From shadow banking to coronavirus, U.S. regulators eye lurking risks
U.S. regulators will gather Wednesday at a scheduled meeting of the Financial Stability Oversight Council (FSOC) to discuss risks to the United States and beyond. With fears around coronavirus driving market turmoil not seen since the 2007-2009 financial crisis, here are some of the top risks in their sights.
The rise of non-banks including hedge funds, private equity, fintech firms and asset managers that now operate outside the traditional banking system has become a growing source of heartburn for global regulators.
These firms have proliferated as strict rules introduced following the financial crisis saw traditional banks pull back from lending. Shadow banks generally operate outside the robust capital, liquidity and operational banking rules and are consequently less visible to regulators.
In particular, FSOC flagged the explosion of nonbank mortgage lenders in its 2019 report. Nonbanks now originate over half of all new mortgages compared with just 10% at the height of the 2007 subprime mortgage crisis. Regulators have warned that nonbanks have fewer resources to weather adverse shocks, and are more reliant on short-term funding that could be hard to come by in periods of significant stress.
Over the past year, regulators have ramped up scrutiny of the booming but risky leveraged lending market, whereby banks and private funds lend to already indebted companies, often to finance deals, at high interest rates. That market stands at about $1.1 trillion, according to FSOC.
Policymakers worry over-extended companies will struggle to pay back those loans during an economic downturn, leaving banks and investors who buy into the loans through structured products at risk of sizeable losses.
They have also warned that the underlying terms of these loans have been deteriorating. Last year, banking regulators wrote to Congress saying they had observed “less stringent protective covenants, more liberal repayment terms” and other provisions that “may inhibit deleveraging capacity and dilute repayment to senior secured creditors.”
Regulators also worry that a large amount of that debt could be downgraded by rating agencies in the event of a recession, which in turn would force some investors to unload the debt in a fire sale that could disrupt markets.
And to make matters worse regulators do not have a full picture of nonbank holdings of leveraged loans, according to a 2019 study by the Financial Stability Board.
Since mid-September, the Federal Reserve Bank of New York has been supporting the overnight lending markets relied on by banks and corporations, after a confluence of events led to sky-rocketing rates.
The $2.2 trillion repo market is a key source of funding for the U.S. financial system, as banks, companies and investors rely on it to meet daily operational needs. The market usually operates smoothly, with firms offering U.S. Treasuries and other high-quality assets as collateral for cash overnight before buying those bonds back the next day. The last time the market seized up was during the financial crisis, as companies became wary of lending, even in low-risk cases.
The Fed has been supporting the market since the fall, but it has said it would like to scale back its operations by the second quarter, wary of prolonged support of a private market. But growing market turmoil could complicate that effort as banks may be hungry for additional overnight liquidity.
CENTRAL CLEARING HOUSES
The expanded role of central clearing houses over the past decade has helped ensure that deals in the global swap market, which stands at more than $600 trillion in notional value, can be completed even if one party fails.
Concerns over cascading failures of derivatives trades were a key contributor to the financial crisis, as banks had to pay huge margin calls to their Wall Street counterparts. As a result, regulators forced banks to process their swaps through clearing houses, which daily gather and manage collateral to secure the trade.
But that effort has sparked some concern among regulators that too much risk may be concentrated in one place.