Economy & Markets

Regulators must take action on shadow banks, which have grown significantly and pose a key risk to the financial system

By James Langton |

Regulators must act to address the rising risks that the so-called "shadow banking" sector poses, argues a new report from the Toronto-based Global Risk Institute (GRI).

Shadow banks, which include various financial intermediaries that operate outside the traditional regulated sector, have grown significantly in the years since the global financial crisis and pose a key risk to the financial system, consumers and investors alike, the report states.

"A growing and evolving sector, with similar risks but fewer formal risk controls, leads one to question whether the existing governance approach is sufficient," the report says. "Our view is that more needs to be done to make the global financial system safer and to curtail regulatory arbitrage."

Specifically, the report calls on regulators to introduce minimum liquidity requirements for shadow banks deemed "systemically important." This should be "a starting point to reduce the risk of a shadow banking sector liquidity event creating a crisis for the broader financial markets," the report suggests.

The report also calls for greater transparency to both consumers and investors who are dealing with firms in the sector. In particular, the paper raises concerns about consumer lending and auto finance activities, which may be increasing the indebtedness of subprime borrowers. As these lenders have fewer constraints, they're "more vulnerable" to a rise in defaults.

On the investment side, the report highlights the risks of complex, credit-related investment products being produced by the shadow sector.

"Enticed by the promise of relatively high returns, unsophisticated investors may not understand that their capital is at risk, or that some of these products are not readily redeemable," the report notes.

Along with liquidity requirements, the report calls for regulators to increase the disclosure provided to consumers who borrow from non-bank entities.

"The products they offer can expose already vulnerable borrowers to significant leverage and the downside risks and impacts should be clearly understood," the report says.

Furthermore, the report calls for improvements in "the disclosure for investors in the growing array of credit-related investment products so that the associated risks to capital, as well as the ability to redeem their investments, are made clear."

"At a minimum, we need transparency standards that shine a brighter light on the risks facing consumers who borrow from non-bank lenders, and better disclosure for those investing in the growing array of credit-based investment products." says Sheila Judd, executive in residence at the GRI and author of the report, in a statement. "And a basic liquidity requirement that would apply to shadow banking entities over a designated size would be a good starting point to mitigate the broader systemic risks."