Professor Vincenzo Bavoso, University of Manchester Law School – Written evidence (PMG0004)

This submission is supported by Policy@Manchester

Executive Summary:

• The present fragility affecting the financial system raises alarm particularly because of the growth of the private credit market. This phenomenon is rooted in the functional integration of banks and capital markets, a shift that materialised in the decades preceding the global financial crisis of 2008.
• This resulted in banking institutions expanding their business beyond core banking activities, into more profitable non-banking ones (among which, investment, insurance). Leading to the growth of what used to be called shadow banking - namely a set of transactions, intermediaries and markets falling outside the perimeter of banking regulation but connected to banks by those same transactions (chiefly securitisation conduits on the assets side of banks and repurchase agreements on the liabilities side).
• Post-2008 regulatory interventions mainly targeted banking organisations and their key objective was to strengthen the balance sheet of banks, by, among other things, limiting banks’ exposure to shadow banking markets. While these regulatory exercises were successful in some ways, they triggered unintended consequences, such as the failure to adequately regulate entities outside of the banking system, and the further growth of the shadow banking system with more banking activities migrating to the non-bank ecosystem.
• In the post-2008 period, shadow banking became progressively rebranded as market-based finance, and its growth was the ultimate objective of many policy efforts in the UK, at the EU level, and globally. The inevitable expansion of this area of the financial system is now widely referred to as non-bank financial intermediation (NBFI) – indeed private finance.
• A quintessential post-2008 phenomenon is the shifting of lending activities from banks to non-bank entities.

1.1      As of December 2024, the volume of loans originated to non-financial companies in the UK stands at a lower level than it was in 2010. Finance companies today hold a percentage of credit that is 43.8% higher than non-financial companies; mortgage lending represents 54% of all lending by commercial banks, while credit originated by commercial banks to non-financial companies stands at 16.6% (it was 21% in 1990).[1]

1.2           The cost of lending for banks was affected after 2008, by the new regulatory framework flowing from Basel III – particularly its capital and liquidity requirements. It has been observed that capital ratios have a negative impact on banks, with respect to retail and commercial lending (regulatory costs encourage banks to substitute loan assets with liquid securities). This line of research is less conclusive with respect to the impact of liquidity requirements on bank lending, and it has also been observed that banks have adjusted the composition of assets and liabilities, without shrinking their balance sheet or reducing lending to the non-financial sector.[2]

1.3           At the same time, non-bank financial intermediation has grown substantially after 2008. This is evident globally, but more specifically in the US, the UK and the Euro area.[3] My research at The University of Manchester shows how this growth manifested itself, on the one hand, with lending facilities being provided by non-bank intermediaries, such as online peer-to-peer platforms, or private equity firms syndicating loans from non-bank intermediaries and repackaging them into structured products.[4]  On the other hand, the expansion of non-bank intermediation saw the contextual growth of money market mutual funds (MMF).[5] In different ways and to differing degrees, banks remain interconnected with these channels of non-bank intermediation. 

1.4      The expansion of banks into capital markets activities was always the root of a significant incentive for banks to engage with the more profitable (investment) business. This is evidenced by the balance sheet of large multifunctional banks, and the percentage of loan assets compared to other asset exposures (as an illustration, in Germany, they are 8% of total assets originated, whereas they account for 28% of total assets for cooperative banks).[6] Post-2008, these long-standing incentives have taken a different turn due to the capacity of banks to arbitrage Basel III, by interfacing with non-bank intermediaries which are not subject to the same regulatory requirements. 

2.1      While before 2008 large banks were clearly connected with the shadow banking system via securitisation conduits and repurchase agreements, post-2008 regulation made these exposures more costly for banks. The interconnections with channels of non-bank intermediation, however, did not disappear, but in fact surged after 2014, and simply took different shapes.[7]

2.2      The interconnectedness between banks and non-banks may be less direct now than it was before 2008. Banks, however, still perform critical warehousing, lending, and underwriting functions with respect to non-bank actors, which entails a significant degree of interconnectedness, and as a result systemic stability concern.[8]

2.3      While the Bank of England keeps monitoring these layers of interconnectedness - in particular the role of private credit providers in it - there are currently no institutional or regulatory frameworks in place, or in the pipeline, designed to contain this phenomenon.[9]

3.1      The implications of the growth of private credit market are consistent with an overall increase in the size of the non-bank ecosystem, together with its inevitable interlinkages with bank, via a set of mutual dependencies (such as lending from banks to NBFIs, liquidity management by banks, clearing services by banks, underwriting by banks, insuring creditworthiness). It is widely accepted that these interlinkages can lead to financial instability risks, as has been the case over the past five years, in cases such as Archegos in the US, the LDI crisis in the UK, the panic of 2020 and the “dash for cash”.[10]

3.2      It has been clearly stated by the IMF that systemic stability concerns are currently caused by the perennial increase in private debt and leverage created by NBFIs.[11] NBFIs do not possess the incentives, nor the structure to monitor the private debt that they originate and disseminate in the financial system.

3.3      It is equally well documented that transmission channels between banks and non-banks can easily transform a peripheral shock into a fully-fledged systemic crisis, due to the transmission of credit risk, excessive leverage, and liquidity spirals across a wide range of market participants. Effectively, the extension of liquidity facilities from key central banks (the Bank of England, the Federal Reserve, and the ECB) to NBFIs is a clear demonstration of the vulnerability of the current system.[12]

3.4      It is hard to dispute that the real economy, and in particular SMEs, prosper in economies characterised by networks of local banks devoted to the business of lending.[13] While banks are beneficiaries of regulatory backstops (deposit insurance protection and lender of last resort) and institutional prerogatives (capacity to access information of the underlying assets they gain exposure to), NBFIs do not possess the same characteristics. Given that NBFIs are in principle not protected by the same regulatory backstops, they remain exposed to credit and liquidity risks, which are not internalised and instead are transmitted across the financial system due to various interlinkages with the banking system. 

4.1      Credit originated by non-bank intermediaries is not subject to the same set of regulatory requirements that apply to banks. The monitoring of private credit market has traditionally remained challenging, due to the opacity of transactions, products and markets. An example is represented by leveraged loans syndicated via private equity firms and repackaged into collateralised loan obligations (CLOs).

4.2      While data with respect to some non-bank channels of intermediation, such as MMFs or mutual funds, is relatively well monitored, other segments of the non-bank ecosystem remain more fragmented and difficult to access. This means that the riskiness of bank exposure and the likelihood of systemic risk are not adequately measured. Similar concerns were expressed by the IMF particularly with respect to the excessive exposure to the private credit market and the concentration of risks therein.[14]

5.1      The Bank of England seems aware of the systemic risks that emanate from the private credit market and more generally NBFIs, particularly in the light of the recent LDI crisis, where a shock in the pension system reverberated through the bond market, eventually impacting on the wider credit market. There emerges awareness of vulnerabilities (such as leverage or liquidity mismatches) that in the private credit market are not captured by relevant regulatory provisions, and that are transmitted and amplified via transactions and markets.

5.2           So far, it appears that systemic risks flowing from the private credit market are being mitigated by enhanced monitoring (via actions by Financial Conduct Authority and Financial Policy Committee), and that the Bank of England is contemplating adopting specific reporting requirements from private funds.[15]  

6.1           Questions related to banks’ provision of credit to the real economy need to be framed in the context of the wider economic crisis that hit the UK after 2008. There is consensus in identifying a decline in the demand for credit, which is a trend that is also consistent with theories of financial cycle, whereby after a shock economic actors are more prudent, both consumers accessing credit and banks originating it.

6.2           This trend partly shifted in the early 2010s where demand for credit started to increase. It is at this point that while banks reduced their lending to the real economy compared to the pre-crisis years, non-bank entities stepped into the market. This trend appears to be characterised by a) demand for unsecured credit by households and small businesses, which was initially absorbed by P2P platforms[16]; and b) demand for high-risk leveraged loans by corporates, whose origination was syndicated through the coordination of private equity firms.[17]

6.3           All this indicates a progressive shift from bank lending towards non-banks. It is far from clear whether this shift provides necessary financial support for real economic activities. Current policy pressures, in the UK as well as globally, prioritise the further development (and integration in the EU) of market-based channels of intermediation, whereby access to finance for businesses would primarily be via bond and equity issues. My research indicates however that there is no evidence this policy can lead to the desired outcomes in terms of ensuring access to credit for the real economy.[18] 

7.1           As stated, the cost of holding loan assets for banks is higher than the cost of holding more liquid assets, such as bonds. Capital regulation under Basel III has made capital requirements more robust, introducing among other things several capital buffers that overall increased regulatory costs for banks. The resulting willingness of banks to extend loans is further constrained by their business model. Large multifunctional banks in fact, have an incentive to engage with capital markets activities instead of lending to the real economy, because engaging with securities trading and proprietary trading is more profitable thank lending to the real economy.[19]  

7.2           The question therefore is not simply one of regulatory incentives, but rather of structural imbalances – indeed the functional integration discussed in the introduction of this submission.[20] Large multifunctional banks that interplay with capital markets activities and with the panoply of market-based intermediations, have no incentive to lend to the real economy. Smaller banks on the other hand such as building societies, face the same costs in terms of capital regulation, without being able to access other channels of business.

7.3           The most straightforward external source of finance for businesses remains bank lending. The idea that businesses, particularly small ones such as SMEs, can resort to capital markets is unfounded and loosely grounded on a misguided view of US capital markets.[21]

8.1           Private credit markets are currently in an advantageous position vis-à-vis banks for two reasons: a) they are not captured by the regulatory provisions enacted after 2008 under Basel III, and overall incur much lower regulatory costs; b) over the past five years they have received liquidity support from central banks (directly or indirectly) despite not being licenced as banks and falling outside the lender of last resort umbrella. So, while remaining unregulated as lenders, NBFIs benefited from the same regulatory backstops as banks.

8.2           Against these regulatory advantages NBFIs do not possess the same institutional prerogatives that banks traditionally have. These pertain to the capacity (organisational and structural) of banks to discover the quality of underlying projects (loan assets) and their credit risk. Banks also have advantages in acquiring and monitoring information about borrowers, in a more efficient way than can be done by other market participants.[22]

8.3           There emerges a scenario where the shift of critical lending facilities from banks to non-banks is informed by regulatory arbitrage incentives. It involves huge risks for two reasons: a) non-banks are not recipient of regulatory requirements and as a result they may contribute to leverage and liquidity crises (as already happened in recent years); b) non-banks are not structurally equipped to screen and monitor the credit they originate which can negatively impact on financial stability.

9.1           Reforms to bank capital alone are not likely to shape the extent to which banks provide credit to the real economy. Reforms should instead focus more squarely on structural elements of the banking industry. They should prioritise and in fact reward the business model of small banks such as building societies, whose mission is directed at extending credit. These financial institutions, whose business model prevents them from engaging with capital markets activities, should benefit from advantageous, tailor-made, capital rules.

9.2           At the same time, it is difficult under current market conditions to come to terms with the extension of regulatory backstops (such as deposit insurance protection and lender of last resort) to entities that do not perform core banking functions (lending and deposit-taking) and do not have a banking licence. The fact that in the post-2008 period these regulatory backstops have been implicitly extended to the non-bank sector represents a rather dangerous message to financial markets participants.

9.3           Similarly, as has been proposed in the US, non-bank institutions should be prohibited from issuing money-like liabilities (deposits).[23] This would drastically reduce interconnectedness between banks and non-banks and as a result reduce systemic stability concerns.

9.4           A regulatory framework focused on capital and liquidity measures, targeting large financial institutions, has not prevented the build-up of huge risks in the post-2008 years. Instead, leverage kept increasing in the financial system (outside the balance sheet of the big banks) and financial stability concerns have been raised on multiple occasions by the IMF.[24] Moreover, crises in the past years have started in relatively remote corners of the financial system, reproposing problems of interconnectedness and systemic risk.

10.1      The recent growth of private credit markets should not be seen as a direct consequence of post-2008 regulatory reforms. While it is correct to infer that the Basel III package created unintended consequences in terms of increased regulatory costs for banks, the development of so-called private markets can be traced back to the late 1980s, in connection with the swiping regulatory changes that were enacted in the US, the UK and eventually globally. These “deregulatory” changes had profound effects in a) enabling the rise of megabanks that extended their business to capital markets activities; and b) eliciting waves of transactional innovation that today provide many of the transmission channels between banks and non-banks.[25]

10.2          This landscape shaped the growth of the shadow banking system in the pre-2008 decade, and as indicated in this submission, that morphed into market-based finance and eventually into private finance.

10.3            There has been increased monitoring and oversight at the international level[26], together with a focus on developing macroprudential tools to mitigate systemic risk. This renewed awareness though has not translated so far into any concrete regulatory frameworks directed at NBFI and the systemic risks they pose.

13 August 2025

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