Non-bank financial institutions pose significant systemic risk
Despite being hit by the biggest exogenous shock in its history in March 2020, the global financial system appears to have weathered the Covid-19 storm. It seems that the regulatory framework put in place after the 2008 financial crisis has passed its first major test. Yet, despite the resilience of banks, non-bank financial institutions – including insurers, pension funds and sovereign wealth funds – have not been subject to the same regulatory overhaul after the crisis.
Therefore, the most serious threats to financial stability come not from the banking system, but from the less regulated and often more indebted NBFIs.
During a live broadcast with OMFIF, Randal Quarles, former Vice Chairman for Oversight at the Federal Reserve Board of Governors, discussed his time at the Fed and as Chairman of the Financial Stability Board. In his first public appearance since his term on the board expired, he reflected on financial stability considerations for monetary policymakers and regulators as they enter the post-pandemic era.
The discussion began with an overview of his efforts to recalibrate Dodd-Frank legislation, for which he drew heavy criticism (in 2019, Senator Elizabeth Warren accused Quarles of intentionally weakening oversight of big banks by “cutting holes in the safety net”). He argued that the reforms introduced under his tenure, which included higher required capital rates and stress tests, brought more transparency, efficiency and certainty to the system.
He also alluded to the risk posed by NBFIs, explaining that it would be difficult for the Fed to close this regulatory loophole. “Our current system is limited and is really more efficient when it comes to banks,” Quarles pointed out, “because the primary responsibility of the central bank is only having the strongest levers on the banking system.”
In the United States, non-banking financial intermediation is regulated in part by the Securities and Exchange Commission, the Commodity Futures Trading Commission and the Financial Stability Oversight Council. Yet Quarles lamented that this disparate system is not “intellectually pleasing” and remains a “historical kaleidoscope” unlikely to change due to bureaucratic and political hurdles.
The regulatory gap has impacted the performance of financial institutions, as evidenced by the superior growth of the banking sector relative to NBFIs in 2020 for the first time in over a decade. In the aftermath of the pandemic, “the banking system worked pretty well, but the non-banking financial system did not,” Quarles said.
This regulatory inadequacy is also found at the international level. the December 2021 Bank for International Settlements Quarterly Review found that early in the pandemic, “NBFIs fell en masse, liquidity evaporated, and markets froze amid deleveraging and feedback loops.” Additionally, the report states that March 2020 was not the first episode of global market turmoil in which the NBFI sector “amplified stress through structural vulnerabilities, including liquidity mismatches and hidden leverage.” .
The drive to close this gap in macroprudential policy comes against a backdrop of financial overheating resulting from the pandemic emergency measures, namely prolonged fiscal stimulus and accommodative monetary policy, which has provided protection against systemic risk. But while the repeated shocks of the pandemic have certainly challenged financial stability, the real test will come when central banks and governments end their support measures.
Since 2020, the FSB has reassessed the stability of the non-banking financial sector. In the international organization 2021 Global Monitoring Report on Nonbank Financial Intermediation, he noted that the impact of the pandemic on financial markets “has highlighted the vulnerability of the NBFI sector related to liquidity mismatches, leverage and interconnectedness.” The FSB is due to revise NBFI regulations in November, with the aim of bolstering the resilience of the sector.
Regulations need to be designed carefully. The lack of more specific guidance at the international level could lead to significant differences in NBFI regimes across jurisdictions, entrenching vulnerability in the global financial system. The need to implement strong, cross-jurisdictional regulation, stress testing and oversight of NBFIs has never been more pressing.
Governments and central banks have done their part to prevent a pandemic-induced financial meltdown. Regulators are now charged with the challenge of maintaining post-pandemic resilience.
Taylor Pearce is Economist, Institute for Economic and Monetary Policy, OMFIF.