SEC commissioner takes aim at shadow banking

American regulators should take a closer look at the shadow banking system to ward off a fresh financial crisis, Democratic SEC Commissioner Caroline Crenshaw said Thursday.

“I worry that this market is becoming riskier in ways that regulators have not yet fully considered,” Crenshaw said in a speech at the Center for American Progress, a liberal advocacy group in Washington. “While some loan syndication may make sense to reduce the risk taken by individual banks, I am concerned that we are now in a world where banks lend, but nearly all the risk is transferred to investors who have no relationship with the borrower, and that investors – including retail investors – frequently have a great deal of exposure to these assets.”

Courts have generally held that syndicated loans aren’t securities, putting them beyond the reach of the SEC. Crenshaw says she’s worried that the “symbiotic arbitrage” that allows the broadly syndicated loan market to operate also means regulators will be “unable to detect risks that could affect the efficiency, fairness, or orderliness of our capital markets. And, if a negative outcome does ultimately occur, the same lack of data could also hamper our ability to effectively respond.”

In April, the Department of Treasury’s Financial Stability Oversight Council – on which SEC Chairman Gary Gensler sits – proposed reviving post Dodd-Frank rules that would allow prudential regulators to label shadow banks “systemically important.” Under Sec 113 of Dodd-Frank, nonbank firms are “systemically important” if their “material financial stress – or the nature, scope, size, scale, concentration, interconnectedness or mix of its activities” – threatens economic stability. Such companies are subject to “consolidated supervision” and “enhanced prudential standards” by the Federal Reserve.

As a practical matter, the new rules would threaten investment advisers the most. According to an April analysis by the International Monetary Fund, investment funds (including money market and hedge funds) account for about 15 percent of the world’s nonbank assets. Insurance companies and pension funds are the next largest sectors, accounting for 9 percent each, the IMF says.

Investor protections

The syndicated loan industry is relatively small, but it’s growing quickly, at nearly 14 percent per year. By 2031, according to one estimate, the market could reach nearly $4 trillion.  Crenshaw says she’s “aware” of the argument that the shadow banking industry – her speech focused particularly on broadly syndicated loans – don’t need heavy regulation because most of the clients are large, sophisticated investors.

“Of course,” she added, “institutional investors also need and deserve the protections of the federal securities laws. Consider the experience of institutional investors who purchased investments based on residential real estate before and during the global financial crisis of 2007 and 2008.”

But retail investors also have “enormous exposure” to the industry, Crenshaw said. “For example, many of the vehicles that purchase BSLs are registered investment companies that focus on these types of assets, and these funds represent an important component of the market for BSLs,” she said.

“These funds, in turn, are owned by retail investors. Even if it is the case that the parties making investment decisions understand the important protections they are giving up, do the underlying investors? Funds investing in BSLs have been heavily marketed to retail investors in recent years as a hedge against rising interest rates. Less prominent, however, have been discussions of the differences in legal status between BSLs and other credit instruments like bonds. I believe it is unlikely that most retail investors in these funds would understand these nuances, and that they would reasonably expect their funds to have more legal protections than in fact exist.”

“At a minimum,” Crenshaw added, syndicated loans ought to be subject to the antifraud provisions of the Securities and Exchange Act.

“Consider: do investors in BSLs have sufficient protection from the risks of insider trading? Investors in traditional securities benefit from the knowledge that the SEC has the power to police when insiders trade on the basis of material non-public information. The enhanced investor protection results in increased market efficiency because investors do not need to worry that the other side is trading on the basis of inside information,” she said.

Systemic risks

At the same time that she worries that ordinary investors could be harmed, Crenshaw says regulators ought to see the shadow banking industry as a growing threat to the wider economy.

“Though BSLs trade regularly, many passive investors will only buy assets that trade on ‘par docs,’” she said. “This essentially means that they are not trading at a discount due to distress or potential distress at the borrower. In fact, many investors have strict guidelines that require them to sell BSLs even when they are downgraded below a certain level — well before the issuer is truly in distress. I am concerned that this can result in a procyclical cycle of sales which in turn could cause forced sales of other BSLs market-wide and affect the ability of companies to receive financing even though they are not otherwise distressed. The echoes of the 2008 financial crisis are hard to ignore.”

More than that, as shadow banks grow, they bring in more investors, Crenshaw says. “If investors sour on the market, (for example due to forced sales by market participants depressing prices throughout the market), the largest loans that depend on being especially widely syndicated are the ones that are most likely to get “hung” on bank balance sheets and potentially affect financing to other companies,” she said.

The next crisis may already be unfolding before our eyes, Crenshaw said. During the covid pandemic, “many companies took advantage of the near-zero interest rates of the pandemic and its immediate aftermath to borrow new money using BSLs,” she said. “The amount of BSLs maturing in the next several years is more than any other comparable period in history.”

We’ve seen this movie before, Crenshaw says.

“In the aftermath of the financial crisis, many companies engaged in ‘extend and pretend’ transactions,” she said. “These involved extending the maturity of the company’s debt on the hope that financial conditions would improve but without any meaningful changes to the company’s business. As of earlier this year, extend and pretend transactions were at their highest on record. Though it appears this has not yet resulted in immediate negative effects, will our luck run out in future years?”