Researchers find new way to detect hidden risks from shadow banking17 November 2015

Associate Professor Necmi Avkiran

New profiling techniques could help detect hidden risks within the banking sector and provide early warning of any future financial crisis, according to two UQ Business School finance experts.

Associate Professor Necmi Avkiran and postdoctoral research fellow Rand Low have pioneered a way to detect threats to banks’ stability caused by shadow banking activities, such as trading in hedge funds and other financial instruments.

Their findings come as financial regulators, which have already introduced new rules forcing banks to shore up their reserves, are now turning their attention to the world of shadow banking, which is less heavily regulated and where the complexity of deals makes it hard to monitor risks.

The shadow banking sector has been growing in recent years and in 2013 it represented 25 per cent of the total financial system, according to the UK Financial Stability Board. Failures in shadow banking – in particular the sale of sub-prime mortgage securities - were blamed for triggering the global financial crisis (GFC) in 2007.

“Shadow banking makes a significant contribution to financing the real economy,” says Associate Professor Avkiran. “However it is also a major source of risk and, because it is so closely intertwined with traditional banking activities, regulators are concerned that it could pose a threat to conventional banks.

“Numerous links exist between the two sectors. In some cases banks have set up their own investment arms to engage in shadow banking. Or they may use securitisation – where parcels of debt are bundled together and sold on to others as highly rated securities.

“In the run-up to the GFC, this allowed banks to maintain higher leverage and still comply with capital requirements. Such a strategy makes banks more vulnerable to shocks and, by raising the level of connectedness among financial institutions, also increases the risk of multiple failures.

“There are many other risks too. For example, both sectors could inadvertently end up investing in the same businesses or same types of asset, increasing their exposure. As many corporates use money market funds to finance their operations, any failure of these facilities could place businesses in financial strife which in turn will affect their ability to repay their bank loans.”

In an attempt to model the effects of shadow banking risk on the banking sector, the two men worked with Christian Ringle of Hamburg University of Technology on a research project studying the accounts of over 60 US bank holding companies. These were then subject to stress testing using a technique called partial least squares structural equation modeling (PLS-SEM) – the first time it has been applied to stress testing the finance sector.

The results indicate that around 75 per cent of the variation in systemic risk in banks can be explained by links to shadow banking activities. Direct links between the sectors – for example where banks have a shadow banking subsidiary – were found to be more risky than indirect connections, which suggests that internal risk management could play a greater role in reducing the likelihood of a future crisis.

The team believe that regulators could use the same approach to monitor risk and inform regulatory decisions. Associate Professor Avkiran says this will become even more important in the future: “There is already concern that banks might be evading increased regulation by shifting activities to shadow banking.

“With even stricter legislation on the way, such as the Basel III Accord and the Dodd-Frank Act in the USA, the shadow banking sector may see further growth so its effect on conventional banks needs to be closely monitored.”

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