This was originally published in connection with CFA Institute's 68th Annual Conference.
When I say “shadow banking,” do you think of money market and bond funds? I can’t blame you if that’s not where your mind goes first. After all, there has been a lot of pressabout shadow banking in China, and we even published some of it.
But even though shadow banking is huge in China, with its largest sector — wealth management products — clocking in at at 12 trillion yuan as of early 2014 and growing by 50% since 2013, it would take a lot of growth for it to be more than a drop in the global bucket.
Speaking at the 68th CFA Institute Annual Conference, Nico Valckx, a senior economist at the International Monetary Fund (IMF), put the global size of the shadow banking sector at just about $75 trillion, which is just shy of the asset management industry’s mark. That’s not really surprising because there’s a lot of double counting there. Many asset management products are also shadow banking products.
If that comes as a shock, it’s because you may not have meditated yet on what shadow banking really means. Simply put, a shadow bank is an entity that engages in credit intermediation without as much regulation as a bank . . . or a formal liquidity backstop.
Sometimes Those Things Can Come in Handy
As Valckx noted in his presentation,”Shadow Banking: Global Trends and Policy Developments,” the fears of many who lose sleep over shadow banks were in some ways realized during the financial crisis in the money market industry. After the failure of Lehman Brothers Holdings led the Reserve Primary Fund to “break the buck” in 2008, investors panicked. (Full disclosure: my mother worked in fixed-income trading at Lehman Brothers from roughly 2000 to 2003.)
Money market fund share values were supposed to be solid at $1! A run on money markets and the asset-backed paper that they held ensued. And as our own research on the subject notes, 43 individual money market funds wound up requiring sponsor support to keep their share price stable at $1.
This is the kind of thing that, if left unchecked, could become a significant problem. The Financial Stability Board (FSB) estimated money market fund assets at $3.8 trillion globally. And money market funds are supposed to be safe! Many practitioners use them as “cash-like” investments, expecting them to hold value during times of crisis. Just imagine the psychological impact of finding out that your “safe” investments . . . aren’t.
The difficulties that these funds experienced resulted from a simple issue: The market didn’t assess Lehman’s creditworthiness appropriately. People misallocated capital. Some people lost money. This sort of thing happens all the time, and most investors should understand that it is a possibility. But it goes from being a few people’s loss to a big deal when isolated losses cascade through an asset class. The reason that happened in this case was simple:
There Was a Liquidity Mismatch
The IMF explains that a money market instrument has two characteristics: a short maturity (under a year) and ready liquidity. The hope is that even if a security still has a couple of months to maturity, a ready market will exist for it so that it can be easily converted to cash.
But sometimes that doesn’t work, and the problem extends to more than just money market funds. When asked to name the two biggest risks in shadow banking, Valckx noted one you may have thought of — China. But he also identified one you probably hadn’t considered — a host of asset management strategies that have the potential for similar liquidity issues. This chart (in which AE and EM stand for advanced economy and emerging market, respectively) shows a number of other strategies that are reasonably exposed to the same risks.
You’ll have to do your own work to find out how this affects your investments in particular, but Jim Grant, CFA, did a great job explaining how this can affect emerging market debt funds in an article about a year ago, which he talked about on Fox Business News. I found that example quite illustrative of a place where we might see stress when risk appetites inevitably wane.
If this has piqued your interest, the longer report that Valckx and his team put together is almost certainly worth a read, as is our own, which was authored by Rhodri Preece, CFA, who also served as moderator during the session. Preece has written a quick primer on it, and the FSB’s monitoring report is likely worth a look as well.
Returning to the question — is shadow banking scary? — I think you’ll answer it about the same way I did after reading these selections: it depends what kind of shadow bank you’re talking about.
If you liked this post, you should subscribe to my newsletter.