The European Central Bank (ECB) has issued a cautionary note on the potential risks of margin calls for the euro zone’s shadow banking sector, which has grown rapidly in recent years and now accounts for almost half of the financial system’s assets.
What are shadow banks and why are they important?
Shadow banks are financial intermediaries that perform bank-like functions, such as lending, investing and providing liquidity, but are not subject to the same regulatory oversight and prudential requirements as traditional banks. They include entities such as money market funds, hedge funds, investment funds, insurance companies, pension funds and broker-dealers.
Shadow banks play an important role in the financial system, as they provide alternative sources of funding, diversify risks and enhance market efficiency. However, they also pose potential challenges for financial stability, as they are more vulnerable to liquidity and solvency shocks, contagion and fire sales.
According to the ECB, the euro area shadow banking sector has increased by 70% since 2014 and reached €25.9 trillion in 2020, representing 46% of the total financial system’s assets. The ECB also estimates that the shadow banking sector’s leverage ratio, which measures the amount of debt relative to equity, rose from 11 in 2019 to 12.4 in 2020, indicating a higher degree of risk-taking.
How does the ECB assess the risks of margin calls?
Margin calls are requests from lenders or counterparties for borrowers or traders to provide additional collateral or cash to cover losses or changes in the value of their positions. Margin calls can be triggered by market volatility, credit rating downgrades, margin breaches or changes in margin requirements.
Margin calls can pose significant risks for shadow banks, as they may face liquidity shortages, forced asset sales, valuation losses or even default if they are unable to meet the margin calls. Moreover, margin calls can create negative spillovers and amplification effects across the financial system, as they can lead to fire sales, contagion and procyclicality.
The ECB has developed a framework to assess the risks of margin calls for the euro area shadow banking sector, based on three main components: (i) the exposure of shadow banks to marginable instruments, such as derivatives, securities financing transactions and leveraged loans; (ii) the sensitivity of shadow banks to margin calls, which depends on their leverage, liquidity and solvency positions; and (iii) the potential impact of margin calls on shadow banks and the financial system, which depends on the size, interconnectedness and substitutability of shadow banks.
Using this framework, the ECB has simulated the effects of different scenarios of market shocks and margin calls on the euro area shadow banking sector. The results show that shadow banks could face significant margin calls in the event of severe market stress, especially those that are highly leveraged, illiquid and insolvent. The ECB also finds that margin calls could have substantial spillover effects on other financial sectors, such as banks, insurers and pension funds, as well as on the real economy.
What are the policy implications of the ECB’s analysis?
The ECB’s analysis highlights the need for enhanced monitoring and regulation of the euro area shadow banking sector, as well as for improved data availability and quality. The ECB also calls for more coordination and cooperation among national and international authorities, as well as for more harmonisation and consistency of the regulatory frameworks for shadow banks.
The ECB also emphasises the importance of ensuring adequate liquidity and capital buffers for shadow banks, as well as of reducing their reliance on short-term funding and leverage. Moreover, the ECB recommends that shadow banks adopt sound risk management practices, such as stress testing, scenario analysis and contingency planning, to cope with potential margin calls and liquidity shocks.
The ECB also acknowledges the role of central banks in providing liquidity support to the financial system in times of stress, as well as in ensuring favourable financing conditions and preserving financial stability. However, the ECB also warns that central bank interventions may create moral hazard and encourage excessive risk-taking by shadow banks, and therefore calls for a careful balance between supporting the financial system and maintaining market discipline.
