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Banking turmoil turns spotlight on shadow banking sector’s resilience and oversight

Date Published: 13/04/23

The collapse of three US regional banks in the space of one week in mid-March exposed hidden vulnerabilities in the banking sector, from idiosyncratic bank management failures to supervisory lapses. Events in the US spilled over into Europe with the Swiss government-led rescue of Credit Suisse by UBS. This raised concerns over the possibility of further vulnerabilities that may still be lurking in the broader global financial system and shone a spotlight on shadow banking sector involving non-bank financial intermediaries (NBFI).

NBFIs largely fall outside the regulatory environment of mainstream banks. They include credit funds, pension funds, insurance companies, asset managers (e.g., open-ended investment funds), hedge funds, and structured finance vehicles. The growth in the NBFI sector accelerated after the global financial crisis and now accounts for nearly 50% of global financial assets, according to the International Monetary Fund (IMF). SMEs and commercial real estate (CRE) investors have been drawn to non-bank lenders for their funding needs for several inter-related reasons. Non-bank lenders tend to offer:

  1. more flexible lending with an appetite for higher leverage and risk;
  2. faster loan approval and rapid access to funds, compared to traditional banks;
  3. less bureaucracy and paperwork in the loan application process;
  4. a wider variety of loan options for SMEs, including invoice financing, merchant cash advances, asset financing, overdrafts, working capital loans, etc.;
    and a more bespoke service.

Non-bank lenders play a vital role in providing credit to corporates and CRE investors. However, this part of the lending market is now starting to gain the attention of the regulatory authorities following the fallout from the SVB debacle, where it is now funding a significant portion of the corporate loan market in the UK, the US and Europe.

Over the coming months, the spotlight on non-bank lenders may intensify, as central banks navigate balancing their interest rate policy against fighting inflation whilst trying to avoid causing a recession without also fuelling the type of financial stability risks that resulted in the collapse of the regional banks in the US. As a result, central banks will need to demonstrate even greater vigilance and agility in the implementation of monetary policy going forward.

In the UK, second-order impacts are expected to lead to diminished bank lending appetites to SMEs and higher-risk CRE investors. These sectors have been under pressure from the near-synchronised lift in interest rates by central banks around the world to tame stubbornly high core inflation – in part due to tight labour markets in many countries. The recent banking sector pressures serve as a reminder of the complex transition for the global financial system from a prolonged period of low interest rates and abundant liquidity to higher rates and tighter liquidity.

In the 15 years since the GFC, regulators have increased bank capital requirements to improve balance sheet resilience in the event of future adverse shocks. Under the Basel regulatory regime for banks, capital requirements have risen (particularly for higher-risk lending), which has disincentivised certain lending to SMEs and CRE investors, as it has become harder to make acceptable returns/profits. This environment opened the door for growth in the NBFI sector.

Last December, the Bank of England’s Prudential Regulation Authority (PRA) announced plans to overhaul the capital treatment for small business lending, as part of broader proposals connected to the implementation of Basel 3.1 rules in the UK. Under the new PRA proposals, the introduction of higher capital allocations will be imposed on banks’ lending to riskier borrowers, including SMEs and CRE investors. For example, one proposal indicates secured lending to an SME backed by commercial property will become more expensive than an unsecured loan due to higher capital charges on property-backed loans. The economic impact of the PRA’s proposals is projected to result in a 32% increase in challenger and specialist bank capital requirements for SME lending. This could reduce overall SME lending by up to £44 billion, according to a study by Oxera, based on an estimated total SME financing market size of £248 billion, according to underlying Bank of England data used in the report, commissioned by SME lender Allica. It also risks increasing the cost of debt for SMEs – who do not have the same access to wholesale debt markets as larger firms – while compromising their ability to invest and create jobs.

“Secured lending, ceteris paribus, should be expected to be less risky than unsecured lending because the loss given default should be lower for secured lending,” wrote Oxera in its March 2023 economic analysis of the PRA’s proposals. The report continued: “It is counterintuitive that the PRA is proposing a higher risk weighting for secured lending to SMEs than for unsecured lending to SMEs. Banks are unlikely to become more prudent if regulation encourages them to offer unsecured rather than secured business loans.” On the contrary, lowering the cost of unsecured loans relative to secured loans may have the perverse effect of incentivising riskier lending by banks. Notably, the EU is reportedly proposing an exemption to this rule for European SMEs.

Moreover, the IMF has suggested that policymakers may look to implement robust surveillance, regulation, and supervision over the NBFI sector to mitigate future risks to financial stability. For example, timely and granular public data disclosures and governance requirements could be imposed to eliminate gaps in regulatory reporting of key data and identify NBFI risk-taking with borrowing and derivatives. Stricter supervision could also include increased capital and liquidity requirements to help steer NBFIs away from excessive risk-taking through incentives and opportunities, but this may come at the risk of higher debt costs to borrowers and lower overall liquidity.

Market participants are left asking: how long is the shadow banking market going to be left to its own devices? And if regulations do come in, will they hinder the ability of smaller borrowers such as SMEs to obtain debt capital in the same way that these borrowers have struggled in recent years to get funding from banks? Time will tell, but the light-touch era for the burgeoning shadow banking sector by regulators could  be over.


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