The Financial Stability Board has reported that the sector known as “shadow banking” now represents $250 trillion, or 49% of the world’s financial assets. Since 2008, hedge funds have seen their combined assets grow fifteenfold. Recent increases in bond yields, resulting from hedge funds unwinding heavily leveraged trades, have raised concerns that this largely unregulated sector could pose a systemic financial threat similar to the 2008 crisis.
The term “shadow banking” was introduced by economist Paul McCulley in 2007, shortly before the collapse of Lehman Brothers. The financial downturn at the time was driven by easy credit fueling a subprime mortgage crisis that nearly crippled the global financial system. Almost two decades on, a sell-off in the bond market triggered by former President Donald Trump’s tariff strategies has reignited fears of a liquidity crisis.
The 2008 financial crisis underscored the risk of financial institutions other than banks engaging in lending without stringent regulation. Currently, attention is directed towards hedge funds and private-equity firms rather than investment banks and mortgage originators. An unusual rise in U.S. Treasury yields, due to highly leveraged hedge-fund trades, has highlighted potential economic threats when these trades unravel.
Traditional banks typically convert customer deposits into long-term, illiquid assets like mortgages, while shadow banking entities fund their operations by raising and borrowing from investors rather than using consumer deposits.
Despite its ominous name, shadow banking is not inherently negative, according to Amit Seru of Stanford’s Graduate School of Business. It can actually increase the resilience of the financial system by shifting risky lending activities outside traditional banking frameworks.
Hedge funds, unrestricted by consumer deposit backing, are able to take larger risks owing to capital raised from investors who lock in their funds for longer durations, facilitating market price discovery.
One example of the hedge funds’ strategies includes “basis trades,” where these funds purchase Treasury bonds and sell futures contracts associated with those bonds to exploit small price differences. Although this arbitrage method addresses credit market imbalances, hedge funds often resort to heavy borrowing to maximize returns, posing risks to short-term debt markets when trades unwind.
While not funded by consumer deposits, hedge funds may nevertheless require governmental intervention during financial distress. The case of Long-Term Capital Management in the late 1990s showed that these funds could still be deemed “too big to fail.” At its peak, LTCM had significant global market influence before unsustainable losses following Russia’s debt default prompted a bailout orchestrated by the U.S. government.
Itay Goldstein from the University of Pennsylvania highlights that the current market exposures exceed those seen historically, as hedge funds such as Lehman Brothers have encountered failures, shaking America’s banking system and impacting federally supported enterprises like Fannie Mae and Freddie Mac.
Following the 2008 crisis, the Dodd-Frank reforms aimed to enhance oversight over both banks and nonbank lenders. Despite this, the shadow banking sector has experienced explosive growth, now controlling half the world’s financial assets. Hedge funds are particularly significant, now managing fifteen times more assets than in 2008.
The Volcker Rule, as part of Dodd-Frank, restricted investment banks from proprietary trading, leaving hedge funds to fill this gap despite concerns over their extensive use of short-term debt and limited oversight.
Michael Green of Simplify Asset Management warns that lending within the shadow banking sphere is the fastest-growing segment of the U.S. banking system, posing risks reminiscent of the 2008 crisis due to its expansive nature.
In times of market stress, hedge funds face potential vulnerability to margin calls, risking instability in Treasury markets usually backed by U.S. debt. This turmoil was evident during the early months of the COVID-19 pandemic, prompting Federal Reserve interventions.
Academics have proposed that the Federal Reserve establish lending facilities for hedge funds to mitigate Treasury market crises. However, political opposition threatens the feasibility of such measures.
Regulating these shadow banking entities involves trade-offs. On one hand, stringent regulation could hinder efficient financial operations while on the other, systemic risk persists despite firms investing their proprietary capital.
The nature of the financial system and how regulations adapt could potentially allow other institutional types to assume similar roles to hedge funds if overly restricted, prompting ongoing debate about regulatory oversight.
Despite concerns over regulation, maintaining transparency and understanding linkages with government-backed lenders are paramount, according to Seru. Meanwhile, Seru cautions that even traditionally transparent institutions can unexpectedly face challenges, exemplified by the collapse of Silicon Valley Bank in 2023.
