Shadow Banks & Private Markets
What happens when the financial system’s new backbone...private markets and shadow banks...starts with illiquidity by design? The next crisis might already be hiding there...
Executive Summary
The transformation of banking and financial services away from traditional public markets and the banking system itself has been dramatic since the Global Financial Crisis (GFC) of 2008.
This shift has reshaped the financial landscape, as more activities that were once dominated by banks and public markets have moved into private and non-bank financial sectors.
In 2008, when the GFC struck, the financial world experienced a severe breakdown.
Banks, which had been the backbone of lending and liquidity, stopped trusting one another, ceasing to lend in overnight markets, which are crucial for short-term liquidity.
Simultaneously, public markets suffered immense losses, with the S&P 500 plunging by roughly 50%.
As a result, both the banking system and public markets effectively froze, becoming illiquid and dysfunctional almost overnight.
What had once been highly liquid, smoothly functioning financial ecosystems ground to a halt.
Fast forward to today, and we are witnessing a striking evolution: the non-bank financial sector, which includes institutions like hedge funds, private equity firms, and shadow banks, has grown larger than the traditional banking sector.
Similarly, private markets, such as those for private equity, private debt, and direct lending, are expanding at a much faster rate than public markets.
This rapid growth is fundamentally altering the structure of global finance.
Such a shift of this magnitude raises critical questions about the potential impact on future financial crises.
One key issue is that risk-taking is now concentrated in markets that are inherently less liquid.
Even before a liquidity crisis occurs, the financial system is building up risk in markets that, by their nature, are harder to exit quickly.
So, what happens when these already illiquid markets face a shock and become even less liquid, potentially triggering a crisis?
Consider direct lending, private credit, and private equity investments, all of which are largely concentrated in the non-bank financial sector.
If the global financial system could experience a crisis of the scale seen in 2008—when liquidity dried up in highly liquid public markets—what might happen when the starting point for risk-taking is in far less liquid, private markets?
The consequences could be even more severe and far-reaching.
This paper explores the rapid expansion of the non-bank financial sector and the liquidity constraints that characterize private markets.
One of the key concerns with liquidity crises is the cascading, second- and third-order effects they can generate.
These effects occur when markets that are perceived to be liquid—markets where investors believe they can easily buy and sell assets—suddenly become illiquid, trapping participants and causing widespread disruptions.
Such second and third order effects often impact investors, institutions, and sectors that would ordinarily consider themselves insulated from high-risk financial activities.
However, the interconnectedness of the global financial ecosystem means that shocks in one part of the system can quickly reverberate through others, catching seemingly unrelated players in the fallout.
This is why understanding shadow banking, private markets, and the broader non-bank financial system is critical for assessing the risks posed to the overall financial system.
The increasing prominence of non-bank and private financial markets presents new challenges for managing liquidity and systemic risk.
As the financial system becomes more dependent on these less liquid sectors, the potential for liquidity crises and their ripple effects across the global economy grows, highlighting the importance of monitoring and addressing risks in the shadow banking and private market ecosystems.
Backdrop – The Global Financial Crisis
No two financial crises are exactly the same, though human behavior and emotions are always central to them.
Each crisis has its own unique characteristics, and as long as human nature remains constant, cycles of boom and bust are inevitable.
Given today’s historically high equity valuations, comparisons to the Global Financial Crisis (GFC) of 2008 and the Dot-Com bubble of the late 1990s are natural, and the current enthusiasm for Artificial Intelligence is reminiscent of past periods of euphoria.
However, it’s important to remember that valuations are symptoms of broader market conditions, not the underlying causes.
For example, during the Dutch Tulip Mania in 1636, a single black tulip was valued at several years’ salary—an indicator that something was amiss, but not the root of the issue.
Pinpointing the exact moment when a financial crisis begins is often only possible in hindsight.
Did the GFC start with the collapse of two Bear Stearns hedge funds in 2007?
Was it the fall of Bear Stearns itself?
Or perhaps Lehman Brothers' collapse? Some might even argue it began with Meredith Whitney’s 2008 analysis, revealing that Citigroup couldn’t maintain its dividend.
The answer depends on perspective—those directly impacted by these events would likely give different timelines.
What’s crucial today is understanding that comparing current credit conditions to 2008 is misleading.
All credit crises share a common feature: relaxed lending standards.
Before the GFC, subprime lending accounted for around 3% of mortgage lending; by 2007, it had surged to nearly 25%.
Loan standards deteriorated so badly that defaults on the first mortgage payment were rising, yet this was just one part of the problem.
Other key players in the crisis were institutions like Fannie Mae, Freddie Mac, and the mortgage insurer MBIA.
As long as these entities retained their high credit ratings, they were able to keep issuing loans to borrowers who couldn't repay.
MBIA, for example, wrote billions in liabilities while holding only $30 million in shareholder funds.
But the real breaking point came when large banks stopped lending to each other overnight, driven by concerns about both their counterparts’ liquidity and their own over-leveraged balance sheets.
Bear Stearns, for instance, had $3 of equity for every $100 in assets, a precarious 33:1 leverage ratio.
Once regulators stepped in after the crisis, they sought to prevent a repeat by imposing stricter rules on large banks through the Dodd-Frank Act.
This curtailed trading and market-making activities, bringing these financial giants into line. But as with any financial system, where there is demand, supply will find a way.
This time, the non-bank financial intermediaries (NBFIs) stepped in. In just over a decade, these NBFIs grew to become the largest lenders, overtaking traditional banks.
The lesson here is simple: credit demand doesn’t disappear—it shifts. Understanding where that demand goes is crucial in predicting how future financial risks may unfold.
The Rapid Growth of Non-Bank Financial Institutions (NBFI)
In addition to the increased regulatory pressure on banks after the 2008 crisis, the prolonged low-interest-rate environment has been a major catalyst for the rapid growth of non-bank financial institutions (NBFIs).
With traditional savings accounts and government bonds offering historically low yields, investors began seeking higher returns through alternative avenues.
NBFIs responded by offering a range of financial products that provided more attractive returns, such as collateralized loan obligations (CLOs), private debt, real estate investment trusts (REITs), and other investment opportunities that banks, due to regulatory constraints, did not provide.
This shift allowed NBFIs to fill a crucial gap in the market by catering to the increasing demand for yield-driven investment products.
As banks became more restricted in their ability to engage in riskier, high-yield activities due to post-crisis regulations like the Dodd-Frank Act, NBFIs stepped in with offerings that were not only higher-yielding but also often more complex and less transparent.
The flexibility of NBFIs to operate with fewer regulatory barriers became an attractive alternative for both institutional and retail investors hungry for returns in a low-rate world.
At the same time, technological innovation has accelerated the growth of NBFIs, especially through the rise of fintech companies.
These firms have revolutionized the financial services sector by utilizing data analytics, artificial intelligence, blockchain, and digital platforms to deliver more efficient and accessible financial solutions.
Fintech innovations such as peer-to-peer lending platforms, robo-advisors, online wealth management services, and digital payment systems have disrupted the traditional banking model.
These technologies offer faster, more cost-effective services tailored to the modern consumer, enabling individuals and businesses to access credit, make investments, and manage their finances without relying on traditional banks.
Fintech's rise has made NBFIs even more prominent by providing an infrastructure that is more agile and responsive to market demands.
However, with this agility comes a trade-off in oversight.
Because NBFIs are subject to fewer regulatory constraints than traditional banks, they can accumulate risks that may not be visible to regulators or market participants until it’s too late.
Hedge funds, for example, often engage in highly leveraged strategies, which can magnify losses during periods of market volatility.
The collapse of such funds can quickly spiral into broader financial instability, as these firms are tightly interconnected with traditional banks and financial institutions through various channels of lending, derivatives, and investment portfolios.
An example of this occurred in 2020, during the market turbulence triggered by the COVID-19 pandemic.
Money market funds, once considered stable and low-risk investments, experienced rapid outflows as investors fled to safety, highlighting the unpredictable fragility within certain corners of the NBFI sector.
The spillover effects of these outflows flowed throughout the broader financial system, underscoring the interconnected nature of banks and NBFIs.
Given the systemic importance of NBFIs, policymakers and regulatory bodies, including the Federal Reserve and the Financial Stability Board (FSB), have become increasingly concerned about the potential risks posed by the growing influence of these institutions.
There is ongoing debate about whether NBFIs should be subject to the same level of scrutiny and oversight as traditional banks, particularly those that have grown large enough to pose a significant threat to financial stability.
The challenge for regulators is to strike a balance between encouraging the innovation and growth that NBFIs bring to the financial system, while ensuring that these institutions do not become the next source of systemic risk.
However, history suggests that regulators are often reactive rather than proactive when it comes to addressing potential crises.
But what if the next liquidity crisis doesn’t come from the usual suspects?
If the financial system is now built atop private markets that are illiquid by design, what happens when that foundation is shaken?
(This is a professional-level report for industry professionals. Please upgrade to Santiago Capital Pro to continue…)