Shadow banks have come under increasing financial pressure in recent months due to interest rate rises, potentially putting Ireland at risk of a mini-crisis in the funds sector, according to UK research firm Capital Economics.
The firm said the changing rate environment has caused a deterioration in liquidity for non-bank financial intermediaries (NBFIs) invested in riskier assets such as junk bonds and emerging market debt.
Spreads are widening and requests for redemption are increasing – both symptoms of stress – meaning funds could be subject to sudden strains due to mismatches in maturities and available cash.
Such problems emerged during the market panic at the onset of the Covid-19 pandemic in March 2020. While nothing as dramatic is currently underway, Capital Economics believes risks are increasing as the cost of money rises.
“There is some evidence to suggest that NBFIs have started to come under more pressure as interest rates have risen and financial conditions have tightened more broadly,” said Capital Economics global economist Ariane Curtis.
She warned that advanced economies with large shadow banking sectors were most vulnerable to any emerging problems with NBFIs and named Ireland as one major financial sector with a high proportion of shadow banking activity relative to its economy.
However, she also said “liquidity mismatches” in the funds sector would be unlikely to trigger a major financial crisis, as happened when the banking sector collapsed in 2008, or spill over into the real economy.
We have to learn from history
But she added that funds are now important lenders and insolvencies in the sector could lead to weaker credit growth for households and businesses or even bankruptcies among firms dependent on non-bank lending.
Gabriel Makhlouf, the governor of the Central Bank of Ireland (CBI), last year called for tighter regulation of “hidden leverage” in the funds sector to prevent major financial shocks caused by too much borrowing.
“We have to learn from history,” he said. “There is clearly hidden leverage, interconnectedness and channels of propagation that we do not yet fully understand, and vulnerabilities building-up in the non-bank sector.”
Ireland has the third-largest funds sector in the world with 10,000 entities holding assets of €5.6trn and is therefore a critical forum for new regulation of funds in Europe.
