Sunday, February 1, 2015

Yet Another Warning from the IMF - This Time on "Shadow Banking"

This time about a growing "shadow banking" system. In this Telegraph article, IMF Deputy Chief Zhu Min speaking at the World Economic Forum in Davos says banking risks have shifted to "shadow banking". What is shadow banking? What risks does it pose? Let's look at it.

We see the term shadow banking pop up pretty often these days. Ever wonder what shadow banking is? Investopedia defines it this way (click here for full explanation):


The financial intermediaries involved in facilitating the creation of credit across the global financial system, but whose members are not subject to regulatory oversight. The shadow banking system also refers to unregulated activities by regulated institutions.

So who might some of these financial lenders "not subject to regulatory oversight" be? Investopedia explains that as well:


Examples of intermediaries not subject to regulation include hedge funds, unlisted derivatives and other unlisted instruments. Examples of unregulated activities by regulated institutions include credit default swaps

OK, that tells us what shadow banking is. But what risks does it pose to us?
The Telegraph article says this:

"Non-financial corporations have raised $1.3 trillion (£860bn) through shadow banking in the US alone," he told the Telegraph."

"The IMF estimates that contingent liabilities of these shadow forms of lending have reached $15 trillion in the US, using a "broad" measure of activities that captures new forms of risk. This is higher than in China. It is roughly 180pc of banking assets and is rising rapidly towards its pre-Lehman peak. It is particularly worrying since it was a "run" on the interlinked world of structured finance that caused the global crisis to metastasise in 2008."

"Zhu Min said the oil price crash is "terrific news" for consumers but warned that its effects are double-edged and raise a whole new set of risks. It may set off a fiscal crisis in producer countries and a debt-repayment crunch for oil companies with $1 trillion of bonds."

"The concerns were echoed by David Rubenstein, head of the Carlyle Group, who said the slide in oil prices to $50 a barrel is likely to set off a chain of defaults by Russian companies that owe $650bn of external debt."

"They can't service the debt. And who owns that debt? It is nearly all held by European banks. They are going to be hurt, and I suspect that currency turbulence in Europe is going to hurt them too," he said."

My added comments: 

This article touches on a key risk that we have talked about here many times. This Telegraph article does a good job of explaining what the risk is, why everyone needs to understand it, and how to be aware of what it could lead to.

In plain terms, this article says we have an IMF estimated $15 Trillion (in the US alone) of risk floating around out in this unregulated "shadow banking" system. And this is probably a drop in the bucket of the true undisclosed derivative related investments and debts in the world. The BIS statistics show that worldwide there were an estimated 691 hundred trillion of various forms of derivatives out there as of June 2014. Some are regulated and disclosed to the public and some aren't. Even the IMF and BIS cannot really be sure what the true risk is out there. The system is too big and complex to track it all.

The reason we need to understand these numbers is because none of us has any idea what the true risk to the overall system is related to these obligations. In theory, banks and financial institutions who deal in these higher risk investments offset their positions (hedge) so that their net exposure to losses is a much smaller number than the full value of the contract. However, there is a problem that can arise suddenly at any time. If one too big to fail entity messes up and goes under due to a mistake in their hedging program and has too little reserve capital, it can make the full value of these highly leveraged obligations come due. Not the much smaller "net" position. 

As a simple example, let's say Bank A has a $100 billion long derivative position on the Euro with  Bank B and a $98 billion short position on the Euro with Bank C. Supposedly, the "net" risk of loss to Bank A would be $2 billion (the net of their hedged long and short positions). But what if the Euro drops too far too fast (as just happened against the Swiss franc). This causes Bank C to go under. Bank C cannot pay Bank A the $98 billion they owe them on their Euro short position? (the BIS has issued a warning that many banks are using models that are too optimistic for these types of investments)

In that case, Bank A sees their $100 billion long position collapse in value very quickly. They cannot collect anything on their hedged short position with Bank C (who went bankrupt and cannot pay). Now Bank A goes under too. The true risk to Bank A is much more than the net $2 billion everyone thought they had. The $2 billion risk assumed everyone stays solvent and can pay what they owe.

This is how these unregulated derivative contracts could create a daisy chain of failures that puts the whole system at risk very quickly. Using the link above to the BIS stats, they show 691 trillion in total derivatives as of June 2014. If 3% of those were to go bad, that is over $20 trillion. 

Given the above, just keep in mind that both the IMF and BIS have issued warnings about this problem. The IMF is doing it again here in this Telegraph article. Jim Rickards has stated the overall system is unstable. He predicts at some point we will get a crisis much bigger than the 2008 crisis (he says at least 6 times as big in a recent article). He uses this forecast as the basis for his prediction that the next crisis will be too big for the US Fed to handle, and that the IMF will take over to deal with the crisis.

This Telegraph article shows how all this could actually happen, why the IMF and BIS keep warning about it, and why we cover it here. If it does happen, the world and the present monetary system will change and everyone will be impacted. The crisis would come very quickly without any warning.

Does that mean we should worry constantly about all this? No!  We don't know what the true risk really is and we can't do anything to prevent a crisis like this if it ever does happen. A better response is to understand the risk is out there and incorporate that risk into your financial planning. Once you devise a personal plan to deal with this risk that fits your situation, don't waste time worrying. Just stay informed and alert and go about your business. We will try to help with the staying informed part here.

Added note 8-6-15: A full list of systemic risk warnings can be found on this blog page 

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