European Union regulators are reportedly preparing their first comprehensive stress test of non-bank financial institutions, including hedge funds and private equity firms, as concerns grow about risks in the rapidly expanding shadow banking sector.

According to The Financial Times, the system-wide exercise would examine how a potential market crisis could impact pension funds, insurers, and other lightly regulated financial groups, following a similar debut test by the Bank of England last year.

Officials at the EU's main financial watchdogs are said to be still discussing details of the stress test, but remain optimistic it could launch next year, according to two people involved in the talks. The move is likely to raise serious concerns among hedge funds, private credit groups and money market funds about facing greater scrutiny and restrictions from European regulators.

Since the 2008 financial crisis, loan provision has shifted from banks' balance sheets towards other firms that behave like traditional lenders but face lighter regulation. Non-banks now account for about a quarter of the total €19tn stock of loans in the Eurozone at the end of 2023, according to the European Central Bank.

Supervisors are increasingly concerned about the opacity and potential risks these firms present, as well as their links back to the banking system. Lending by Eurozone banks to non-bank firms has tripled since 1999 to reach €6 trillion by the end of 2023.

Non-banks have featured in several recent market turmoil episodes, including bond market stress after the pandemic hit, the collapse of family office Archegos Capital Management three years ago, and liquidity problems at energy traders following Russia's invasion of Ukraine.

"We've seen some crisis episodes where liquidity risk spillovers came from the NBFI, non-bank financial intermediation space," Claudia Buch, chair of the European Central Bank's supervisory board, told the European parliament in a recent hearing.

"So, it's important that this is also well understood and well regulated," Buch said. "So not all NBFIs are more risky than banks or other financial institutions, but we need to address the risks there in the right way and also the regulation needs to be targeted to those risks."

The EU exercise would build on sector-focused stress tests already carried out regularly for banks, insurance companies, money market funds and clearing houses in the 27-country bloc. The aim is to examine how a crisis would spread between different parts of the financial system and whether this could magnify rather than absorb shocks.

Discussions have included the European Banking Authority, the European Securities and Markets Authority, the European Insurance and Occupational Pensions Authority and the European Central Bank, as well as the European Commission and the European Systemic Risk Board.

The Bank of England involved more than 50 City of London institutions in its system-wide exploratory scenario last year, which included the theoretical default of a hedge fund to model how stress would ripple through non-bank firms.

Some national authorities in Europe, including France, have already announced plans to launch similar stress tests of non-bank financial intermediaries.

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