Shadow Banking Can Cause Another Financial Crisis For Big Banks

The Financial Stability Board (FSB), the world’s global financial regulator, has recently issued another major warning on shadow banking. The watchdog published a report emphasizing that the industry has high leverage and is completely opaque, even to financial regulators.

If you follow our banking work, you are well aware of these issues. Still, the FSB’s report is concerning, as the global regulator has essentially stated that the shadow banking industry is entirely untransparent and poses major risks to financial stability.

First, according to the FSB, high leverage creates a position liquidation channel involving deleveraging through position unwinds and asset sales. This occurs when an adverse shock triggers unexpected liquidity demands on leveraged positions from collateral or margin calls. Procyclical deleveraging can also happen when investors breach risk or stop-loss limits or aim to maintain a target risk level (e.g., value-at-risk) in their portfolios. Such asset sales and position unwinding—especially under stressed market conditions—can further depress asset prices, creating a feedback loop of additional liquidity demands and risk reduction that affects other market participants exposed to the same asset class.

Second, the counterparty channel involves default or distress at leveraged entities, imposing direct losses on counterparties and triggering cascading financial stress that forces liquidations. For example, a leveraged entity may default if its liquid resources are insufficient to meet counterparties’ collateral or margin calls, or if mark-to-market losses entirely erode its capital. This propagates the initial shock to the defaulting entity’s counterparties. If these counterparties lack resilience to absorb losses, they may face financial distress, amplifying the shock. Stress can also spread without a default if counterparties reprice or withdraw financing due to the shock, creating funding stress for the leveraged entity.

The FSB also notes that shadow lenders have interlinkages with large banks, including those providing them leverage. Thus, a shadow lender’s default or distress can propagate stress to systemically important counterparties (large banks) primarily through the counterparty default channel. The FSB highlights that shadow bankers remain completely opaque even to regulators, creating additional risks for banks lending to this industry.

As discussed in our previous articles, US banks have extended nearly $5T to shadow bankers through on- and off-balance-sheet exposures. Crucially, almost 80% of these loans were granted by the 25 largest US banks.

The FSB also provides examples of shadow banking’s impact on global financial stability during recent stress episodes:

• March 2020: The ‘dash for cash’. Rising Treasury market volatility increased margins on US Treasury futures and repo borrowing rates. This prompted traders in the US Treasury cash-futures basis trade to partially unwind positions, exacerbating sales volumes from other participants and amplifying instability. A lack of supervisory leverage limits for investment funds (including hedge funds) in non-centrally cleared government bond repo markets allowed extreme leverage via near-zero haircut borrowing. Leverage providers also lacked visibility into clients’ overall positioning and Treasury-dependent strategies, hinting at gaps in credit risk management.
• March 2021: Archegos’ default. As covered extensively in prior articles, Archegos’ collapse led to Credit Suisse’s downfall. Notably, many analysts and rating agencies had labeled Credit Suisse “one of the safest financial institutions globally,” ignoring its significant exposure to shadow lenders like Archegos.
• 2022: Commodities market stress. Position liquidations occurred in response to rising margins and counterparty credit risk, as CCP clearing members faced increased client default risk—and in some cases, actual defaults.
• September 2022: LDI crisis. Leverage in GBP-denominated Liability-Driven Investment strategies amplified stress in the UK Gilt market, triggering position liquidations due to margin calls, risk-limit breaches, and heightened counterparty risks.

Obviously, a major crisis would yield far more stress episodes caused by shadow bankers. Given US banks’ outsized exposure to shadow lenders, such events would likely severely impact large US banks.

Bottom line

Believe it or not, there are more major issues on the larger bank balance sheets as compared to smaller banks, which we have covered in past articles. Moreover, consider that there was one major issue which caused the GFC back in 2008, whereas today, we currently have many more large issues on bank balance sheets. These risk factors include major issues in commercial real estate, rising risks in consumer debt (approaching 2007 levels), underwater long-term securities, over-the-counter derivatives, and high-risk shadow banking (the lending for which has exploded). So, in our opinion, the current banking environment presents even greater risks than what we have seen during the 2008 GFC.

Almost all the banks that we have recommended to our clients are community banks, which do not have any of the issues we have been outlining over the last several years. Of course, we're not saying that all community banks are good. There are a lot of small community banks that are much weaker than larger banks. That’s why it's absolutely imperative to engage in a thorough due diligence to find a safer bank for your hard-earned money. And what we have found is that there are still some very solid and safe community banks with conservative business models.

So, I want to take this opportunity to remind you that we have reviewed many larger banks in our public articles. But I must warn you: The substance of that analysis is not looking too good for the future of the larger banks in the United States, and you can read about them in the prior articles we have written.

Moreover, if you believe that the banking issues have been addressed, I think that New York Community Bank is reminding us that we have likely only seen the tip of the iceberg. We were also able to identify the exact reasons in a public article which caused SVB to fail. And I can assure you that they have not been resolved. It's now only a matter of time before the rest of the market begins to take notice. By then, it will likely be too late for many bank deposit holders.

At the end of the day, we're speaking of protecting your hard-earned money. Therefore, it behooves you to engage in due diligence regarding the banks which currently house your money.

You have a responsibility to yourself and your family to make sure your money resides in only the safest of institutions. And if you're relying on the FDIC, I suggest you read our prior articles, which outline why such reliance will not be as prudent as you may believe in the coming years, with one of the main reasons being the banking industry’s desired move towards bail-ins. (And, if you do not know what a bail-in is, I suggest you read our prior articles.)

It's time for you to do a deep dive on the banks that house your hard-earned money in order to determine whether your bank is truly solid or not. You can feel free to review our due diligence methodology here.

Avi Gilburt is founder of ElliottWaveTrader.net and SaferBankingResearch.com. 

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