CRS Highlights Growing Risks from "Shadow Banking"

The Congressional Research Service ("CRS") highlighted systemic vulnerabilities within the nonbank financial intermediation ("NBFI" a/k/a "shadow banking" ) sector.

According to the CRS, report, as of 2023, total financial assets at US NBFI reached $85.7 trillion, more than 2.5 times the $31.1 trillion held by traditional banks.

The CRS identified several key areas of vulnerability exposed during recent market events:

• "Runnable" Behavior: The CRS pointed to the "run-like" behavior seen in MMFs during both the 2008 financial crisis and the COVID-19 induced "dash for cash" in March 2020. The CRS concluded that In both instances, investor outflows threatened to destabilize short-term funding markets, which prompted emergency interventions by the Federal Reserve and the Treasury. The CRS said that as of 2023, the total value of "runnable" money-like instruments in the US financial system stood at $21 trillion.

• Excessive Leverage: The CRS warned that use of borrowed funds to amplify returns—and risks—was a major concern. The CRS cited the 1998 collapse of hedge fund Long-Term Capital Management and the 2021 default of the family office Archegos Capital Management. The CRS said that the Archegos failure, driven by leveraged bets, resulted in over $10 billion in losses for its global bank counterparties, which demonstrated how NBFI risks could directly impact the core banking system.

• Interconnectedness with Banks: The CRS highlighted the growing "NBFI-bank nexus," or the interconnectedness of traditional banks and nonbanks through lending, prime brokerage services and risk-transfer arrangements. The CRS said this interconnectedness suggests that a shock originating in the less-regulated NBFI sector could transmit to and be amplified by the banking system.

• Liquidity Mismatch: The CRS stated that open-end funds, particularly Exchange-Traded Funds ("ETFs"), create a liquidity mismatch by offering daily redemptions to investors while holding less-liquid underlying assets like corporate bonds. The CRS said that during the market stress of March 2020, this mismatch led to dislocations, with the market prices of some bond ETFs trading at steep discounts to the value of their underlying assets.

• Concentration Risk: The CRS highlighted two forms of concentration risk: (i) the growing influence of the "Big Three" asset managers (BlackRock, Vanguard and State Street), which collectively control an estimated 22% of the S&P 500, thereby raising corporate governance concerns; and (ii) the concentration of critical services in a few firms, such as Central Counterparties ("CCPs") that clear financial trades, suggesting that a failure at a single entity could have system-wide consequences.

The CRS reviewed various policy options to address each of these vulnerabilities. The CRS also reviewed the FSOC's 2023 guidance, which made it easier to designate nonbank firms as "systemically important financial institutions" ("SIFIs"), subjecting them to Fed supervision. The CRS said that some policymakers argue this move was a necessary step to preemptively address systemic risks, while others contend it was an overreach that could stifle innovation.