The shadow banking sector is made up of companies that act as intermediaries in the credit market; arranging loans that regulated banks could not or would not want to make directly. They are the same kind of companies that acted as intermediaries arranging all of those sub-prime mortgage loans that crashed so spectacularly in 2008. And it turns out that they have been up to their old tricks in the energy sector according to Mary Childs at the Financial Times:
“Volatile markets could trip US business development companies’ covenants, triggering defaults in the $34bn corner of the shadow banking system… Falls in the valuations of energy companies to which some of the largest BDCs are heavily exposed have weakened their profitability and capital buffers.”
The problems arise because the debts of BDCs are not permitted to exceed their equity:
“Unless BDCs stay above a 200 per cent asset coverage limit, regulators will not let them borrow or pay out dividends.”
This is a particular difficulty in relation to energy in general and oil in particular because of the volatility in prices in recent years. Most of the loans to the US fracking industry were made in the days when global oil prices were more than $100 per barrel. But the sustained fall in oil prices since mid-2014 has caused a large number of bankruptcies and has left the remaining frackers struggling to service their debts. This has caused the ratio of loans to equity for the BDCs to fall perilously close to their regulatory limit.
Although the ratings agencies are putting a positive spin on the $34bn exposure to energy, the concern has to be whether a crash in the shale patch will cause a domino-type collapse in global finance in the way a collapse in sub-prime mortgages did in 2007/8.