27 June 2016

ECB: Shadow banking in the euro area: risks and vulnerabilities in the investment fund sector

This paper highlights the structural features of shadow banking in the euro area, focussing on investment funds. It also discusses the potential systemic risks that the recent expansion of the investment fund sector presents.

The size and role of the euro area shadow banking sector within the euro area and global financial system has increased. According to a broad measure covering financial institutions other than banks, insurance corporations and pension funds, the financial assets held or managed by the sector in the euro area have doubled over the past decade (to reach nearly EUR 28 trillion in December 2015) and account for over a third of the euro area financial system.

More detailed statistics for investment funds (IFs), financial vehicle corporations (FVCs) and money-market funds (MMFs) allow a closer monitoring of balance sheet developments within a more narrowly defined shadow banking sector. During the crisis years, shadow banks, notably investment funds, have acted as an important buffer for the real economy as bank credit to the private sector contracted. In addition, their increasing role within the financial system has meant that the distribution of risk exposures has become wider. However, the expansion of the sector also may present systemic risks that need to be detected, monitored and managed. Similar to financial intermediation activities of banks, credit intermediation by this sector involves maturity and liquidity transformation and the use of leverage. However, unlike banks, these entities do not have access to central bank liquidity. The shadow banking sector is highly interconnected with euro area banks and an important source of credit for euro area non-financial corporates (NFCs). Therefore, difficulties in the sector can propagate quickly to the banking sector and the real economy.

Among the main vulnerabilities within the sector, the growing liquidity mismatch within the investment fund sector is a key concern.

While solvency concerns are muted due to a high share of equity in the fund sector, the redeemable nature of equity introduces leverage-like risks as its sudden withdrawal can affect the liquidity position of funds. Balance sheet measures of leverage are misleading owing to the callable nature of the equity denominator as well as a failure to capture effective leverage that is also created synthetically through derivatives exposures or repo and securities lending transactions.

The increased involvement of shadow banking entities in credit intermediation and capital markets, the growing footprint of systemically important institutions, and the strengthening of inter and cross-sector linkages increase the potential ramifications of adverse developments in the shadow banking sector on the financial system and real economy.

While limited balance sheet data suggest that vulnerabilities within the shadow banking sector are growing and links to the wider financial system and real economy are strengthening, data limitations prevent drawing a definitive conclusion on the systemic nature of the risks. Additional balance sheet statistics for the sub-components are needed to draw firm conclusions.

Working paper

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