Regulating the financial sector is a bit like a game of whack-a-mole. Raise oversight in one area, and the risks migrate elsewhere. That is precisely what has happened with non-bank financial intermediaries, an assortment of institutions, often called “shadow banks”, that provide a range of investment and funding services but lie outside the scope of bank regulation because they do not take deposits. They have grown rapidly since the global financial crisis, filling the void left by tighter risk controls on commercial banks, rising from 40 to almost 50 per cent of international financial assets. This makes the health of NBFIs vital for financial stability — and the lack of comprehensive oversight of the sector all the more alarming.
The disparate group — which includes insurers, hedge funds, pension funds and other asset managers — are an important part of the financial system. They provide credit and equity to the real economy. A diverse financial sector also acts as a shock absorber when the banking sector is under stress, much like a “spare tire” to quote Alan Greenspan, former chair of the US Federal Reserve. They buy bonds and drive global capital flows. But without effective regulation, NBFIs can exacerbate fragility. This was evident in March 2020 when hedge funds were sucked into a dash for cash by Covid-panicked markets and last year when the Bank of England had to come to the rescue of UK pension funds operating obscure investment strategies.
Financial vulnerabilities built up over a decade of cheap money are now being exposed by rapid increases in interest rates by central banks. Although banking oversight has its flaws — as recent turmoil in the US and Europe showed — bank capital and liquidity has been strengthened since the financial crisis and there are pre-designed resolution mechanisms. Exposures in non-banks, meanwhile, remain something of a black box. The IMF cites three factors that make NBFIs a significant source of risk amid tight monetary policy and shrinking liquidity. These are the build-up of leverage in some institutions (albeit less so than banks), rising interconnectedness among non-banks and with banks, and the potential for asset and liability mismatches due to differences in liquidity and maturity. Crucially, NBFIs do not benefit from similar guarantees extended to deposit-taking banks.
Regulators need to get a handle on non-banks quickly, particularly if high inflation persists and rates need to go higher. The Financial Stability Board, a global body monitoring risks in the financial system, needs to play a stronger role in providing remedies and ensuring they are actually implemented. Systemic oversight of the full array of NBFIs also often falls between the cracks of various national regulatory bodies that are geared to look at risks through either a banking or securities lens. Indeed, the US needs to bolster the non-bank activities of its Financial Stability Oversight Council and Office of Financial Research which surveil financial risks.
As a basis for better regulation that de-risks rather than suffocates the sector, policymakers must reduce gaps in data, including on NBFIs’ liquidity and leverage. This requires more disclosures from institutions. Stress testing on non-bank financial markets risks needs to be a norm. The BoE recently announced plans to conduct the first such test. With the chain of exposures across borders, global co-operation to support risk mitigation remains vital. Ultimately, central banks will need to be prepared to provide appropriate liquidity support if incidents of systemic stress arise.
Providing the right safeguards and keeping tabs on a dynamic and amorphous group of institutions is not easy. But with pensions, retail investments and lending to small businesses all at risk, it is crucial that national and international regulators shed more light on the shadow banking sector.
Source: Economy - ft.com
