European Systemic Risk Board (ESRB) examine the potential systemic risks that can arise from connections between banks and shadow banks driven by the important roles that both sectors play in liquidity management, supplying leverage and market-making.
Among other things, the report finds that deepening connections between banks and non-bank financial intermediaries — such as securities firms, hedge funds and investment funds generally — are significant and “they create important vulnerabilities that could amplify stress in adverse market conditions.”
According to the report, those risks come largely from banks lending to non-banks that are highly leveraged, and, conversely, the concentrated role of shadow banks in supplying short-term funding to banks.
For instance, the banks’ lending to shadow banks exposes them to the results of the non-banks’ trading strategies, the report said — increasing their vulnerability to market volatility, which can lead to asset fire sales that further exacerbate that volatility, and create losses for both bank and non-bank players.
At the same time, the banks’ reliance on non-banks for short-term funding could pose a risk to the banks in periods of market stress, if that funding dries up as shadow banks come under pressure — and that funding source can’t easily be replaced.
“A negative and systemic price shock in asset markets could trigger redemption requests to [non-banks] and margin calls on derivatives and repo trades. This, in turn, could potentially result in a broad-based decline in [non-bank] funding to banks,” the report said.
These vulnerabilities primarily accumulate at the large, globally-active European banks that often serve as intermediaries between Wall Street firms and hedge funds, it noted.
As a result, the report finds that “risk-bearing capacity” among these banks “is key to absorbing shocks in the financial system and preventing the amplification of financial stress.”
For instance, capital and liquidity buffers need to be adequate to guard against the risk of “procyclical” actions — financial stress causing banks to withdraw leverage, or increase margin requirements on non-banks, which could, in turn, cause non-banks to liquidate assets.
The existence of capital cushions “allow banks to maintain smooth provision of liquidity, leverage and financial services to the [non-bank] sector during episodes of financial stress,” the report said.
Against that backdrop, the report also called for action to ensure that regulators have adequate data to oversee the potential build-up of these kinds of risks.
“The limited availability of data on balance sheets and the financial risk of [non-bank] entities such as hedge funds, private equity and private credit funds is a key gap hindering assessment of the riskiness of bank exposures,” it said.
In particular, regulators have very little data on the European banks’ exposures outside of Europe — including their exposure to Wall Street firms, and other global players, which reduces the visibility of the banks’ risks.
“Improved information sharing, including a centralized mechanism for data access and sharing, could remedy some of these constraints,” the report said.
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