Forget Banks: There Are New Sources Of Risk In The Financial System

Forget Banks: There Are New Sources Of Risk In The Financial System
Stéphane Renevier, CFA

about 1 year ago2 mins

Ever since the global financial crisis, banks have been falling in importance, and non-bank financial intermediaries (NBFIs) have been rising. They now account for almost half of the global financial system’s total lending and investing activities. Like banks, NBFIs act as go-betweens for savers and borrowers, and facilitate trading. Unlike banks, they aren’t tightly regulated, and there are big uncertainties about how they really function – and how much risk they might pose.

Different NBFIs perform different functions. Institutional investors like hedge funds, asset managers, and money market funds handle people’s savings and invest them to generate returns. Market intermediaries, like broker-dealers and principal trading firms, deal in securities by providing both buy and sell orders. And exchanges, platforms, and central counterparties (CCPs) provide the infrastructure for all that to function smoothly.

On one hand, you could say the overall financial system is safer today: banks are better capitalized (meaning, they hold more money on their balance sheets, relative to what they lend out), central counterparties have been introduced to shrink the risk of defaults, and new players like principal trading firms – which “make markets” by putting up their own capital – have generally improved liquidity, making trading easier. And big investment funds have smoothed the process for companies to get funding outside of banks.

On the other hand, you could say the system’s actually riskier. For one thing, many institutional investors use a lot of leverage. If markets tank, they could be forced to liquidate their positions (in other words, sell) to cover their losses, pushing prices lower and forcing others to liquidate at fire-sale prices. Many are also holding less-liquid assets, or riskier ones, which could create all sorts of problems if their investors ask for their money back. Money-market funds and open-ended bond funds have both been flagged by risk watchdogs as a threat to financial stability.

For another, the reduced importance of banks in market-making activities has also made many markets – like bond markets – a lot less liquid. Plus, new intermediaries like principal trading firms tend to stop providing liquidity – i.e. buying from sellers, and selling to buyers – in stressed periods. That makes liquidity scarce when it’s most needed, which in turn could exacerbate price moves – and in the most extreme cases threaten the normal functioning of markets.

And lastly, central counterparties can fan the flames on selling pressures by asking their members to post more collateral, forcing them to sell assets. Add to that the fact that these NBFIs are tightly linked with each other (and with banks), and a shock could spiral and spread quickly to the rest of the system.

So, yes, the financial system looks generally safer today. But it may not be as safe as some would like to believe. The risks may have simply moved to darker corners of the market. Let’s hope we never have to find out.



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