As rising interest rates shake financial markets, dangers are growing in the "shadow banking system," a network of largely unregulated institutions that provides more than half of all U.S. consumer and business credit.
The Federal Reserve has lifted its benchmark lending rate this year to its highest level in 15 years, triggering a sharp decline in speculative cryptocurrencies, technology stocks and housing prices.
Now, if the economy plunges into a recession next year as rates continue rising, some regulators fear that problems at unpoliced "shadow banks" will ricochet through the financial system or increase the number of lost jobs.
The Fed hopes to bring inflation under control without causing a recession. And so far, traditional banks like JPMorgan Chase and Goldman Sachs are weathering the storm, thanks to regulations imposed after the 2008 financial crisis that required the banks to hold more capital in reserve to absorb losses.
But financial risks have not gone away; they have just moved out of the spotlight.
While the new regulations made the big banks safer, they did nothing to prevent other institutions, such as hedge funds, insurance companies, asset managers, money market funds and fintech companies, from taking risks. Facing few of the disclosure requirements of deposit-taking banks, these so-called shadow banks binged on borrowed money and acquired assets that will likely be hard to sell in rocky markets, analysts said.
"We need to worry, a lot, about nonbank risks to financial stability," Michael Barr, the Fed's vice chair for supervision, said in a speech earlier this month.
PRIVATE CREDIT
One area that has some analysts concerned is the roughly $1.5 trillion market in private lending, which has more than doubled in size over the past several years and now rivals junk bonds as a source of corporate funds. Among the largest investors in the private credit funds that provide these loans are state pension plans, including those in California, New York and Arizona.
Desperate to earn higher returns when interest rates were low, these plans invested in funds that make loans to risky midsize companies and corporate takeover artists.
Private equity companies use much of that borrowed money in leveraged buyouts. Some of the deals are sizable: Blackstone Credit, Ares Capital and a Canadian pension fund last year provided a combined $2.6 billion to help finance Thoma Bravo's buyout of Stamps.com that took the company private.
Borrowers are attracted to private credit, rather than commercial banks, by the ability to borrow more relative to their earnings and the ease of negotiating terms with a smaller number of lenders.
In 2013, the Fed discouraged banks from lending to companies if the loan would push total debt to more than six times earnings. Some private credit funds, however, will exceed that limit, according to Ana Arsov, managing director at Moody's, the credit rating agency.
Most private loans carry a floating interest rate. So the Fed's higher rates are good for the loan-making funds' profits. But they make it harder for the heavily indebted borrowers to make their payments, Arsov said.
The financial pressure on companies could lead to a wave of cost-cutting, including layoffs.
"There is a significant piece of the underlying employment of the U.S. economy that is linked to this," she added.
Financial institutions other than banks now provide nearly 60% of total consumer and business credit, twice the 1980 share, according to Barr. Nonbank mortgage providers such as Quicken Loans last year wrote more than 7 out of every 10 home loans. These institutions are vital to the economy. But they have a habit of getting into trouble.
In March 2020, amid the covid-19 pandemic's first panicky weeks, hedge funds sold massive amounts of Treasury securities to raise cash. With sellers greatly outnumbering buyers, trading in the normally liquid market -- which influences the value of all financial assets -- broke down. Only after the Fed took emergency action by buying $1 trillion worth of Treasurys did markets return to normal.
Likewise, it was nonbanks such as the failed investment bank Lehman Brothers and the giant insurer AIG, which required a $182 billion federal bailout, that fueled the 2008 financial crisis.
The Financial Stability Oversight Council, created by the 2010 Dodd-Frank legislation, initially designated four nonbanks as "systemically important," requiring them to face tighter regulations because their failure could cause a broader crisis. But the Trump administration made it harder to issue such "too big to fail" verdicts and freed the last nonbank from that special scrutiny in 2018.
2023 GUIDANCE
Under Treasury Secretary Janet Yellen, the council next year is expected to rewrite the Trump-era regulations. "The 2019 nonbank designation guidance undercuts the Council's ability to address risks to financial stability," said John Rizzo, a treasury spokesman. "Secretary Yellen expressed her concerns about the 2019 guidance when it was issued and continues to believe it should be reassessed."
On Friday, the council's annual report said nonbank institutions represented a potential weak spot for the financial system, adding that "rising interest rates or a broader economic downturn could further amplify these vulnerabilities." The report warned of a possible "deterioration in credit quality" in nonbank lending as borrowers made "optimistic" projections of their prospects for growing revenue and cutting costs.
The Fed's multiple rate increases since March threaten to hurt investors who took on too much risk when money was inexpensive. Higher interest rates increase the cost of repaying debt. But they also affect investment flows, by making it possible to earn a better return on safe assets, like bonds, and making risky stocks, such as those of high-tech companies that won't post substantial profits for years, less attractive.
An early sign of how hard the adjustment to a higher-rate environment came in October, when the British government bond market was rocked after bond traders rejected a proposed tax-and-spending plan as inflationary. The frenzied trading rattled pension funds that had bet on interest rates staying low.
Since the 2008 crisis, persistently low rates encouraged companies to load up on borrowed funds. Business debt this year rose to almost $20 trillion, equal to more than 78% of the economy, up from about 66%, or $9.5 trillion, in mid-2007, according to the Fed.
"Risk is definitely building up, unseen and unmonitored, and it's going to surprise regulators just like AIG surprised regulators in 2008," said Dennis Kelleher, president of Better Markets, a nonprofit that promotes tighter regulation of the financial industry.
Still, some analysts play down the likelihood of any contagion, noting that the regulated banks at the core of the financial system remain healthy and that the rate increases so far have not caused widespread financial problems.
"So far, this seems to be a controlled burn, much as the Fed intended," said Steven Kelly, senior research associate at the Yale Program on Financial Stability.