How many times does Ireland have to be warned about shadow banking?

Elizabeth McCaul is no fool. The only American on the supervisory board of the European Central Bank, she has had a long career in finance starting with Goldman Sachs in 1985 and including a stint as the superintendent of banks for New York state between 1997 and 2003.

She was in effect the regulator of Wall Street. After that, she worked for Promontory Financial Group, a consultancy, and her clients included the pope for whom she carried out a review of the Vatican Bank.

McCaul is coming to the end of her term on the ECB supervisory board and will leave in November. When she used an interview with the Financial Times last week to warn against the dangers of shadow bankingm we really should sit up and take notice. But we probably won’t.

In her view, the growth in lending by non-bank financial intermediaries is the biggest single threat to the stability of the euro zone financial system. To be clear, when she talks about non-bank financial intermediaries, she does not mean the people who will give you an expensive mortgage when the banks turns you down.

McCaul is talking about investment and money market funds and other financial organisations that behave like lenders and have assets of €43 trillion compared to regulated European banks assets of €38 trillion.

McCaul draws parallels with the collapse of Long Term Capital Management in 1998 during her time as a regulator in New York. The hedge fund’s opaque but profitable trading strategy blew up spectacularly due to unforeseen events – the financial crises in Asia and Russia in 1997 and 1998 respectively.

[ Ireland and Luxembourg step up calls for tougher shadow banking rulesOpens in new window ]

She also likens it to the subprime mortgage crisis which triggered the global financial crash in 2007. At the heart of the crisis was the erroneous assumption that if you packaged good mortgages with risky ones and sold them on, the risk of defaults could be negated.

McCaul’s point is a simple one: regulators have no real clarity about the strategies and assumptions that have been made by shadow banks and as a result are in the dark as to both the possibility of one of them falling over and what the consequences might be.

It is an issue of particular importance to Ireland, which it is an important location for some types of shadow banking and home to entities that hold some €3.5 trillion in assets, dwarfing the domestic banking system.

Unsurprisingly, Ireland and Luxembourg are among the most enthusiastic advocates of the ECB taking a more proactive role in regulating shadow banks. Both had a taste of what is at stake in 2022 when Liz Truss’s mini budget triggered a run on UK gilts.

At the heart of the run were Dublin-based shadow banks called LDI funds whose customers included UK pension schemes. The LDIs were forced to offload gilts exacerbating the run. Ultimately, the Bank of England was forced to step in and buy £65 billion (€77.3 billion) worth of gilt to prop up the LDI funds and stave off the potential insolvency of some UK pension funds.

[ Shadow banking could trigger next financial crisis, ECB warnsOpens in new window ]

It was a wake-up call. Shadow banking is a crash – or series of accidents – waiting to happen.

Complacency is both widespread and unsurprising. It’s hard to be concerned about something you cannot see and struggle to understand without a degree in mathematics. It is also fed by an apparent assumption that Irish banks are so boring and heavily regulated post the crash that we are insulated from any shadow banking meltdown.

That is a mistake. The tentacles of shadow banking extend into the Irish economy in many ways. Two are obvious.

The first is the small number of multinationals on which the exchequer depends very heavily for corporation tax. For many of them, Ireland is part of elaborate treasury management operations aimed minimising their global tax bill. It would be only prudent to assume that shadow banking, along with its unknown and potentially catastrophic risks, is part and parcel of these structures.

[ ECB faces banks blowback on high-risk loan inquiryOpens in new window ]

The second area is lending to the commercial property sector. Having learned their lesson the hard way, Irish banks have a limited direct exposure to the sector and much of the slack has been picked up by Irish real estate investment funds and real estate investment trusts (better known as Reits). According to a 2019 study by the Central Bank of Ireland, they account for about three-quarters of the €29 billion invested in real estate here by non-bank institutions. About half of their money comes from overseas institutions and the extent of their exposure to shadow banking is simply unknown, but the risk is clear. A second report from 2021 notes the vulnerability of Irish property funds to asset fire sales driven by external shocks and their reliance on “liquidity management tools”.

The notion that Ireland is in some way immune from the consequences of something going badly wrong in the shadow banking sector is a foolhardy one. But it seems to prevail. For anyone who remembers the banking crash it is uncomfortably familiar.