In the last two years, international workstreams to address systemic risks in Non-Bank Financial Intermediation (‘NBFI’) have moved forward with renewed vigour. As the Financial Stability Board (FSB) drives forward policy and regulatory convergence, there will be substantive policy changes in most major jurisdictions over the next decade. However, given the perceived role of NBFI in several recent crises, there is a significant risk that policymakers may over-correct and introduce regulation which unnecessarily stifles NBFI.
This risk is recognised within the policymaker community and fault lines have emerged between central banks and securities regulators, with the latter resisting excessively cautious regulation as NBFI provide much-needed diversification from bank-based finance and increased efficiency across the financial system, while risks from NBFI have rarely proven systemic. To ensure a well-balanced approach to regulation, leading actors should engage with the policy process to promote regulation which addresses systemic risk yet maintains the benefits of NBFI.
Rapid growth has attracted attention
Following the financial crisis, NBFI has grown from 42% of global financial assets in 2008 to 49% in 2021 – with growth particularly concentrated in collective investment vehicles. Consequently, the reliance on market-based intermediation and its importance to the real economy has grown in both advanced and emerging economies. NBFI is expected to grow further, particularly in emerging economies where NBFI still plays a smaller role than bank-based finance.
Extreme market turmoil in the March 2020 “dash for cash” crystallised many concerns which authorities and standard-setting bodies (SSBs) had about the role of NBFI in amplifying shocks and prompted a concerted international effort to address systemic risks from NBFI. Subsequent crises, including the failure of Archegos and meltdown in liability-driven investment (LDI) funds in the UK, have only strengthened these calls for more regulation of NBFI.
Significant work is already underway to address perceived weaknesses
Internationally, the policy work is coordinated by the FSB, and kicked off following the 2020 Holistic Review of the March Market Turmoil. The 2021 and 2022 progress reports outline how the FSB’s work has enhanced the resilience of NBFI, including significant reforms to Money Market Funds (MMFs) and Open-Ended Funds (OEFs).
The latest progress report identifies “key amplifiers” which contribute to liquidity imbalances and transmission and amplification of shocks. Drawing on this analysis, the FSB sets out how the existing policy toolkit can be modified to address systemic risks. While the FSB has already brought forward significant proposals for MMFs and OEFs, the next phase will target a different set of NBFIs.
The FSB will look into the role of leverage, particularly from more lightly-regulated hedge funds and family offices, in amplifying liquidity imbalances as well as concerning markets including private equity (specifically Collateralised Loan Obligations), commodity markets and LDI funds.
Proposals to reform corporate and government bond markets will also be consequential – for example, mandating central clearing and relaxing Basel III requirements on investment banks for trading in bond markets could lead to more intermediation by banks and crowd out principal trading firms.
Another important initiative is reducing spikes in liquidity demand from margin requirements, impacting participants from CCPs to asset managers and trading firms. Reducing procyclicality of margin and increasing liquidity preparedness of market participants could increase the capital- and liquidity-intensiveness of trading activity and exposures.
IOSCO is also a central stakeholder in the FSB’s work programme, leading or contributing to a significant number of the FSB’s proposals, particularly those relating to MMFs and OEFs.
An opportunity to shape evolving proposals
The FSB will drive forward its workstream in 2023 and provide a progress report to the G20 in late 2023 with its findings and policy proposals to address systemic risks.
While the FSB’s proposals are not legally binding, the role of the FSB in setting internationally agreed policies and minimum standards means that national authorities will adopt them. Therefore, it is crucial firms engage with the policymaking process before the FSB publishes its final proposals.
There are opportunities to engage directly with the FSB or with FSB members. In the UK, the Bank, FCA and HM Treasury are members of the FSB, while European member states are represented at the national and EU level. To ensure an appropriately well-balanced approach to regulation, leading actors in the industry should highlight and evidence:
This is a complex and highly consequential area of regulation. The debate on NBFI is now coming to the boil and the way forward is starting to crystallise - there is a material risk that the cautious views of central banks will prevail at a cost to the wider economy. This creates a real opportunity to influence the FSB’s thinking to achieve an effective, yet proportionate, outcome.
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