Is there a map through the land of shadow banking?

Banks are still reluctant to lend, especially in their non-core markets as either their balance sheets are too fragile or the current regulations have constrained them. As a result, the diminished availability of financing is of concern resulting in different funding gaps across different sectors (infrastructure, real estate, industrial etc.) and regions.

The lending void left by banks is gradually being filled by non-banking entities or so called ‘shadow banks’. Regulators have consequently been increasingly focused on the perceived risks this change might represent. However, at the same time opportunities are arising for alternative lenders and more particularly private debt funds, their investors and borrowers.


The term “shadow bank” was initially coined by the economist Paul McCulley in 2007. Following the 2010 G20 summit in Seoul, the Financial Stability Board (FSB) together with other international bodies were given a clear mandate to address the need for strengthening regulation and the supervision of shadow banking. In its 2011 October report, the FSB defined shadow banking as “the system of credit intermediation that involves entities and activities outside the regular banking system”.


The FSB report has provided some guidance to define the borders of the shadows. Since the FSB monitoring exercise has been setup, data has been obtained from 25 jurisdictions and the euro area as a whole. To date shadow banking amounts to $71 trillion which represents 25 percent to 30 percent of the total financial system and half the size of bank assets. As a result, the estimated size in absolute terms and as a share of the financial system shows that some of its components could be systemically significant and clearly merit review from a financial risk perspective.

An additional aspect triggering the need for regulation is the high level of inter-connectivity between shadow banking and the banking system. Any crisis occurring in the nonbanking system, such as “Runs” in depositlike funding structures, could potentially destabilise the banking system and regulators are keen to avoid a contagion to the latter. The potential build-up of high and hidden leverage may also pose problems, especially if collateral has been churned several times. Finally, there is also a need to avoid regulatory arbitrage where financing moves entirely out of the regulated banking arena or operations are partly outsourced into the shadows.


Amidst the clamour of regulation required, the positive role of shadow banking should not be overlooked. Providing funding to the real economy is one of the aspects to be considered and it is vital to support real economic activity. Obtaining such financing is a hot topic not only for governments who wish to promote economic growth in their countries and support entrepreneurial behaviour but also for many corporates having maturing existing loans and business development requirements. If the bank will not or cannot provide the financing needed, alternative financing sources and solutions must be forthcoming. Therefore at a time of growing demand with a falling supply, non-bank institutions can help in closing part of the European funding gap (estimated at €2.8 trillion over the next 5 years ) and reinforce the stability of the financial system.

It is also fair to note that while large companies can access credit in the public market by issuing bonds or other debt instruments, small and medium-sized enterprises (SMEs) – which represent 99.8 percent of the number of companies in the Euro area as well as 66 percent of the employment – do not often possess the resources, expertise and critical size to do so. The 2013 Commission report on SME’s access to finance, where 85 percent of loans in Europe were granted by banks, illustrates this particularly well. Likewise, infrastructure and real estate finance may involve investment horizons that are too long for public bond markets. As a result, the alternative of a non bank institution provides additional diversity in the financial ecosystem, helping to ensure that it does not become widely or mainly dependent on the behaviour of banks. With an increasing number of market participants, the risks of “too big to fail” will not disappear but it will participate in reducing the size of the different market players.

In recognition of this positive role of non bank financing the economy, recent public initiatives have tended to support non-bank lending. As an example, the UK Government, through the Business Finance Partnership (BFP) – whereby fund managers are selected and required to co-invest with the government by making loans to SMEs – created a £1bn lending scheme with non bank lenders.

On the borrowers’ side, the three main advantages offered by non bank lenders are (i) a longer term-financing in comparison with the banking industry, (ii) flexibility in the lending arrangements (ie senior, mezzanine, unitranche/unirate and non amortizing element, greater covenants headroom) and (iii) use of the facility for wider needs such as acquisition, growth or capital expenditure. Finally in the current lending environment, non bank lenders are more willing to look at geographical jurisdictions or sectors which banks are less keen to service.


At the level of an alternative fund, a prospectus is in place which contains risk disclosure, liquidity requirements, lock-in periods, investment policies…etc. so the approach, processes and goals are totally different from depositing money with a bank. Additionally there are different techniques at fund level to minimize the “run risk” on which banks are exposed with specific or restricted redemption mechanisms. As a result the systemic risk arising from liquidity and maturity transformation will be very limited if the fund is properly set-up. It is also important to bear in mind that in the alternative space most of the funds are either closed ended funds with very limited options in terms of redemptions, or open-ended funds with strict redemption mechanisms.

It is worth noting also that the investor base in the alternative world is mostly made up of institutional, professional and well informed investors with a long term investment horizon and understanding of the risk in the alternative assets classes they invest. Due to a restricted distribution within a specific target group, the contagion risk is therefore limited.

The combination of the investor base and alternative fund type with longer holding periods allow us to conclude that we are not in deposit like funding structures exposed to the same extent to run-event risks, as in other funds.


We are now at a turning point where some clarity has emerged from the regulators, and actions have been focused on areas of concern such as strengthening of the Money Market Funds (MMF) framework and more transparency for securities financing transactions. On top of these new proposals for regulating the shadow banking environment various measures and steps have already been taken, especially in the asset management and insurance sectors, to address some of the existing challenges:

The Alternative Investment Fund Management Directive (“AIFMD”)
Under AIFMD, Alternative Investment Fund Managers (AIFMs), for each AIF they manage, which is not an unleveraged closed ended fund, are now required to monitor liquidity risks and employ a liquidity management system to cope with unexpected redemption events. Regular stress testing has also to be conducted to assess and monitor liquidity risk.

Insurance Companies
In the current low interest rate environment, the search for yield and need for diversification have also influenced the expansion of the insurance sector, directly or indirectly, into the mid to long term financing space. As a result, within the shadow banking debate some entities or activities from the insurance sector may be included but today pose little additional risk to overall financial stability. Indeed the new prudential rules for European insurance companies with the Solvency II Directive addressed a number of shadow banking concerns by providing consistent risk-based solvency requirements and increased transparency through reporting.


There is a misconception that shadow banking is unregulated and it is often portrayed as a “negative” concept.

Some light is finally emerging from the regulatory debate but the biggest challenge that the regulators are facing today remains achieving the right balance between harmonious regulations which handle systemic risk without adversely impacting the required economic growth rates.

Within the AIFMD and Solvency II directives, many of the shadow banking issues have been already addressed and most of the entities concerned are already part of a strong regulatory framework. Alternative lenders are likely to play an ever increasing role in providing financial solutions particularly in Europe. At the same time, regulators and service providers need to adapt themselves to support them and in turn play their part in helping stimulate the wider economy.

Maximilien Dambax is Head of Debt Administration Services at Alter Domus, based in Luxembourg. He can be reached at: +352 48 18 28 3539 or via email at

Alter Domus is a leading European provider of Fund and Corporate Services, dedicated to international private equity & infrastructure houses, real estate firms, multinationals, private clients and private debt managers. Founded in Luxembourg in 2003 Alter Domus has continually expanded its global service offer and today counts 28 offices and desks across four continents. It serves 8 of the 10 largest private equity houses, 6 of the 10 largest real estate firms and 3 of the 10 largest private debt managers in the world. Alter Domus has a dedicated debt team of 40 professionals that manages the administration of debt funds, related corporate entities, special purpose and securitisation vehicles with more than EUR 22 billion of assets under administration