Pressure builds on shadow banks as pandemic spurs rush to cash

During the financial crisis it was obvious where the stresses within the global financial system lay. With the pandemic-induced panic now flowing through the financial system, the threats to system stability aren’t as visible or concentrated.

With all the post-crisis reforms, the world’s banking systems are certainly far better capitalised and funded than they were in 2008, if not immune to the economic fallout from the coronavirus. While there are weaknesses in some systems, particularly Europe, they haven’t provided the instant flashpoint that they did at that time.

While the banks were a crucial flashpoint during the GFC, shadow banks are bearing the brunt of the coronavirus-induced panic currently roiling markets.Credit:Bloomberg

Instead, the initial impacts of the dramatic falls in sharemarkets – the US market was down 15 per cent last week and is now down almost a third from its February peak – and the crashing of bond prices have been far more widely distributed among non-bank institutions and, ultimately, among individual investors.

With banks ruled out of proprietary trading and withdrawing from market-making because of the post-crisis rules, it has been non-banks – shadow banks – that have been most affected by the turmoil in the markets.

In the post-crisis era there’s been massive growth in the funds under management of passive, or index-related, investing and in the exchange-traded fund sector. The ETF sector has roughly doubled in the last three years alone, with assets under management approaching $US6.5 trillion ($11.3 trillion).

Financial regulators have been concerned but uncertain about the implications of the growth of passive investing and of the ETF sector, particularly about the more exotic ETFs that are highly leveraged or that invest in physical commodities, junk bonds and even other ETFs. The regulators have been worried that there could be value or liquidity mismatches that could exacerbate a future financial crisis.

Those fears have been increased by the search for yield. With banks being forced by the post-crisis regulatory environment to become more conservative in their lending, asset managers have become the main source of higher-risk funding and the search for yield in a low-rate environment has drawn them further along the risk spectrum.

That search for yield and the low-cost access ETFs provide to markets has also seen the funds’ investor bases increasingly institutionalised. Pension funds, hedge funds and insurers are heavily exposed to the performance of the big index-investing and ETF managers.

The crisis is now upon us but, so far, the index funds and ETFs are performing as advertised, providing secondary market liquidity even when the liquidity in the underlying securities they hold has dried up.

That doesn’t mean they haven’t been impacted. The headlong scramble by investors for cash last week that caused the yields on three-month and six-month Treasury bills to dive into negative territory has also seen a flood of redemptions from ETFs and other funds.

Last week, Black Rock and Vanguard quadrupled the costs for large investors wanting to cash out their investments in some of their fixed-interest funds. Big investors have had the ability to exchange their shares in ETFs for the fund’s underlying investments. That abruptly became far more expensive as the managers moved to protect the liquidity of their funds.

Asset managers shouldn’t pose systemic risks. They are, or at least should be, purely middlemen, with their investors the ones exposed to movements in the value of the underlying securities they hold.

Given that there are funds with leveraged exposures to high-yield, or junk, bonds and volatile commodity prices, some funds – and their investors – may well see the value of those underlying assets implode.

The collapse in oil prices, for instance, will see the value of the assets within those funds most exposed to the US shale oil and gas sector decimated, with the end investors in the funds wearing the losses.

In effect, losses that might previously have been concentrated within financial institutions closer to the centre of the financial system are being democratised.

What the growth in passive funds and ETFs may be doing, however, is exaggerating the volatility within financial markets. The daily and intra-day fluctuations in equity and bond markets have been extreme.

With little liquidity in the underlying bonds or shares – in the absence of market makers – the funds provide the ability to cash out and, with all asset classes unusually correlated during the waves of panic selling, that magnifies the market moves.

Mutual funds with redemption facilities are, obviously, a different case. The US Federal Reserve Board was last week forced to offer emergency loans to banks to fund purchases of commercial paper and other securities from money market funds that invest in short-term debt.

That will help the funds to finance the tide of redemptions they have been experiencing as investors seek the safety of cash.

So far, the difference between the 2008 crisis and the melt downs created by this pandemic is that, whereas in 2008 the risk was concentrated within banking systems, this time it is being distributed widely to end investors.

Banking systems will, of course, face their own challenges and are very exposed to the savage economic downturn and the impact of social distancing directives on their business customer bases.

So far the system generally is holding up but the pandemic is providing the first test of a shadow banking system that exploded in the aftermath of the last crisis.

As Warren Buffett has said, it is only when the tide goes out that you find out who has been swimming naked. The tide is definitely ebbing, rapidly. If there are weaknesses in asset management entities or elements of the non-bank sector, the pandemic will inevitably expose them.

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