Is a financial crisis in the offing? Watch US rules, not shadow banks

America’s President Donald Trump has unleashed a tariff war that will most certainly slow down global economic growth in 2025.  The world can live with slower growth. The worrying prospect is that slow growth combines with turbulence in the financial markets to cause a financial crisis.  

Is such a crisis in the offing? In recent weeks, three entities have raised the possibility of a financial crisis-— though none is forecasting one. The International Monetary Fund (IMF) flags it in its Global Financial Stability Report (GSFR), April 2025. The Economist, in a special report dated May 31, speculates about where the next financial crisis could originate. Moody’s Analytics talks about it in a study published this month. 

The IMF and The Economist believe that the likeliest source of the next financial crisis will be from outside the banking system. Moody’s Analytics thinks that entities outside the banking system will worsen any systemic shocks that arise.  

Financial crises cause greater loss of economic output than macroeconomic crises. They are also more difficult to get out of. On average, it takes eight years to come out of one, according to Kenneth Rogoff and Carmen Reinhart, two economists who have studied financial crises in great detail.  

The IMF worries about US banks’ exposure to non-bank financial institutions (NBFIs), up from 6 per cent of total bank loans and commitments in 2010 to about 16 per cent in 2024. NBFIs are a very broad category. These include not just financing companies, but also investment funds such as mutual funds, hedge funds, private equity, and credit funds. It’s not clear why that should cause concern.  US bank exposure to NBFIs seems extremely diversified. It should be a source of comfort, not concern. 

The IMF frets about a sub-category of NBFIs, namely, private credit funds. These are typically closed-ended funds that rely on long-term capital from institutional investors and banks for funding. Unlike banks, they do not face the possibility of a run from short-term depositors and hence are less likely to fail. Private credit funds go for higher-risk, higher-return exposures than banks. Precisely because of the higher risks they take, and also because private credit is interconnected, the GSFR thinks they can spread credit shocks across institutions and countries. 

The Economist sees a possible crisis emerging from either private credit or hedge funds, apart from a few other sources. It sees the sheer size of these funds as a problem. It says, “The five top players in private credit manage $1.9trn of credit assets across funds and insurance balance-sheets. Assets of the five biggest multi-manager hedge funds sit at $1.6trn, including huge leverage.” 

Moody’s Analytics warns that private credit’s linkages with banks and insurers could make it a “locus of contagion” in the next crisis. It warns that private credit could amplify a future financial crisis even if it’s not the source of one. 

What do we make of these apprehensions? International agencies, rating agencies, academics, and media commentators failed miserably to see the global financial crisis (GFC). It is safer now to keep sounding warnings so that your back is covered if crisis strikes. For the reasons given below, apprehensions about a financial crisis are premature.  

Various financial entities may fail. These failures need not translate into a financial crisis unless banks are heavily exposed to them. If a mutual fund fails, it would be a problem for investors, but not for banks — unless they have made large investments through it.  

Bank exposure to private credit has been growing fast, but it remains small. The GFSR estimates bank exposure to private credit at $500 billion. This is just 0.4 per cent of banks’ outstanding exposure of $12.5 trillion. Total exposure may not be great, but a few banks may be excessively exposed. That needs to be monitored. 

Bank exposure to hedge funds is a source of concern ever since the hedge fund, Long-Term Capital Management (LTCM), imploded in 1998 and had to be rescued by a consortium of bankers.  Ever since LTCM blew up, bank exposure to Highly Leveraged Institutions has come to be closely monitored.  

Moreover, after the GFC, bank ownership or sponsorship of hedge funds in the US has come to be heavily restricted under the Volcker Rule. Data on bank exposure to hedge funds in the US must be made public. If bank exposure to all NBFIs, including hedge funds, is 16 per cent of bank loans as mentioned above, exposure to hedge funds alone can’t be very high. That’s reassuring. 

Bank failure during the GFC was pervasive due to the combination of three factors: Excessive leverage, inadequate liquidity and mark-to-market losses on the proprietary trading book (and not losses on loan exposures). All three have come to be addressed by regulation.  

Banks are better capitalised. The Liquidity Coverage Ratio ensures that banks are better covered for liquidity. Stiffer capital requirements have discouraged proprietary trading. These measures may need to be augmented by bringing systemically important entities among hedge funds and private credit under the ambit of regulation if required. The Financial Stability Oversight Council in the US has the authority to do so.  

The US needs more intrusive regulation and supervision of banking, along the lines of what the Reserve Bank of India (RBI) practises here. US regulators must ask banks to set stringent exposure limits to areas such as private credit or hedge funds. If bank credit to such sectors is growing too fast, they must clamp down by increasing the risk weights for these sectors. 

Alas, the mood in the US today is anti-regulation. With banks losing market share of credit to non-bank entities, there is intense lobbying to weaken bank regulation so that banks can compete better. Moves are afoot to reduce or modify the Supplementary Leverage Ratio, which mandates a minimum capital requirement against total assets (and not just against risk-weighted assets).  

This is part of a larger attempt to reduce compliance with Basel III regulations that were meant to significantly boost capital requirements for banks. Late last year, the US Federal Reserve slashed additional capital requirements it had proposed earlier for the biggest banks by half. It also reduced the number of banks that would require additional capital. Banks are not satisfied. They want more dilution. Private credit and hedge funds will resist regulation even more fiercely. 

Therein lies the nub of the problem. Contrary to what the IMF and others believe, a financial crisis is more likely to arise from a rolling back of bank regulations than from failures of NBFIs such as private credit or hedge funds. Here is a suggestion that The Economist might want to publicise. The RBI and its affiliates run training programmes for regulators and supervisors from emerging markets. Developed countries might want to start sending their personnel to these programmes. That would make banking systems safer in these uncertain times.

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