Nonbank Financial Sector Vulnerabilities Surface as Financial Conditions Tighten

IMF Blog, April 4, 2023

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Bibliographic details

• Authors: Antonio Garcia Pascual, Fabio Natalucci, Thomas Piontek
• Published: April 4, 2023

Overview and context

• Recent strains at some banks in the United States and Europe highlight pockets of elevated financial vulnerabilities built over years of low rates, compressed volatility, and ample liquidity.
• Nonbank financial intermediaries (NBFIs), including pension funds, insurers, and hedge funds, play a key role in the global financial system by providing financial services and credit and thus supporting economic growth.
• The growth of the NBFI sector accelerated after the global financial crisis, accounting now for nearly 50 percent of global financial assets.
• The blog is authored by Antonio Garcia Pascual, Fabio Natalucci, and Thomas Piontek and dated April 4, 2023.

Key vulnerabilities identified

• Elevated leverage: NBFI stress tends to emerge alongside elevated leverage, for example borrowing money to finance investments or boost returns, or using financial instruments, like derivatives.
• Liquidity mismatches: Stress is also brought on by liquidity mismatches, where an institution is unable to generate sufficient cash either through liquidation of assets, such as bonds or equities, or use of credit lines to satisfy investor redemption requests.
• Interconnectedness: High levels of interconnectedness among NBFIs and with traditional banks can become a crucial amplification channel of financial stress.
• Recent episode example: The UK pension fund and liability-driven investment strategies episode—where concerns about the country’s fiscal outlook led to a sharp rise in UK sovereign bond yields, large losses in defined-benefit pension fund investments that borrowed against such collateral, margin and collateral calls, forced sales of government bonds, and further increases in yields—illustrates the perilous interplay of leverage, liquidity risk, and interconnectedness.

Policy tradeoffs in the current environment

• Central banks face challenging tradeoffs amid the fastest inflation in decades: injecting liquidity for financial stability purposes could complicate the fight against inflation.
• In a low-inflation environment, central banks can respond to financial stress by easing policy (cutting interest rates or purchasing assets). Amid high inflation, such responses risk undermining price stability objectives.
• Clear communication is critical so that liquidity support is not perceived to be working at cross-purposes with monetary policy; announcements should explain financial stability objectives, program parameters, and timing.

Surveillance, regulation, and supervisory recommendations

• Strengthen surveillance, regulation, and supervision as essential prerequisites to address NBFI turmoil that may adversely affect financial stability.
• Narrow or eliminate gaps in regulatory reporting of key data, including how much risk firms are taking with their borrowing or use of derivatives.
• Improve private sector risk management through timely and granular public data disclosures and governance requirements.
• Support private sector improvements with appropriate prudential standards, including capital and liquidity requirements, alongside better resourced and stricter supervision.
• These measures aim to steer NBFI business decisions away from excessive risk taking by removing both the incentive and opportunity to take on too much risk, and to reduce the need for central bank intervention.

Central bank liquidity support: three broad types and design principles

• Discretionary market-wide intervention
  • Should be temporary and targeted to those NBFI segments posing risk to financial stability.
  • Timing is critical: a framework should be in place where data-driven metrics trigger a potential intervention, while policymakers ultimately retain discretion to intervene.
• Lender-of-last-resort intervention
  • Should be available when a systemically important nonbank institution comes under stress.
  • Such lending should be at the discretion of the central bank, at a higher interest rate, fully collateralized, and accompanied by greater supervisory oversight.
  • A clear timeline should be established for restoring the NBFI’s liquidity and return to market finance.
• Access to standing lending facilities
  • Could be granted to specific NBFI entities to reduce spillovers to the financial system, although the bar for such access should be very high to avoid moral hazard.
  • Access should not be granted without the appropriate regulatory and supervisory regimes for the different types of NBFIs.

International coordination and final priority

• Cooperation between domestic policymakers and international coordination between national authorities is essential to better identify risks and manage crises.
• Internationally coordinated reforms can reduce the risks of cross-border spillovers, regulatory arbitrage, and market fragmentation.
• Given the growing size and intermediation capacity of the NBFI sector globally, developing the right toolbox for access to central bank liquidity, along with appropriate guardrails limiting the need for its use, is a priority as financial sector vulnerabilities could grow amid continued tightening of monetary policy.

This blog is based on Chapter 2 of the April 2023 Global Financial Stability Report, “Nonbank Financial Intermediaries: Vulnerabilities Amid Tighter Financial Conditions.”

References

• analytical chapter