As of 2021, these non-bank lenders were sitting on $226tn in assets – equivalent to about two and half times global GDP. In the UK, non-bank lenders now provide close to half of all credit.

Alternative lenders make a compelling case that their activities benefit borrowers, financial markets and the global economy. In particular, as stricter controls following the global financial crisis made banks reluctant to lend to some segments, shadow banks stepped in.

Non-bank lenders have become a critical “source of new investment capital” to businesses, especially small and medium-sized enterprises, “reducing the impact of economic shocks during times when banks are unable or unwilling to lend”, according to a recent paper by the Alternative Credit Council, which represents such shadow lenders in the EU.

They also argue that such credit comes with less peril to the public or governments than bank lending. While the collapse of a major bank can threaten retail payments systems, or cause a domino effect in markets – potentially forcing governments to rescue failing institutions – non-bank lenders do not deal with retail customers and say they pose less systemic risk.

But regulators are not so convinced that private funds aren’t deeply intertwined with banks and, therefore, deserving of lighter touch regulation. In the UK, the Financial Conduct Authority (FCA) is due to begin a review of the valuations in private markets, according to a report in the Financial Times in late September 2023.

The FCA launched a ‘system-wide exploratory exercise’ to understand the interplay of banks and non-banks in stressed financial markets earlier this year, which is due to report in 2024. In the US, the Securities and Exchange Commission voted at the end of August to require VCs, hedge funds and private equity to issue detailed quarterly reports to investors to boost “transparency, competition, and efficiency” in private markets. It also put a stop to “preferential” deals if they have a “material, negative effect” on other investors. The US private funds industry is suing the SEC to try to derail the new rules.

There’s no doubt that non-bank lending has its perils. Alternative lenders have been at the heart of several recent crises from the UK, to China, to Mexico. This includes the surge in UK gilt yields in September 2022 that contributed to the collapse of the 44-day premiership of Liz Truss. While the episode was triggered by alarm over the government’s plan for £45bn in unfunded tax cuts, borrowing costs were driven still higher by a relatively obscure fault line in the financial system.

While the Bank of England was able to diffuse the crisis, the incident underlined that shadow banks can “act as amplifiers of liquidity stress”, argues David Blake, a professor at the Bayes Business School, City University of London, and Director of the Pensions Institute. Shadow banks, he says, can be vulnerable to “a doom loop in a financial crisis, whereby they are forced to sell assets in an illiquid market to meet margin calls and this leads to asset prices falling even faster, creating even bigger margin calls”.

This sentiment was echoed by Gabriel Makhlouf, Governor of the Central Bank of Ireland, who warned about recent “near misses”, adding that we need “to move urgently towards developing a framework that tackles the systemic risks that non-banks now pose to the stability of the financial system as a whole”.

Shadow banking has also been at the heart of another high-profile economic crisis – the struggles of China’s property sector, which has slowed growth in the world’s second largest economy. China’s effort to bring non-bank lending under control – after burgeoning credit to inexperienced retail investors contributed to the 2015 crash that wiped a third off the value of Chinese shares within a month – has had unintended consequences. Notably, credit-starved property developers, who had relied heavily on shadow banks, came to depend more on pre-construction sales, creating an incentive to boost construction at a time of weakening housing demand.

An additional problem, Wright argues, is that because of this regulatory arbitrage, “you can’t always know how large shadow banking is”. As a result, if governments try to control it, any curbs can have a larger impact on the economy than expected. This is, Wright says, “exactly what happened in China, with restrictions on shadow banking cutting overall credit growth in half, which had a huge effect on the economy”.

One of the main lessons from China’s experience is that keeping track of threats posed by shadow banks is best achieved by broader government and international initiatives, rather than just individual national regulators. This explains the attention that non-bank lending is now receiving from the International Monetary Fund, the Financial Stability Board and BIS.

While much research has highlighted the potential of non-bank lenders to generate market turmoil, a BIS report from earlier this year on ‘Non-Bank Lending During Crises’ wondered about the impact of non-bank lenders on the supply of syndicated lending to large corporations in a crisis. The conclusion was that “non-banks cut their syndicated credit by significantly more than banks during crises”. The gap was mostly explained by the fact that non-banks behave as transaction lenders rather than relationship lenders in this part of the market, and so have less incentive to maintain the flow of credit when times get tough.

But despite a growing awareness of the risks, governments and international bodies face a delicate balance in managing non-bank lending, says Professor Barbara Casu, Director of the Centre for Banking Research at Bayes Business School. “Regulators do not want to stifle innovation,” she argues. “The challenge will be to identify where pockets of risk are arising and to diffuse them without cutting off credit to important parts of the economy. And supervising such a dynamic industry is no easy task.”

After all, non-bank lending is a significant chunk of the market, largely because of the constraints imposed on the ‘creativity’ of banks after the global financial crisis. And non-bank lending could grow further, says Jonathan McMahon, Chairman of Parallel Wealth Management and a director of the Central Bank of Ireland during the global financial crisis.

“The availability of liquidity outside the banking system is one factor driving growth,” he argues. “Banks’ reticence to lend in the face of rising credit risks and their own need to preserve liquidity are additional factors. If one buys into the ‘reticent bank’ hypothesis, it’s likely that larger loans to companies, and longer duration loans to households, are the most likely areas of growth in non-bank funding.”