Lenders must be more cautious when dealing with such companies since shadow banks are expanding swiftly throughout the euro zone and pose a growing risk to the entire financial system, according to supervisor Andrea Enria of the European Central Bank.

With assets of 31 trillion euros ($33.9 trillion), or 80% of the supervised bank sector, shadow banks, such as investment funds and insurance businesses, frequently take on riskier risks and are less tightly regulated.

“Risks among non-bank financial intermediaries (NBFI) could intensify in coming months as monetary policy continues its effort to bring inflation back to its target,” Enria said on Tuesday, arguing that risks have built up “profoundly”.

Shadow banks’ leverage has increased significantly, there is a significant mismatch between the length of their assets and obligations, and there is indication that they are not adequately prepared to fulfil the high demand for liquidity, Enria said.

Enria expressed alarm over the fact that dangers have been mainly left unmanaged and shadow banks have remained mostly unregulated.

However, because shadow banks are intimately related to the more strictly regulated bank sector, stress there could extend to more established lenders, necessitating rigorous client risk management on the part of banks.

“Funding from NBFI entities is possibly one of the most significant spillover channels from a systemic risk perspective, given that NBFI entities maintain their liquidity buffers primarily as deposits in banks and interact in the repo markets with banks,” Enria said.

Shadow banks frequently work with a select few banks that are considered to be systemically significant, therefore their stress would probably affect several of Europe’s largest lenders.

Even while new regulations are excellent, they are difficult to negotiate and put into place, making institutions susceptible in the near term.

Therefore, Enria stated, for the time being, the most crucial precaution is for banks to be conscious of the dangers and to actively manage them when working with shadow banks.

“The key message is that we expect institutions to go beyond mere compliance with regulatory requirements when designing their approaches,” Enria said.

(Adapted from FT.com)