Funding options for consumers and companies have increased significantly with the rise of innovative tools and new business models. Their common standout feature is that those next-generation lenders are unregulated by central banks, enabling them to finance a broader consumer base than traditional commercial banks.
“The growth of the [non-bank financial institutions] sector accelerated after the global financial crisis, accounting now for nearly 50% of global financial assets,” the IMF said in April 2023.
Those private credit providers have a noticeable impact on any economy. A paper from the European Central Bank (ECB) in 2021 noted, that while “bank loans clearly remain the dominant debt instrument, … it is crucial to understand the impact of the rise and heterogeneity of non-bank finance.”
Among the various types of non-bank financial services companies, shadow banks are the equivalent of central bank-regulated commercial banks. Investment glossary Investopedia defines them as “financial intermediaries that participate in creating credit, but are not subject to regulatory oversight.” Examples of those shadow banks include “hedge funds, private equity funds, mortgage lenders and even large investment banks.”
In Egypt, the phrase “shadow banks” is uncommon. Instead, they are referred to as non-bank financial institutions, according to research from Cairo University titled “Growth of the Shadow Banking System and Effectiveness of Monetary Policy in Egypt.”
Despite the macroeconomic benefits stemming from shadow banks’ ability to offer faster access to funds to more individuals versus commercial banks, they are risky. “Shadow banking symbolizes one of the many failings of the financial system,” said Laura Kodres, division chief of the Global Financial Stability Division at the IMF. She identified it as the root cause of the 2008 global financial crisis.
In the coming years, economies will likely be even more affected by the pros and cons of increasingly thriving shadow banking systems. Since 2021, rising interest rates worldwide have subdued shadow banks’ growth as almost all nations mirrored the U.S. Federal Reserve’s (Fed) contractionary monetary policy. In September, the Fed reversed that policy, dropping interest rates to encourage consumption. That means shadow banks could offer less expensive credit, attracting more potential borrowers.
Part of the system
Nicolas Charnay, managing director and sector lead for European financial institutions at Standard & Poor Global (S&P), stressed that non-banks are essential to the global financial system. “Growth in global financial assets held outside the banking system in non-bank financial institutions has been a key feature of the past decade,” he wrote in June in International Banker, a specialized publication.
In developed nations, such as the United States, European countries and Canada, shadow banks account for about 10% of total loans, according to Charnay. In low and middle income nations, they play a more prominent role, funding a sizable portion of societies that aren’t banked or that commercial banks deem too risky. “Shadow banks are relatively important sources of funding in Brazil, Mexico, China, India, and Korea,” Charnay said.
On the ground, non-banks “improve the efficiency and depth of … financial systems,” noted a March S&P research note. That invariably creates more innovation opportunities in the financial sector and beyond.
Those non-banks could also push commercial banks to improve and diversify their services and tools; as S&P noted, “private credit providers… add to the competition banks face.”
Local shadow banking
The Cairo University paper described the financial system in Egypt as a “Twin-Peak Model.” The CBE only regulates all commercial banks. Meanwhile, “most of [the country’s] shadow banking system [is] regulated by the Egyptian Financial Regulatory Authority (FRA),” including consumer finance companies and fintechs.
However, some local shadow banks are not regulated by either CBE or FRA, including “private and public pension funds, the Social Fund for Development and Nasser Social Bank, which [isn’t] regulated by Egyptian Central Bank, like [the] other 40 traditional banks,” the Cairo University note said.
The document also noted the complete administrative and regulatory separation between the CBE and FRA. “There is no coordination between the monetary policy and regulatory authorities of shadow banking.”
According to FRA stats, overall credit offered by regulated firms jumped 66% in the first half of 2024 compared to the same period last year. Consumer finance increased by about 23.3%, while real estate financing tripled.
Conversely, local businesses scaled back their dependence on shadow banks in the first half of the year. According to the FRA, SME funding dropped nearly 29% versus the first half of 2023. Meanwhile, leasing, where companies secure long-term contracts to rent equipment, machinery or commercial vehicles, also declined by nearly 11% in the same time frame.
Risky financiers?
The S&P paper noted, “At their best, shadow banks can [finance consumers] without adding significant incremental risk.” That usually doesn’t happen, as Charnay of S&P noted those lenders “bring meaningful risks.”
Non-banks’ potential dangers usually stem from business-related decisions rather than a fault in the business model. “Some shadow banks have elevated leverage, structural liquidity mismatches and heavy credit exposure to specific economic segments, such as real estate financing,” S&P noted.
Such sector-specific focus means risks vary significantly among shadow banks, depending on which sector and niche they focus on and their business models, Charnay noted. That makes developing regulations and policies to protect and promote the sector tricky.
Another risk is that because central banks don’t regulate them, non-bank borrowers’ profiles will likely be far more risky and, hence more prone to defaults than commercial banks. Non-banks “have increasingly positioned themselves as alternatives to other funding sources,” Charnay said. “Facing limited prudential regulations, [non-banks] compete on terms, structure, and execution, offering one-stop solutions to many borrowers.”
Shadow banks must also deal with risks similar to those faced by commercial counterparts. For one, non-banks “are involved in credit intermediation in similar ways [to] banks, [and hence] are exposed to bank-like risks,” the S&P paper said. Kodres also noted shadow and commercial banks face the same types of risks when using “short-term funds in the money markets … to buy assets with longer-term maturities [aka maturity transformation].”
However, shadow banks will be in more trouble than their central bank-regulated counterparts if their lending goes awry. “[Because non-banks] are not subject to traditional bank regulations, they cannot – as banks can – borrow in an emergency from the … central bank and do not have traditional depositors whose funds are covered by insurance,” said Kodres of the IMF.
Spillover effect
If too many shadow banks fail, it could affect both central and commercial banks, spilling over to the rest of the economy. “At first glance, direct financial linkages between traditional banks and shadow banks appear limited,” noted the S&P paper. “But we believe there is more to this than meets the eye.”
The first type of link is direct, as “some shadow banks are controlled by commercial banks,” Kordes said. That setup could entice both the commercial bank and their shadow bank operation to take more risk than usual, safe in the knowledge that, ultimately, the central bank governing the traditional bank would protect them in case of massive defaults.
Kordes also noted that while commercial banks could be financially unrelated to non-bank institutions, the latter could still impact the former. “Because shadow banks [have] to withdraw from other markets — including those in which banks sold commercial paper and other short-term debt — these sources of funding to banks [are] also impaired.”
The other link is evident when “under stress [non-banks] create a problem for global banks simply by spreading or exacerbating financial risk,” S&P Global said.
Meanwhile, as an alternative financing option unregulated by the CBE, shadow banks “affect inflation and monetary policy effectiveness in Egypt,” the Cairo University paper said. That could be positive if the CBE pursues an expansionary monetary policy, as shadow banks encourage spending. However, non-banks would undermine a tightening monetary policy that combats inflation by reducing spending.
The S&P report said the interplay between central, commercial and shadow banks poses risks. “Regulators now have a better understanding of the direct and indirect risks that the non-bank sector poses to the financial system … [but] they have limited tools to mitigate … risks.”
Booming future?
According to S&P’s note, high interest rates generally curb the operations of shadow banks, forcing them to charge high rates. In Egypt, interest rates went from 8.25% by the end of 2021 to 27.25% at press time.
Those high rates subdued local non-bank credit growth, as “people calculate the real cost of the loan,” said Walid Hassouna, CEO of ValU, a consumer finance non-bank, during a September conference. “They understand how much they are paying in admin fees, interest and everything else, and they actually compare the price of the product they are buying in cash or if they buy it through [non-bank financial services companies].”
However, with the Fed announcing a 50 basis point reduction in interest rates to April 2023 levels, non-banks should boost their operations if their central banks follow suit. That growth pace will likely accelerate in the coming two years as “officials’ expectations point to another full percentage point in cuts by the end of 2025 and a half point in 2026,” CNBC reported in September.
That likely means low and middle-income nations would be eager to follow in the Fed’s footsteps by decreasing borrowing costs for companies and governments (treasuries) after years of high interest. Hassouna added that in Egypt, “customers became more conservative in their purchases after the Ras El Hekma agreement, knowing that even though products were available, interest rates were bound to decrease sooner or later.”
Nevertheless, S&P said, “conditions remain tight, particularly for speculative-grade issuers.” At press time, S&P rated Egypt “B-/B [for] long- and short-term foreign and local currency sovereign credit ratings.” That rating means the country is “speculative grade: More vulnerable to adverse business, financial and economic conditions, but currently can meet financial commitments.”
Another pressure point that could curb non-bank activity in Egypt is that “interest rates [are] still high, [meaning] restricted funding access,” S&P said. Additionally, “risks will be most pronounced for issuers that rely heavily on short-term funding or whose long-term funding will mature” by March 2025.
This article first appeared in November’s print edition of Business Monthly.
