“Non-bank financial intermediaries” regulatory framework reform

In the foreword of the latest Quarterly review report of the Bank for International Settlements (BIS) from December 2021, Agustín Carsten (BIS´s General Manager) calls for fundamental adjustments to the regulatory framework of “Non-bank financial intermediaries” (NBFIs), also known as the “shadow banking” sector, to better address its current structural vulnerabilities that could undermine financial stability, notably liquidity and leverage mismatches.

Key takeaways from the Agustín Carsten foreword:

“When things go wrong, NBFIs can trigger or amplify market stress”: NBFIs (investment funds, specialized lending institutions, broker dealers, securitization vehicles…) have increased their weight in the financial system since the Great Financial Crisis making the financial system more efficient but also more unstable, which could impact financial stability. NBFIs can be procyclical as a sector as it happened last March 2020 when NBFIs retreated in masse, liquidity evaporated, and markets froze. These dynamics are strengthened due to some characteristics of the NBFIs:

• The liquidity mismatch at NBFIs: It has to do with the promise of on-demand convertibility of illiquid investments into cash, causing fire selling of assets, exacerbating the system-wide liquidity shortage. This happens in the prime money market and open-ended funds (OEFs) but it can also happen in the growing crypto universe of decentralised finance, based on automated smart contracts, also subject to classic runs when liquidity needs cause downward price spirals.
• Leverage at NBFIs: the use of leverage by hedge funds and asset managers, notably for the purchase of securities with borrowed funds or the risk taking in private companies (through equity investments or lending) has become high and pervasive, contributing to the recent accumulation of debt in the system and may have broader financial stability implications, because ultimately banks fund private market operations and investors. In such a context, price drops and increases in measured risks may make the lender call in the loan or charge a higher haircut, inducing forced selling causing downward price spirals.

Central bank liquidity assistance should not be the only means of filling the liquidity and leverage gaps. The expectation of such assistance creates moral hazard and distorts prices, leading to resource misallocation. In addition, it comes with implementation and exit challenges and side effects.

A systemic approach to regulating “Non-bank financial intermediaries” is needed. According to the report, the policy response should count with a reliable and better information enhancing reporting as a basis for stronger monitoring. In addition, it should be able to ensure that NBFIs have sufficient shock-absorbing capacity, tailored to the liquidity and leverage vulnerabilities and it should include a less fragmented and more consolidated supervisory perspective.