ECB warns of risks posed by shadow banking sector

May 28, 2015 5:09 pm FT.com James Shotter in Frankfurt and Claire Jones in Dresden

Mario Draghi, European Central Bank president

The rapid growth of the shadow banking sector poses a risk to financial stability in the eurozone, the European Central Bank has warned.

The lightly-regulated sector, which includes a broad array of institutions engaged in banklike activities, such as investment funds, could be part of “future systemic events”, due in part to its “increased size and remaining opaqueness”, the ECB said.

“The greater the leverage, liquidity mismatch and size of certain intermediaries, the more likely they are to amplify shocks,” it said in its twice-yearly financial stability review, adding that the sector’s risk exposure could be higher than widely assumed, due to the use of derivatives.

The shadow banking sector has grown dramatically in the years since the financial crisis as banks have been hit by tough new regulations that have squeezed some of their traditional activities. Over the past decade the sector’s eurozone assets have more than doubled to €23.5tn. However, the accumulation of risk in this more thinly-policed part of the financial system has prompted growing concern among regulators.

One way that trouble in the shadow banking sector could spill over into other parts of the financial system would be in the event of a sharp fall in asset prices, the ECB said. This could prompt investors to pull their money from investment funds, forcing the funds to sell their holdings, in turn pushing asset prices even lower.

“Large-scale outflows cannot be ruled out in the event of adverse economic or policy surprises over the medium term,” the central bank concluded.

A sharp sell-off in financial markets was one of three other risks the ECB identified in its report. While the central bank’s aggressive monetary easing has helped boost hopes of a more meaningful recovery in the eurozone, it has also led to concerns over inflating asset prices.

Vítor Constâncio, ECB vice-president, said that he did not think eurozone assets were generally overvalued, but conceded that there were “pockets” of “rich” valuations. Mario Draghi, ECB president, said this month that aggressive monetary easing, including mass bond-buying, could lead to financial instability.

The third risk outlined by the ECB was the lacklustre profitability of banks and insurers, both of which have seen their earnings crushed by the low interest rates that have prevailed since the financial crisis.

The ECB’s landmark €1.1tn quantitative easing programme, unleashed in January, has dramatically lowered yields on sovereign debt, and the paper of several eurozone governments, including Germany, now trades at negative yields. Such yields make it hard for insurers to earn enough from their investments to cover the claims they must pay out to clients.

Last June, the ECB became the first major central bank to introduce negative interest rates. It imposes a levy of 0.2 per cent on banks’ reserves parked in its coffers. Few banks have been able to pass on these costs to their customers, and have seen their margins squeezed as a result.

The ECB also warned about the sustainability of corporate and sovereign debt burdens, if economic growth does not pick up.

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