The financial system is loaded up with a lot more debt than Wall Street wants you to know

  • New report from the International Monetary Fund highlights the risks of non-bank finance, which helps hide debt levels in the financial system.
  • The debt has shifted over to the so-called shadow banking system.

Federal Reserve officials love to say the risk of another financial crisis has been severely curtailed by new post-crisis rules that forced the largest banks to raise substantially greater levels of equity capital than they had before the meltdown.

However, a new report from the International Monetary Fund suggests a lot of the debt that was sloshing around on bank balance sheets hasn’t exactly disappeared, but merely shifted over to less regulated portions of financial markets – the so-called shadow banking system.

“Traditional metrics of leverage in the financial sector have important shortcomings,” the IMF said in the report. “Leverage metrics commonly used in the literature are primarily based on bank balance sheet data (to be precise, on-balance sheet data), even though recent Basel rules propose to pick up several off-balance sheet transactions for their monitoring reports.”

The problem is that “these measures do not fully capture the bank-nonbank nexus, since the size of nonbank funding to banks is not readily available in standard bank databases constructed from on-balance sheet data only.”

This means that “the omission of off-balance sheet items in the standard measures implies a substantial underestimation of bank leverage.”

The IMF says “nonbank funding (households and wholesale) is on the rise since the Lehman-crisis, and constitutes a major source of bank credit to the economy.”

The chart below offers a visual illustration of how the money flows through the system from the more regulated entities to the less closely-supervised ones.

Shadow Bank IMF chart

The report cites Barclays as a case in point.

Barclays reported a total pledged collateral of £466 billion ($US656.2 billion) in 2016, but only £34 billion ($US47.88 billion) made it onto the balance sheet. The discrepancy is very large considering Barclays reported total on-balance sheet assets of £1.2 trillion ($US1.47 trillion) in 2016.

“A fuller view of assets naturally has implications for leverage,” the report said. “Barclays’ leverage (defined as assets/equity) rises from about 20.7 (based on balance sheet data alone) to 28.1, if their pledged collateral transactions are fully recorded. This rise occurs because pledged collateral transactions that do not make it to the balance sheet-£432 billion-do not have corresponding equity.”

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