Shadow banking: a ticking time bomb under the US economy

For months, the most peculiar situation has been playing out in front of our eyes. On the one hand, global capitalism has clearly entered a prolonged phase of crisis which is expressing itself at all levels. On the other hand, the US stock market is booming. 

The world economy is mired in historically low levels of investment, and is facing the consequences of the whole fabric of international trade being ripped apart by Trump’s tariffs and trade wars. The ongoing confrontation between the US and China is spiralling out of control with tit-for-tat retaliatory protectionist measures.

Two major conflicts, the Ukraine war and the crisis in the Middle East, are far from being resolved, while Trump is opening a new crisis in the Caribbean, which could engulf the whole of Latin America. Meanwhile, states are drowning in unprecedented levels of debt, including China and all the advanced capitalist countries. Thus, the main tool of state intervention that gave the system a way out of previous crises – such as in 2008, or more recently with the COVID-19 pandemic – is now blunt.

The ability of the state to run to the rescue and prevent the meltdown of the system, by opening the public purse to bail out the usual suspects, or to subsidise its way out of social convulsions is undermined by the present levels of state debt. This is epitomised by the US government entering a shutdown on 1 October, and there is no end in sight to the current paralysis.

Unlike 17 years ago, we must add to this the experience of a prolonged, toxic combination of austerity for the vast majority, and obscene levels of wealth concentrated in the hands of the richest few. This has produced endemic and growing resentment among the masses, and deep mistrust towards every institution of bourgeois rule, national and international.

The crisis of capitalism, even before it has reached the point of a world slump, has been grinding down the conditions of life for the vast majority, fuelling social and political instability and a global revolutionary wave. 

Alarm among the strategists of capital

Meanwhile, as if none of the above was happening, the booming US stock market is beating record after record in a triumphant march. Like a black hole, it is sucking up the savings of the US middle class and the world’s idle capital in a swindle of promised, but implausible, sky-high returns in the AI sector.

Like the orchestra on the sinking Titanic, economic commentators and advisors continue to sing the praises of the wonders of the ‘bullish’ markets. For example, Goldman Sachs went out of its way to explain that this situation is very different from the bubbles of the past, because, they say, profit rates are high and companies’ balance sheets are looking good.

However, the tune is now acquiring a more sinister tone. The show must go on, because the penalty for not feeding the bubble further will be its sudden demise, with catastrophic consequences. 

There are dissonant notes, however. Over the past few weeks, there have been a flurry of alarmed statements by several strategists of international capital. They all agree on the following:

1. The present boom in the US stock markets is unsustainable; 
2. A serious ‘correction’ (read: crash) is not only likely, but may even be imminent;
3. The unprecedented level of exposure of US families’ savings to the stock market will make such a ‘correction’ extremely painful;
4. It is doubtful that the impact of such a ‘correction’ can be minimised as with the 2001 DotCom bust, or saved by a bailout as in 2008; and,
5. Eventually, whatever happens in the US will have deep global repercussions.

Attention is focused on the recent collapse of two US companies, Tricolor and First Brands. Most remarkably, we are not talking here about the collapse of anything comparable to Tesla, Alphabet, or a major bank. These two companies were sizable (First Brands employed 26,000 workers), but relatively obscure.

One of them, Tricolor, was providing sub-prime lending for people with no access to banking loans for the used cars market. The second, First Brands, was a large supplier of unbranded spare parts for cars. Their collapse has left a hole of many billions of dollars, but it is not the scale of the losses that are causing the greatest concern.

Kristalina Georgieva, admitted that concern about the US private equity and private credit sectors was the “question that keeps me awake every so often at night” / Image: World Economic Forum, Flickr

The IMF’s managing director, Kristalina Georgieva, admitted that concern about the US private equity and private credit sectors was the “question that keeps me awake every so often at night”. 

Let’s hold that thought. What is private equity and credit? And why should any of this disturb the sound sleep of the director of the IMF?

By taking a closer look, what emerges is a troublesome connection between the US financial system and unregulated shadow banking (private credit), that has surged in the USA to circumvent the regulations introduced after the 2008 crisis. This sector seems to have grown significantly since the pandemic, stoking concern that it can now seriously affect the whole US financial system. 

This is further proof of what we have been saying all along: capitalism can never be regulated – eventually, the pursuit of maximum profit finds a way around even the most tested and well-conceived sets of rules and regulations, let alone improvised, shoddy ones.

The trouble is that no one seems to have a clear understanding of how big the problem is – and hence the loss of sleep in certain quarters.

Private credit and ‘shadow’ banking

The collapse of Tricolor, and especially of First Brands, revealed the pervasiveness of the US shadow banking system. Now estimated to be worth about $4 trillion, this sector is unregulated and has grown to a size that converts it into a systemic threat. 

In 2008, after taking a step back from the precipice, the capitalists vowed ‘never again’, while they were pocketing massive bailouts of public money. Their losses were nationalised, and effectively converted into public debt. The bill was presented to the working class in the form of cuts to social public spending, and austerity.

On the other hand, stricter regulations were introduced, forcing banks to significantly increase the amount of capital they hold relative to the amount they lend, and introducing tougher criteria on lending. These measures limited access to credit for riskier enterprises, leaving a vacuum which was filled by shadow banking.

First Brands is becoming a case study. It carried out a debt-fuelled acquisition spree over the past years, to reach a dominant position on the spare parts market in the US. On the surface, it may look like an overambitious expansion plan has gone bust. However, there is an additional layer. 

“The company until recently had a decent cash buffer, but it was using private debt or ‘shadow banking’ to borrow against invoices, in effect keeping debt off its balance-sheet disclosures, and turning a company with 26,000 employees into a finance company more than the supplier of auto parts.” (Our emphasis)

Among those sounding the alarm on the implications of these crashes is the Governor of the Bank of England (BoE), Andrew Bailey. He compared the collapse of Tricolor and First Brands, to the sub-prime mortgage crisis that predated the financial crisis of 2008.

Testifying to the House of Lords Financial Services Regulation Committee, Bailey explained that the big, and open, question today is whether the two failures are idiosyncratic or “the canary in the coalmine”.

“I don’t want to sound too foreboding, but the added reason this question is important is if you go back to before the financial crisis when we were having this debate about sub-prime mortgages in the US, people were telling us: ‘No it’s too small to be systemic; it’s idiosyncratic.’ That was the wrong call.”

Bailey continues: “We certainly are beginning to see, for instance, what used to be called slicing and dicing and tranching of loan structures going on, and if you were involved before the financial crisis and during it, alarm bells start going off at that point.”

In 2008, after taking a step back from the precipice, the capitalists vowed ‘never again’ / Image: Flying Logos, Wikimedia Commons

The deputy governor of the BoE, Sarah Breeden doubled down on this analysis: 

“It’s about high leverage, it’s about opacity, it’s about complexity and it’s about weak underwriting standards. Those are things that we were talking about in the abstract as a source of vulnerability in this bit of the financial system, and those appear to have been at play in the context of these two defaults.” 

In other words, Breeden is saying, “we suspected that something very disturbing was happening on a large scale in the private credit sector, which is unaccountable and opaque. Now we have concrete proof.”

They are joined by other voices. Jamie Dimon, the boss of JPMorgan Chase, a bank facing a $170 million hit from the Tricolor crash said: “My antenna goes up when things like that happen. I probably shouldn’t say this, but when you see one cockroach, there are probably more.”

Mr. Dimon’s ‘antenna’ has rightly detected the sheer scale of the problem. Going back to the quality (or lack thereof) of the IMF director’s sleep, the key to resolve the puzzle is provided by recent IMF research, which estimates that American and European banks have lent $4.5 trillion to private-credit firms, hedge funds and other non-bank lenders.

This means, according to The Economist, “that what happens in private credit matters more to banks, and vice versa. Neither would be immune to a general downturn in the economy, or rising bankruptcies. In private, both investors and bankers worry that lending standards have been too loose of late.” (Our emphasis) 

Another comment by BoE Governor Bailey reveals just how out of touch the main actors in the private equity sector are, with the dangers posed by the present situation: “I sat in a session with people from the private equity and private credit world some months ago who of course told me everything was fine in their world, apart from the role of the ratings agencies, and I said: ‘We’re not playing that movie again are we?’”

So the BoE chiefs think we are replaying the run up to 2008 – what could possibly go wrong? 

How would a US stock exchange crash today compare to previous crises?

Ms Gita Gopinath, the former first deputy managing director of the IMF, wrote an interesting opinion article for The Economist, explaining why a crisis in the US stock market will have global consequences. Ms Gopinath points out:

“…there are good reasons to worry that the current rally may be setting the stage for another painful market correction. The consequences of such a crash, however, could be far more severe and global in scope than those felt a quarter of a century ago.

“At the heart of this concern is the sheer scale of exposure, both domestic and international, to American equities.”

The bubble is drawing everyone in. US households have substantially increased their holdings on the US stock market. Foreign investors – especially from the EU – hedge funds, and pension funds have poured capital into US stocks.

“This growing interconnectedness means that any sharp downturn in American markets will reverberate around the world.”

What is most interesting in Ms Gopinath’s article is that she attempts to put some numbers to her estimates.

“To put the potential impact in perspective, I calculate that a market correction of the same magnitude as the dotcom crash could wipe out over $20trn in wealth for American households, equivalent to roughly 70% of American GDP in 2024. This is several times larger than the losses incurred during the crash of the early 2000s.

“Foreign investors could face wealth losses exceeding $15trn, or about 20% of the rest of the world’s GDP. For comparison, the dotcom crash resulted in foreign losses of around $2trn, roughly $4trn in today’s money and less than 10% of rest-of-world GDP at the time.

“In sum, a market crash today is unlikely to result in the brief and relatively benign economic downturn that followed the dotcom bust. There is a lot more wealth on the line now—and much less policy space to soften the blow of a correction. The structural vulnerabilities and macroeconomic context are more perilous. We should prepare for more severe global consequences.”

There are clear indications that the speculative bubble is about to burst. One indication of that is the spike in ‘margin debt’, loans taken out by investors from brokers, in order to buy stocks. It is the equivalent of getting a loan from the casino in order to bet more at that casino. When the bet is lost, one ends up losing the money and having to repay a debt to the casino owner.

Ms Gopinath informs us that margin debt among investors has spiked by 32 percent to $1.3 trillion between May and September of this year. The only times margin debt has increased at a faster pace over a five month period was during the COVID-19 pandemic in 2020 – when it rose by 35 percent – and in early 2000, right before the dotcom bubble burst.

The market is overheating. More people are getting in debt, to maximise their expected returns / Image: Katrina.Tuliao, Wikimedia Commons

In fact, these figures tell a story. The market is overheating. More people are getting in debt, to maximise their expected returns. In other words, this means that they are gambling for higher stakes. Should anything happen to destabilise the market – and it’s a matter of when, rather than if – the consequences will be even more catastrophic.

This will not affect ‘shadow’ banking alone. As we explained before, there is a growing overlap, to the tune of several trillion dollars lent to ‘shadow’ banking operators by the US and European banking sector.

How will the global strategists of capitalism react to the prospect of a new crash? Most likely they will attempt to resort once again to state intervention, both by increasing public spending and liquidity injections into the system by the central banks. However, even before such a crisis hits, state finances are already being drained.

Gross public debt as a share of GDP in advanced economies is currently almost 110 percent, close to an all-time high. A rise in interest rates since 2022 – initiated by central banks to control inflation that was partly caused by previous increases in debt – has made debt far more burdensome.

Rich countries now spend half as much again on interest as they do on national defence. And they keep on borrowing. This year, the average deficit in advanced economies will be over 4 percent of GDP – in America, the figure is over 6 percent of GDP. US public debt just broke through the historic level of $38 trillion (up by $1 trillion in just two months).

Any attempt to use state finances to shoulder the impact of the crisis will immediately pose the question, once again, “who pays the bill?” 17 years after the 2008 crash, a whole generation has only experienced falling living standards, and it is denied a future by this decaying system, capitalism. The coming period will be a crash test for the stability of capitalist rule on a world scale.