If you asked a few months ago where the next financial crisis might emanate from, most people probably wouldn’t have said regional banking. Rather, they might have guessed at the shadow banking sector, which has grown dramatically since the global financial crisis of 2008. It remains far less regulated than the traditional banking sector.
When the pandemic hit, non-banks such as hedge funds and open-ended money market funds pulled out of key credit markets, forcing governments to intervene to stabilise things. As Treasury secretary Janet Yellen said in a speech last week, “Put simply, the Covid shock reaffirmed the significance of structural vulnerabilities in non-banks.” Yellen pointed out a number of ways in which US regulators are trying to better monitor hedge fund leverage and address liquidity mismatches in open-ended funds and money markets. These can, when under pressure, “break the buck”, leaving small investors with big losses.
It’s good that policymakers are focusing on shadow banks, because I’d still bet that this is where the real nexus of risk in 2023 and beyond will lie.