Is Ireland vulnerable again as the world’s vast shadow banking system starts to crack?

“As we saw in 2008 and 2020, runs and fire sales can spread like a contagion. The financial stability risks posed by money market and open-end funds have not been sufficiently addressed,” warned US Treasury Secretary Janet Yellen last Thursday. 

The US narrowly averted disaster at the onset of the pandemic in March 2020 when its shadow banks seized up.

“Extraordinary intervention by the government was necessary to stabilise these distressed markets. Put simply, the Covid shock reaffirmed the significance of structural vulnerabilities in non-banks,” she said.

Her tone has changed. Five years ago, she told a forum in London that we would never see another financial crisis “in our lifetimes”. The collapse of Silicon Valley Bank and the rescue of First Republic under her watch has been a sobering check to regulatory hubris. 

In what looks like coordinated rhetoric, the European Central Bank’s Luis de Guindos issued a parallel warning last week, flagging the shadow banks as a potential “source of problems for the whole financial system”, though he was careful not to finger any one eurozone country.

The regulators are faced with the unintended consequence of their own actions. By binding banks in a suffocating straightjacket for the last 14 years – by the wrong mechanism as we now learn, since Credit Suisse came close to collapse with super-safe capital ratios – they have pushed lending off books and have helped create what may or may not prove to be a systemic monster.

The Basel-based Financial Stability Board says the shadow nexus – or non-bank financial intermediaries – has mushroomed to $239 trillion and displaced traditional lenders ($183 trillion) as the main source of global finance. Much of this is benign and helps to keep the global economy growing.   

The “core” shadow component that keeps regulators awake at night amounts to $67 trillion. These are investment vehicles and funds that pose “bank-like financial stability risks” but without guardrails. The FSB says they are susceptible to “margin call dynamics” and act as “amplifiers of liquidity stress”.

We had a taste of this when Liz Truss blew up the British pension system. A spike in gilt yields exposed the hidden interest rate risk of “liability driven investments”, setting off a £1 trillion margin call. The Bank of England had large enough shoulders to stabilise the market with emergency purchases of gilts.

What happens if the next blow-up happens in a country such as Ireland, host to the world’s fifth-biggest shadow banking industry, with exposure tripling in a decade and now surpassing 900pc of Irish GDP under the FSB’s core measure? Some argue that the ratio is even higher.

The Irish state may not be big enough to stand behind this edifice in a crisis. Nor can it safely wash its hands of the problem on the grounds that shadow banks operate outside the normal Irish payments system, unrelated to the daily needs of Irish households and firms. That became clear last September.

Gabriel Makhlouf, the governor of the Irish central bank, said contagion from the Truss episode spread to Irish-domiciled funds with £267bn in holdings of UK gilts. It threatened to metastasise into a broader financial crisis. What it showed is that any spark, from any source, can set off a brush-fire that spills across borders instantly. 

“The recent events were ‘near misses’. 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,” he said.

Dublin is a well-regulated hub but the pace of expansion has been torrid for a decade, and the QE-driven shadow boom has the character of a bubble. 

I do not wish to overstate parallels with the Lehman crisis, but the liabilities of the Irish financial system were 800pc of GDP in 2008 when the music stopped and global capital markets slammed shut. Ireland found itself in the invidious position of being deemed “systemic” for the whole of Europe.

The ECB threatened to cut off liquidity to the Irish banking system (the secret “Trichet letter”) unless Dublin swallowed the bad debts of lenders operating from its soil, fearing that an Irish haircut for creditors would have set off pan-European banking contagion.

The Irish government took a bullet for the team. This meant taking over the egregious liabilities of Anglo-Irish Bank, built up speculating on foreign real estate. What seemed at first blush to have nothing to do with the Irish people ended up in their laps.

Can we say with any certainty today that the eurozone’s bailout machinery would immediately deploy all means to put out a raging fire in any country within EU jurisdiction if the source of the problem was in shadow banking? Or would perennial arguments over moral hazard again intrude? Would the fractious politics of Europe’s half-formed monetary union again allow the problem to fester? We do not know.

Shadow banks could get into trouble in any number of jurisdictions, including the Cayman Islands or Luxembourg, which host even larger shadow liabilities than Ireland. Or skeletons could emerge in some of the more exotic corners of the cross-border market.

“I am convinced there must be large losses on bond holdings of all sorts of funds which are being disguised,” said Professor Philip Turner, who used to track shadow lenders at the Bank for International Settlements. 

There are worries about insidious practices within the $1.2 trillion US debt private debt market, where players “mark-to-myth” whole portfolios by arranging bilateral trades with each other to overvalue each leg of the transaction. “You overpay for my rubbish and I’ll overpay for yours,” he said.

At some point this will be exposed. “Once they nail one firm with this, they will quickly nail their immediate counterparts. Word will spread, and force hurried re-statements of values. So it’ll be like dominos,” Prof Turner said.

Yellen seems most worried about the US money market funds, which have ballooned to $5 trillion as investors pull money out of banks, either to chase higher yield or in the belief that these funds are safer (because they invest chiefly in short-term Treasuries).

The obvious candidate for trouble is US commercial property. Smaller regional US banks normally provide 70pc of US real estate loans but they are having to retrench after haemorrhaging some $800bn of deposits. This threatens to compound distress already eating away at funds sitting on empty office blocks and shopping malls. 

Brookfield Properties defaulted on $784m of loans on two Los Angeles skyscrapers in February. The ratio of distressed debt in US commercial real estate hit 5.2pc in February, the highest since 2009. This shake-out has barely begun. 

We can be sure of one thing only: it would be a miracle if nothing bad happens as the US Federal Reserve and the ECB ram through the most aggressive monetary tightening in the working lifetime of most traders currently in the market.

Rates have of course spiked: less understood is that the abrupt switch from QE to QT (asset sales) amounts to a $2 trillion reversal in annualised liquidity flows, and this in turn is causing the money supply to contract at record post-war rates.

Such tightening operates with a long lag. Central banks will not know how much damage they have done until many months later. Since shadow lenders are largely outside their field of view, they can only guess what level of pain will tip the financial system into a destructive vortex. By then it will be too late.

This article is an extract from The Telegraph’s Economic Intelligence newsletter. Sign up here to get exclusive insight from two of the UK’s leading economic commentators – Ambrose Evans-Pritchard and Jeremy Warner – delivered direct to your inbox every Tuesday.