The Bank of England has ordered a stress test of the shadow banking sector after the sudden collapse of two US firms raised fears that much bigger problems were lurking in the financial system.
Bank Governor Andrew Bailey said ‘alarm bells’ were ringing over risky lending in the unregulated private credit market after the failure of car parts maker First Brands and sub-prime auto lender Tricolor.
Speaking to peers on the House of Lords Economic Affairs Committee, Bailey drew parallels with the run-up to the 2008 financial crisis.
He said: ‘We certainly are beginning to see, for instance, what used to be called slicing and dicing and tranching of loan structures going on, and if you were involved before the financial crisis then alarm bells start going off at that point.’
Peers are looking at the growth of so-called private credit markets – finance provided to large businesses outside of normal bank lending or the issuing of publicly traded shares or bonds.
They have become a vital source of funding for consumers and businesses as traditional banks have retreated from riskier lending since the financial crisis.
Warning: Bank of England governor Andrew Bailey (pictured) said ‘alarm bells’ were ringing over risky lending in the unregulated private credit market
But there are concerns that loose lending by private equity firms and hedge funds could pose a systemic risk to the wider financial sector because shadow banking is unregulated.
Highlighting the ‘interconnections’ with mainstream banks, Deputy Governor Sarah Breeden said: ‘We can see the vulnerabilities here, the opacity, the leverage, the weak underwriting standards.’
Appearing alongside Bailey, she added: ‘We can see parallels with the global financial crisis. What we don’t know is how macro-significant those issues are.’
Bank shares fell sharply last week on fears that more companies who rely heavily on private finance could collapse.
Mainstream banks are also potentially exposed because they provide credit to non-banks in the form of loans and other funding.
Bailey said the Bank planned to conduct a ‘system-wide exploratory scenario’ with banks, insurers, private equity companies, pension fund investors and other non-bank lenders.
The collapse of First Brands and Tricolor was ‘another reason to have more drains up, frankly’, he added.
The war-gaming exercise will be similar to last year’s review of financial risks in core UK financial markets.
Following that exercise Bailey revealed he had urged some mainstream British banks to ‘get their act together, hopefully before it is too late’ in working out what their exposure was to private markets.
‘I think that has now happened,’ he said.
‘It was a surprise to find for some of them how far back they were in terms of being able to aggregate their exposures.’
More details on how much UK banks are exposed to private credit is expected today when Barclays posts latest results. It will be followed by Lloyds tomorrow and NatWest on Friday.
Bailey did not rule out widening the Bank’s powers if the shadow banking review found there was a risk to the financial system from private credit.
He said the issue could also be escalated to the Financial Stability Board, which he chairs, for cross-border collaboration.
The Bank is expected to complete its non-bank review by the end of next year.
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