Observers are scrutinizing the clandestine financial institutions, often known as the 'shadow banks'.
European Union Plans First Stress Test for Hedge Funds and Private Debt Firms Beginning 2026
Frankfurt - In response to the growing influence of non-bank financial intermediaries (NBFIs) in the aftermath of the 2008 financial crisis, EU authorities plan to conduct a comprehensive stress test of the so-called shadow banking sector next year. This significant regulatory move aims to evaluate the vulnerabilities of these actors in private markets.
Growing Market Power and Interdependencies
The European Systemic Risk Board (ESRB), European Banking Authority (EBA), European Insurance and Occupational Pensions Authority (EIOPA), and other supervisors will assess the interdependencies between banks and NBFIs in various stress scenarios during the planned exercise. By the end of 2023, non-banks accounted for a quarter of loans in the eurozone, according to data from the European Central Bank (ECB), and their ties to business banks have grown significantly since 1999, with lending to shadow banks tripling to 6 billion euros during that period.
Europe-wide Stress Test May Render National Exercises Obsolete
The upcoming Europe-wide stress test of shadow banks could potentially render national exercises redundant. Preliminary plans for this exercise have already been proposed by authorities like the French central bank. By determining how interdependencies evolve in stress situations, regulators can gain a deeper understanding of potential risks and ensure more effective oversight.
Liquidity as a Potential Weak Point
Beyond credit granting standards, the resilience to meet additional liquidity needs during times of crisis will also be assessed. The Bank of England (BoE) concluded that while non-banks generally demonstrated strong resilience during its "system-wide exploratory scenario" stress test in late 2024, some actors were underprepared for obtaining additional liquidity in case of a major crisis. Furthermore, forced sales of financial vehicles could exacerbate a market crisis.
Identifying and Addressing Risks
A central focus of the EU stress test for shadow banks will be determining whether risks spill over to banks or if these entities can absorb shocks in a manner that stabilizes the financial system. Claudia Buch, the head of the ECB's banking supervision, recently emphasized in the EU Parliament that risk spillovers from non-bank intermediaries have been observed during crisis episodes, but not all shadow banks exhibit increased risk. EU regulators are actively working to more accurately assess and address these risks.
The ECB did not comment on the report, but it was noted in financial circles that the ECB's banking supervision may not lead the stress test, with EBA, ESMA, and EIOPA potentially taking the lead. EU supervisory authorities recently submitted their position on the macroprudential handling of non-banks as part of a consultation with the EU Commission, and the ESRB was mandated in December to develop a framework that allows for comprehensive assessment of systemic risks in the EU financial market. Recommendations have been made, but this remains a work in progress, with the ESRB and ECB supporting each other in this endeavor. The ECB has already conducted initial scenario analyses of counterparty risks in the non-bank sector in parallel to general stress tests.
The planned stress test is an integral part of broader efforts by EU regulators to enhance financial stability and address potential vulnerabilities in the non-bank financial sector. By ensuring the resilience of these entities, the stress tests aim to contribute to overall financial stability, impose additional regulatory requirements, boost transparency and investor confidence, and provide a more comprehensive view of potential systemic risks.
The European Union's stress test for hedge funds and private debt firms, set to begin in 2026, will evaluate the vulnerabilities of these non-bank financial intermediaries (NBFIs) in private markets. Since non-banks accounted for a quarter of loans in the eurozone by the end of 2023, and their ties to business banks have grown significantly since 1999, the stress test is crucial to ensure financial stability and address potential systemic risks.
