Risky 'Shadow Banks' Are Still Unregulated: Are They A Threat To The UK Economy?

The Bank of England recently unpacked £65 billion ($72 billion) in an emergency measure to avoid a crash in government bond prices. Without the intervention, the U.K.’s pension funds, which rely heavily on bond holdings, would have entered default.

A larger economic crisis was averted.

However, according to recent comments by former government officials and market analysts, the British economy is far from off the hook: other non-bank financial institutions still pose a risk to the country’s stability.

Related Link: Why Did The Bank Of England Lay Down $72B To Prevent A Lehman Moment

This week, former British Prime Minister Gordon Brown echoed these fears on a BBC Radio interview.

“I don’t think this crisis is over because the pension funds have been rescued last week,” Brown said. He called upon UK regulators to tighten their supervision of shadow banks.

“I do think there’s got to be eternal vigilance about what has happened to what is called the shadow banking sector, and I do fear that there could be further crises to come,” he added.

Unregulated Lenders

Bond funds, private lenders and companies involved in cryptocurrencies are handing out credit with regulations in place. As a result, the country’s central bank authority risks losing its influence on monetary policy.

In early August, Paul Tucker, former deputy governor for the Bank of England, accused the central bank of inadequate regulation around the shadow banking sector.

“What if another decade passes without a general policy, and then some massive part of shadow banking unravels?” Tucker told the Financial Times, almost predicting the recent near-crash of the bond market in the hands of pension funds.

Last year, the Bank for International Settlements (BIS), an international organization composed of most major central banks, called upon central banks to tighten regulation around non-bank financial institutions.

Shadow banks cover areas that banks do not, and as such, they’re a healthy source of diversity in external financing, said the BIS report. 

“They can make the financial system more efficient but also more unstable,” it stated.

Since shadow banks are not regulated by a central bank, the capital requirements are not set by the government, but by the private institutions they do business with. 

As interest rates rise and liquidity lowers, other non-bank financial institutions could run into trouble if they face margin calls by their lenders and need to come up very quickly with new collateral they don’t have, while also not receiving payments from their debtors.

Avoiding Nightmare Scenarios

According to Giles Coghlan, Chief Market Analyst at HYCM, Britain’s shadow banking sector is smaller than the certified banking system and provides a way of borrowing at lower rates, but lending at higher ones. 

“As such, the sudden rises in interest rates that we have seen of late were always going to put the shadow banking business model at risk, especially if the people a lender has lent to are no longer in a position to repay their loans,” he told Benzinga.

They're still a relatively small part of the U.K.’s wider financial infrastructure, and the impact of this stress has not been felt to the extent that it might have been if normal banking institutions were facing comparative challenges, he said.

Regulation around the traditional banking sector is designed to avoid these nightmare scenarios that could lead to major defaults with no capital buffers. Similar regulation around shadow banks could allow the U.K. government to prevent future economic crashes.

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