Paritosh Bansal
(Reuters) – The U.S. Federal Reserve has proposed new rules that would allow it to collect more information about banks’ exposure to shadow banks, a sign that regulators are trying to understand the risks of shadow banking and the limitations of their approach.
Shadow banks are a collective term for non-bank financial institutions such as private funds and mortgage servicing companies that are lightly regulated and opaque.
Regulators and industry experts have increasingly expressed concern about systemic risks that could lurk as interest rates remain higher for longer than the market expected, particularly in areas such as private credit and lending to private funds. Shadow banks have expanded as regulation makes it more costly for banks to borrow in some areas.
Over the past month, I’ve asked lawyers, bankers and market participants what U.S. regulators have done to address these risks.
One banker said regulators have asked his firm, a major Wall Street bank, for details about its overall exposure to individual companies with far-reaching shadow-banking operations, such as the big private-equity firms. The banker, who spoke on condition of anonymity to be candid, said regulators even want to know whether the bank is lending to portfolio companies of those funds.
Then on June 21, the Fed released detailed proposed rule changes that would essentially allow it to collect that kind of information more broadly and systematically from large banks.
Regulators are requiring banks to regularly report detailed information about their loans to shadow banks, including the structure of the banks, the collateral used for the loans and how the collateral was valued. They also want to know whether the companies the banks have loaned to are owned by financial sponsors.
Substack publication Bank Reg Blog previously reported on the proposal.
But despite these efforts, regulators will still ignore large parts of the financial sector. For example, the Fed estimates that U.S. banks’ total exposure to nondepository financial institutions will reach $2 trillion by the end of 2022. The private credit market alone is currently worth $1.5 trillion, according to data provider Preqin.
Chip McDonald, a financial-services lawyer in Atlanta, said regulators are trying to catch up on new banking-like activities. “There’s been a lot of discussion about this, and I’m not sure this proposal is going to answer the questions,” Mr. McDonald said.
Regulators are aware of the problem: The chair of Europe’s banking regulator told my colleagues last week that they face a “black hole” of information that can only be solved by mandatory disclosure, a process that could take years.
The story continues
The G20’s Financial Stability Board is collecting data on shadow banks’ relationships with lenders, and Reuters reported in December that the Bank of England had also asked banks to report their private credit exposures.
The Fed’s data-gathering efforts are driven by annual stress tests that test how well big banks can withstand economic shocks, for example, and are unclear how well coordinated those efforts are across jurisdictions and regulators.
Further information
In its proposal, the Fed said the expansion of shadow banks poses risks to banks but a lack of data hinders their “ability to consistently measure, monitor, and model risks from these exposures under stress.”
The proposal seeks to address this issue by requiring more “detailed information” about lending to shadow banks, in the form of collecting detailed loan-level data for stress tests. The confidential form, called the FR Y-14, is used widely across the Fed for supervision and assessment of financial stability risks.
The Fed will have to finalize the rules after a comment period, so data collection probably won’t begin until the end of the year or the first quarter of 2025. The Fed will then have to decide how to incorporate this information into future annual stress tests.
No alternative
Meanwhile, as the economy slows and business models dependent on ultra-low interest rates adjust to a more normal environment, the risks will only grow. Some companies may not be able to withstand it.
For example, private equity firm Vista Equity is in talks to sell control of its PluralSite subsidiary to private credit lenders, in the first major debt restructuring by a shadow bank borrower.
Andrew Metrick, a finance professor at Yale University and director of the school’s Financial Stability Program, said he couldn’t see a better alternative.
“It’s useful to look at banks; they’re a major linchpin of the system,” Metrick said, but he added that regulators “need to be concerned about how private credit interacts with a range of things, not just banks.”
(Reporting by Paritosh Bansal; Editing by Anna Driver)