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Shadow banking poses challenges for global financial markets in coronavirus crisis - DBRS Morningstar

Friday, April 03, 2020
Opalesque Industry Update - Ongoing disruptions in the global financial markets have refocused attention on nonbank financial intermediaries (FIs) and shadow banking. These nonbank FIs are important, especially now. Shadow banking assets now represent more than a third of the global assets held by banking organizations.

The financial authorities globally have been concerned with the risks posed by these FIs. In a stressed environment, withdrawals, funding difficulties and other disruptions at these nonbank FIs can have a widespread impact on the financial markets. With the heightened uncertainty surrounding the spread of the Coronavirus Disease (COVID-19), that stressed environment is here and the stress on these FIs is having an impact.

Investors may be surprised to hear that their investment in a fixed income fund is a part of shadow banking. These funds are bank like in supplying financing to the market, but also in allowing investors to withdraw their funds. It's not just about hedge funds and exotic funding vehicles. The consequences for the markets are the same, if investors draw down their holdings and the fund has to sell bonds or other assets, which can amplify market declines.

That is what is happening now, with more withdrawals leading to more selling. Declines in fund values can exacerbate investors' concerns and lead to further withdrawals. There are other consequences. Credit may become less available, as some of these nonbank FIs struggle to roll their funding in more stressed markets. Some nonbank FIs may also reduce the funding that they provide to other participants in the financial markets. Bond funds may choose to stay more liquid, rather than buying new bonds.

Given the high level of current uncertainty around cashflows, many businesses, nonbank FIs and individuals are seeking to have more cash on hand. Credit lines are being tapped and cash conserved, rather than being put to work. Banks are also facing stress as businesses draw on their credit lines.

The resulting disruptions are likely to present greater challenges to shadow banking FIs. The business mix at shadow banks are generally more monoline and less diversified than banking groups. Many have less resources and capacity to manage deteriorating credits in a stressed environment. Moreover, they generally don't have direct access to borrowing from central banks, unlike banking groups.

The current stresses are now evident in widening spreads and falling prices for both high yield, as well as investment grade corporate bonds. In the face of this liquidity squeeze, central banks globally have been taking various actions to inject liquidity into the financial markets. For more details see Sovereigns Taking Action to Mitigate Impact of Coronavirus, March 2020.

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