The 2008 Financial Crisis was a hard school for all of us on interconnectedness: a failure in one corner of the system will rapidly metastasize into a crisis for the entire edifice. And yet, fifteen years later, regulation is still largely centered on the old-fashioned commercial banks. Meanwhile, a vast, rapidly growing, and often shadowy sector—the Nonbank Financial Intermediaries (NBFIs), or “shadow banks”—is piling up systemic risks which can precipitate the next global financial shock.
These NBFIs like hedge funds, money market funds, private equity, and stablecoin issuers today act in many respects like banks but beyond the tight oversight of typical banks. Their growth is creating growing maturity mismatches and closely interconnected dependencies with traditional banks, and therefore the potential for being amplifiers of financial distress.
The Expanding Interconnected Web
The greatest risk that NBFIs pose is their widespread but sometimes hidden reliance on the traditional banking system. It is this interconnectedness that is the channel for passing on shocks:
- Funding Links (The Short-Term Debt): NBFIs, particularly hedge funds and money market funds, finance their long-term, illiquid assets with short-term debt (i.e., repurchase agreements, or “repos”). Banks usually extend the greatest amounts of such short-term finance. When NBFIs do experience losses, banks face instant enormous counterparty risk and potential write-down of collateral.
- Maturity Mismatches: The old bank risk is transformed into the shadow economy. NBFIs promise investors liquidity (they will receive their money on time—a stablecoin collateralized at a $1 peg or a money market fund redeemable daily) but possess illiquid, difficult-to-value assets (e.g., commercial real estate or corporate bonds). Panic makes investors want to get their money back instantly, which forces NBFIs to sell assets in a rush and at a loss. Fire sale hurts asset values all over, hurting everyone, even regulated banks with the same assets.
- Digital NBFIs (Stablecoins) Emergence: Stablecoin issuers operate a digital money market fund, usually collateralizing the stable value with liquid, short-term securities. Rush loss of confidence or bank run against a stablecoin issuer forces them to unwind their reserves rapidly, injecting huge volatility into the government bond and commercial paper markets for short-term, potentially destabilizing traditional finance.
Riding on Vulnerability: The Systemic Risk
The source of the problem is that NBFIs are most levered and less transparent than banks, and therefore, regulators cannot estimate the real magnitude of risk until too late.
- Procyclical Behavior: NBFIs tend to amplify market booms and busts. During boom times, they borrow to acquire assets, pushing their prices higher. During crises, their compulsion to deleverage (sell) ignites the bust, making the shock more severe to the overall financial system. This is “procyclical” behavior—”current cycle accentuating.”.
- Arbitrage Regulatory: NBFIs are so attractive because they can avoid the highly regulated capital and liquidity mandates banks have to comply with since 2008. Efficiency is a welcome concept, but it simply means systemic risk is being shifted to the least regulated areas of the financial universe.
The Need for a Wider Regulatory Lens
The problem today is not how to shut down NBFIs, which are required for credit and liquidity supply. It is how to keep their systemic risk in check:
- Better Data Collection: Regulators (e.g., the Financial Stability Board) need better, more comprehensive data on NBFI leverage, counterparty exposures, and asset positions so that they can reasonably monitor the interdependences among shadow banks and commercial banks.
- Liquidity Backstops: The March 2020 events (during which Money Market Funds nearly collapsed due to an unexpected liquidity crisis) highlighted the need for central banks to be ready to function as “lender of last resort” for key nonbank sectors during times of distress in order to maintain market functionality.
- Activity-Based Regulation: Instead of regulating the institution (hedge fund versus bank), regulation would be aimed at the activity (e.g., leverage, maturity transformation). If a stablecoin issuer is doing banking-type activities, it should be regulated with banking-type standards.
The sheer scale of the shadow banking system—one bigger even than the conventional banking system in much of the developed world—is so great that we simply cannot afford to turn our backs. To turn our backs on the shadow banks is to plug one leak in a dam while a dozen others are torn below the waterline. What we require is a more general, more adaptive regulatory structure to secure the global financial architecture.