Can the risk of financial instability come from Non-Bank Financial Institutions? (NBFIs)
Market finance and NBFIs (pension funds, insurers, investment funds, hedge funds) have seen a sharp increase in their share worldwide since the Great Financial Crisis. It now accounts for around 50% of global financing and 30% in the corporate sector. Obviously, because banks alone cannot guarantee the full amount to be financed, it is very useful that the NBFIs, as major players on the financial markets, take part in financing. As the NBFIs sector accounts a lot in global financial assets, the correct functioning of the non-bank sector is crucial for financial stability. However, NBFIs potential fragility has been increasing for the last 15 years or so. All in all, there is a high level of financial vulnerabilities in the financial system. Recent stresses at some banks remind us of the elevated financial vulnerabilities built over years of too low for too long interest rates and ample liquidity. The recent manifestations of these strains – Silicon Valley Bank being a good example – appeared to be more idiosyncratic. This bank was in fact very badly managed and severely undersupervised. But, this bank was not the only bank to face this situation and the fast contagion we witnessed, shows in my opinion, that we are facing a potential systemic issue, rather than a simple idiosyncratic problem. As a matter of fact, as I said, too low for too long interest rates, with very abundant liquidity have led to a high level of vulnerabilities in many balance sheets. On the liability side, numerous firms and states, and even sometimes individuals, in both Advanced and Emerging Countries, have been able to run up debts painlessly, until over-indebtedness is proven when interest rates normalize. On the asset side, because of zero, or even negatives rates, final investors or their asset managers were incited to take more and more risk to get a little return. By lengthening the maturities, by increasing the mismatch between the asset and liability duration, by choosing higher and higher leverage, including by using more and more derivatives, etc. The rapid rise in rates has of course brutally interrupted this too long period of too low rates, during which the accumulation of vulnerabilities took place. As far as banks are concerned, since the Great Financial Crisis, the bank regulation has increased significantly, notably through the increase in the required capital adequacy ratios and the setting of restrictive ratios limiting liquidity risks. So, on average, banks are much more solid than before the Great Financial Crisis. But, there is no such regulation for non-bank financial institutions, and specifically for funds. So, the former financial environment led the NBFIs, on behalf of savers, to seek returns, but increasingly taking on risks. Let me be more explicative: 1st. In terms of credit risks – including higher and higher leverage ratios, with squashed risk premiums. 2nd. In terms of liquidity, by further extending the securities of bonds or credit, and by lowering the expected level of their liquidity. And doing so, endangering their liquidity risk, with bigger and bigger liquidity mismatching. 3rd.The funds’ use of derivatives (futures, repo, etc.) amplified tremendously their own leverage. For example, between 2015 and 2022, the financial leverage (measured by derivatives over total assets) of macro-hedge funds came from 15% to more than 30%. And for relative value funds: from 15% to 25%. On top of that, Margin calls as well as collateral calls may be fatal.
All this has been highlighted by numerous organisations in charge of supervising financial stability around the world. So, all in all, financial risk could have been partly pushed out of the banking system onto NBFIs, without control.
A piece of evidence: The violent financial crisis of March 2020, triggered by the expected impact of the pandemic, was fortunately brought swiftly under control by the Central Banks. They acted very strongly and very quickly. The violence of this flash crisis was much more due to the vulnerability of many funds, than to banks which demonstrated, by the way, their resilience. Central Banks had to buy very large amounts of securities, including high yield bonds, from funds in difficulty. Central Banks had to prevent a catastrophic chain of events, due in particular to sudden withdrawal from final investors, that these funds could not absorb without incurring excessive losses or without a major liquidity crisis.
Of course, additionally, high levels of interconnectedness among NFBIs and with banks can also be a crucial channel of financial stress.
And, obviously, possible repeated Central Banks’ interventions to provide them with liquidity support during systemic stress events could bring a very dangerous moral hazard effect !
So, some ideas arising from these facts and analyses, converging with the IMF proposals: 1st.Robust surveillance, regulation (capital and liquidity requirements) and supervision are needed. 2nd.Public data disclosures are required to post the liquidity mismatch chosen, the level of leverage (including derivatives), etc. 3rd.Only under these conditions, access to Central Banks facilities liquidity at a high interest rate and/or fully collateralized should be envisaged. Otherwise, there would be a free option!
As NBFIs became more and more important in the financial intermediation, and because of their systemic risk and potential vulnerabilities, an appropriate international regulation of the NBFIs seems to me a priority.
Finally, I’d like to say that prudential and macro-prudential regulation cannot do everything. But it is essential to mitigate the intrinsic procyclicality of finance and to prevent -better then to cure-financial instability, as much as possible.
So, in my opinion, prudential and macro-prudential regulation must now be extended and adapted notably to investment and hedge funds.