Financial intermediaries must be kept in check to avoid a repeat of the 2020 turmoil
- Nonbank financial intermediaries have become intertwined with the rest of the financial system and their activities can affect the real economy, yet they remain poorly regulated
- Closer monitoring can reduce the likelihood of financial stress – and the need for central banks to step in
Investment funds and asset managers are playing an ever more crucial role in the financial system. They provide funding in areas that traditional banks do not cover, manage and share risks, and enhance innovation and economic growth.
Liquidity mismatches are common for prime money market and open-ended funds that hold illiquid investments but promise to convert their shares into cash on demand. At times of stress, this gives investors an incentive to get out before others. Faced with this demand in March 2020, funds hoarded liquidity rather than falling back on their buffers. As they sold assets, liquidity conditions deteriorated further, leading to a collapse in system-wide funding liquidity.
Stresses can spill over borders. NBFIs in some Asian emerging market economies, which have become significant creditors in global markets, were hit hard when US dollar funding dried up. The strains were particularly severe for institutions with dollar investments and local-currency debt, and who hedge the risk with short-term instruments such as FX swaps, themselves a source of hidden debt.
Leverage is also pervasive in the opaque private capital markets, which revolve around funds gathered from institutional investors by alternative asset managers. As banks have retrenched, these have gained ground, bolstering the recent ramp-up of debt in the system at large.
As in traditional finance, price drops and increases in measured risks in decentralised finance may make the lender call in the loan or charge a higher haircut, inducing forced selling. The lubricant in this universe – stablecoins – are subject to classic runs, with possible repercussions for the financial system at large.
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All these factors underscore the lesson that financial stability is best viewed by considering the forest, not just the trees. Taking a system-wide, or macroprudential, approach to regulation and supervision has strengthened banks and reduced their systemic impact. A similar approach should apply to NBFIs. The goal is to build war chests in tranquil times to mitigate any collective retrenchment in times of stress.
The public interest must prevail – it is an unacceptable status quo for central banks to support risk-taking by private institutions. More effective prevention should be the main answer to regulatory gaps. Reducing the likelihood and intensity of financial stress would reduce the need for emergency help.
One element of the response should be better information through stronger monitoring and enhanced regulatory reporting and public disclosures. Another is to ensure that NBFIs have enough buffers to absorb shocks. There are numerous, well-known mechanisms, such as higher capital or liquidity buffers and through-the-cycle margining practices.
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Other steps include supervisors taking a more consolidated perspective. Gaps in supervision left NBFIs in Asian emerging markets with excessive exposure to rollover risks, while banks had limited capacity to mitigate these risks.
Policymakers must manage these risks effectively while allowing the financial system to function in the interests of society. We cannot afford to fall behind the curve.
Agustín Carstens is general manager of the Bank for International Settlements
