While most people are familiar with the conventional banking model – where you go to a bank to borrow money or deposit funds to earn interest – the financial world has evolved significantly. A range of new vehicles, securities and institutions now operate outside this traditional framework yet still perform bank-like functions such as lending.
This is what we refer to as the “shadow banking” system. A term used to describe financial entities that mirror the activities of conventional banks, without being regulated in the same way.
The scale of this system is remarkable. Today, shadow banking accounts for more than half of the world’s financial assets, exceeding $250 trillion, and is growing at close to 10% a year. Within that, certain segments are expanding even faster, particularly those considered higher risk, which now represent roughly $76 trillion in assets.
To understand the risks involved, it’s important to go back to first principles. Traditional banks are subject to strict capital and liquidity requirements, shaped by frameworks such as Basel. These regulations exist largely because of historical events like a run on the bank – when too many depositors attempt to withdraw funds at the same time, leaving the institution unable to meet its obligations.
Over time, these risks have been mitigated through regulation. However, those safeguards apply primarily to large commercial banks. In the shadow banking system, similar protections are often absent. That creates a gap – and it’s within this gap that many of the risks emerge.
One of the fastest-growing areas within this ecosystem is private credit. Just five years ago, this segment stood at around $500 billion. Today, it has grown to more than $2 trillion. This expansion has been driven in part by increased marketing to retail investors, which is a concern, as the vehicle may not be appropriate for these clients.
Even asset classes typically viewed as low risk can form part of the shadow banking system. Money-market funds, for example, are widely considered safe, yet they are not subject to the same regulatory framework as banks. While additional rules and protections have been introduced – including insurance-type measures – the underlying risk remains that, in a panic, large-scale withdrawals could create liquidity pressures similar to those seen in traditional bank runs.
Hedge funds are another major component, representing approximately $12.5 trillion globally. What stands out here is the level of leverage. On average, leverage in this space has reached around eight times net asset value – a record high. That increases the sensitivity of these investments to market stress.
Then there is the crypto market, particularly where leveraged exposure is available. These platforms combine two powerful risk drivers: sentiment and leverage. Crypto markets are inherently volatile, and adding leverage amplifies that risk significantly. Unlike traditional banking environments, the safeguards that protect investors are largely absent.
Recent events have already highlighted some of these vulnerabilities. In the private credit space, funds have faced liquidity constraints, forcing them to gate redemptions. In practical terms, this means investors are told that they cannot access their capital when they want to. That is a very different experience from what many expect when investing.
These issues point to a broader concern: liquidity mismatches. Many entities in the shadow banking system borrow short term and lend long term. When investors demand their capital back, there may not be sufficient liquidity available to meet those requests. This creates the potential for stress events that can spread through the system.
Contagion risk is a key consideration here. These institutions are often interconnected, so problems at one large player can quickly affect others, creating broader instability. This is how typical financial crises unfold.
Another important risk is how these instruments are presented to investors. In some cases, they are described as less volatile than traditional assets. However, that perceived stability is often a function of how they are priced. Unlike listed equities, which are priced continuously, many of these instruments are valued less frequently. That can create the impression of lower volatility, when in reality the underlying risk has not disappeared – it has simply not been fully reflected in the price. That opacity is a risk in itself.
Regulators are increasingly aware of these challenges, but they are struggling to keep pace with the size and complexity of the sector. Stress tests conducted by central banks aim to identify vulnerabilities, yet large parts of the shadow banking system remain untested in a real crisis.
Historically, regulation tends to follow events rather than anticipate them. Lessons are often learned after a crisis has already occurred. The risk for investors is that they become those lessons.
This does not mean that the shadow banking system should be avoided entirely. It plays an important role in providing liquidity and expanding access to capital. But it does require a far more careful and informed approach.
Investors need to be clear about what they are investing in, understand the liquidity profile of those investments, and be mindful of leverage and valuation risks. Most importantly, they should ensure they are not overexposed to areas where regulation is limited and risks are not fully visible.
Written by Adriaan Pask, Chief Investment Officer at PSG Wealth, highlights what investors need to know about the risks, rewards and regulatory gaps in this non-bank $256 trillion sector.