The shadow banking system can essentially be described as lending by institutions outside of the regular banking system. Examples include investment funds investing in home mortgages. Although the term shadow banks has a negative connotation, they represent a welcome source of funding alongside regular bank credit, particularly in Europe, where economies are heavily reliant on banks. Providing businesses with better access to a range of different sources of funding increases the economy’s resilience to shocks. It is important, however, to keep a close eye on any new risks to financial stability that may build up. This is why the Financial Stability Board (FSB) is coordinating a worldwide project to monitor developments in shadow banking from year to year. This year, a new and more risk-based framework was introduced to provide more details on the extent and risks of shadow banking, including in the Netherlands.
“Shadow banking system smaller than previously thought, but new risks are being created.”
|Date||18 December 2015|
The Dutch shadow banking system is significantly smaller in size than previously estimated. The size and the risks of securitisation vehicles – which played a major role in the credit crisis – have declined substantially. At the same time, however, the rapid worldwide growth of investment funds in the shadow banking system is creating new risks. DNB is seeking to limit these risks through international agreements on the macroprudential use of existing policy instruments. DNB also plans to take steps to ensure proper monitoring of alternative credit platforms, such as crowdfunding and credit unions, so that transparent and resilient alternatives exist alongside bank funding.
Strong growth in investment funds creates new risks
Investment funds have expanded rapidly in recent years, with average annual growth of 10% since 2011. This applies also in respect to bond funds, funds-of-funds, mortgage funds, money market funds and hedge funds, all of which are seen as part of the shadow banking system because they invest in bonds and loans, either directly or indirectly, and act as a link in the chain of credit intermediation (see Figure 2). This sharp growth in investment funds is related to the stricter regulations that now apply to banks and that have prompted a shift in credit intermediation towards less regulated market participants. In addition, exceptionally accommodative monetary policy is squeezing the risk-free return, and that is encouraging investors to invest in funds with higher returns (and risks).
The strong growth in investment funds, however, is creating new risks. The main systemic risk in this respect is a scenario in which large numbers of investors decide to exit such funds (i.e. a run). Decisions by investors to sell their investments in such funds can force the fund managers into selling assets in less liquid markets and, therefore, at substantial discounts. This in turn can reinforce the impact of price shocks in the financial markets – certainly if funds are highly leveraged – and cause losses for Dutch banks, insurers and pension funds. This risk has increased in recent years because of the worsening liquidity in certain segments of the financial markets.
In order to counter these liquidity risks, fund managers need to take account of the possibility of a reduction in the tradability of those investments. In addition, DNB is seeking to further limit the risk of large-scale withdrawals from investment funds through international agreements on the macroprudential use of existing policy instruments – including stress tests, leverage limits and other restrictions. International coordination is important in this respect because investment funds can easily move across national borders; the risks arising are therefore of an international nature.
Clearer picture of securitisation vehicles since the credit crisis
Securitisation vehicles played a major role in the systemic risks built up in the period before the credit crisis. These parties packaged loans, which were then sold on to investors. The systemic risks increased because the risk profile of the loans that were split up and packaged was higher than it initially appeared, while the risks were propagated throughout the financial system in a non-transparent way. Owing to lower investor demand, securitisation vehicles have steadily decreased in size since the credit crisis, while supervision has also been tightened. As a result, average securitisations are now of lower risk than before, while the risks in Dutch financial institutions’ balance sheets are also more visible.
A quarter of the securitisation vehicles (EUR 81 billion; see Figure 1) are not covered by the prudential supervision system in the Netherlands and comprise part of the Dutch shadow banking system. Many of these securitisations belong to foreign parties and have a higher risk profile. The fact that regulation has become more stringent and the total assets held by these securitisation vehicles have fallen by over 40% means the risks are currently limited. DNB closely monitors the securitisation market so as to ensure any new systemic risks are promptly identified.
Limited size of finance companies and alternative credit platforms
A small part of the Dutch shadow banking system consists of finance companies that are not part of a bank (EUR 16 billion; see Figure 1). These companies provide credit – usually consumer credit or leasing contracts – and this may involve short-term funding and, therefore, bank-like risks.
Lastly, there are growing numbers of alternative credit platforms, such as crowd funding and credit unions. These initiatives bring those requiring credit into contact with those able to provide it and thus contribute to the diversity of the funding landscape. Given that alternative credit platforms facilitate activities involving bank-like risks and are still subject to very little supervision, they are regarded as part of the shadow banking system. As these platforms provide only a few tens of millions of euros in loans in the Netherlands, they still represent a very small share of the overall credit market. Requiring finance companies to be reporting agents and extending the reporting requirements for credit platforms where necessary will enable DNB to monitor future developments more closely and thus ensure healthy market finance