Beyond banks: four ways regulators are tackling perceived NBFI risks

Authors:

Thomas Bellini

David Strachan

Margarita Streltses

Relevant to: CROs, CCOs, Chief Internal Auditors and their teams, and first and second line of defence risk managers in banks and non-bank financial institutions

At a glance:

It is no secret that policymakers around the world are increasingly concerned about growing financial risk outside the banking system. Some regulators talk about the risks posed by non-bank financial institutions (NBFIs), others about market-based finance (MBF) - a broader concept which also includes markets and infrastructure. Whichever definition is used, the challenge is clear: the non-bank financial system accounts for c50% of UK (and global) financial sector assets but the framework for identifying any systemic risks that NBFIs may pose and the toolkit for responding to them are much less developed than for banks.
Systemic risk regulators see a need for a system-wide approach to analysing NBFI risks and developing policies to address them. However, achieving a global consensus on what these policies should be and then ensuring they are implemented consistently has so far proved difficult. That said, there is no shortage of ongoing workstreams. Some are internationally coordinated by the Financial Stability Board (FSB), while others originate from national regulators in their respective jurisdictions. We have taken stock of the various regulatory initiatives currently in train and allocated them to one of four approaches:

1) understanding the risks within the system or market as a whole;

2) developing and deploying macroprudential tools designed to address system-wide risks;

3) recalibrating existing or introducing new microprudential measures imposed directly on NBFIs; and

4) focusing on the key role that banks play in terms of providing funding and liquidity to NBFIs and addressing deficiencies in banks’ counterparty credit risk (CCR) management.

The approaches are complementary and mutually reinforcing – as far as many policymakers are concerned, progress is needed on all four to deal comprehensively with NBFI risks. However, work on the four approaches is proceeding at different speeds which leaves certain risks unaddressed in some policymakers’ eyes.
The following analysis is intended to help readers navigate this complex landscape by summarising the four approaches to dealing with the risks that may be posed by NBFIs. We will build on this with a second note that focuses on the actions that banks can take to address increasing supervisory expectations on CCR management.

Why regulators’ focus turned to NBFIs

A number of factors drove the substantial growth of the non-bank financial system after the 2008 financial crisis. The FSB cited “conjunctural factors and structural changes in the global financial systemⁱ” as the reason for increased reliance on market-based intermediation, which likely includes, among other things, the much tougher bank capital regulation in the post crisis era. As capital becomes scarce, a need for higher yield emerges to support the returns. The European Central Bank (ECB) noted that the prolonged period of low interest rates encouraged banks to provide capital markets services to a wider variety of counterparties, often NBFIs, driven by a search for higher yieldsⁱⁱ.

As a result of this multitude of factors, the non-bank financial system more than doubled in size between 2008 and 2020, and now accounts for c50% of global financial system assets. In the UK, NBFIs provided c£740bn (around 55% of all lending) to UK businesses as of early 2023 and in the EU the sector grew from €25 trillion in 2009 to €51 trillion in 2023 and is now larger than the banking sectorⁱⁱⁱ.

There are of course benefits of financial system diversification, acknowledged by the Bank of England (BoE), but for those benefits to be sustainable, NBFIs need to be resilient enough to absorb shocks and not amplify them^iv.

The fast growth of NBFIs has resulted in increased demand for liquidity, making effective management of idiosyncratic and system-wide liquidity risks crucial. The leverage across NBFIs has further intensified these risks, as collateral and margin calls can amplify liquidity needs in a stress.

As interest rates increased, the ECB noted that the combination of increased funding costs and heightened market volatility is “amplifying risks to higher leveraged non-bank financial institutions, especially those with large derivative positions”^v.

There is a perceived challenge of managing potential risks stemming from the NBFI sector which, according to some policymakers, can be exacerbated by several factors:

NBFIs are part of a financial system which is global, complex, and highly interconnected. This in turn makes it difficult for banks to understand fully risk concentrations, including to NBFIs, and for supervisors to identify potential pockets of stress.
There are material gaps in data availability, constraining supervisors’ ability to assess NBFI risks effectively^vi.
As the FSB noted, NBFIs are often characterised by limited standardisation, a low level of automated trading and turnover, and heavy reliance on dealer intermediation^vii, which, according to the FSB, could contribute to intensifying stress as it may hinder an efficient use of liquidity.
Many market participants are correlated and groups of NBFIs with a similar strategy often react in the same way in a stress scenario, exacerbating the market shock.
Many NBFIs’ business models have inherent maturity and liquidity mismatches.
Most NBFI growth occurred in a prolonged period of low interest rates. Increased funding costs may put their business models and risk management to the test.

Many of these challenges also apply to banks, but they are subject to a global regulatory framework and regulators have a better developed toolkit for identifying both microprudential and macroprudential risks.

The charts below illustrate NBFI growth trends over the past decade and approximate MBF composition.

Four regulatory approaches to tackling NBFI risks

We see regulators typically adopting four complementary approaches in their response to the risks they have identified in relation to NBFIs. The first seeks to understand the risks within the system or market as a whole; the second considers the deployment of macroprudential tools; the third involves recalibrating existing or introducing new microprudential measures imposed directly on NBFIs; and the fourth focuses on the key role that banks play in terms of providing funding and liquidity to NBFIs and addressing deficiencies in banks’ CCR management.

Approach 1: Improving understanding of the risks within the system as a whole

Regulators have made it clear that the size, pace of growth and complexity of NBFIs require them to improve their understanding of any fragilities and interconnections and to be more pro-active in promoting NBFIs’ financial stability. This in turn means “casting the net wider” to spot any vulnerabilities^viii.

To address the existing data gaps, the BoE has introduced a system-wide exploratory scenario exercise (SWES)^ix which aims to increase its understanding of how NBFIs operate, the risks they may pose and how the actions of individual firms can interact to exacerbate market shocks. The first phase of SWES took place between November 2023 and January 2024. Phase two will run in mid-2024 with results to be published in H2 2024. SWES results could feed into firms’ strategic and operational planning and drive changes in firms’ risk profiles, risk appetite and broader risk management framework.

The BoE’s Financial Policy Committee (FPC) has established an approach to “identifying, assessing, monitoring, and responding to financial stability risks associated with MBF”^x. As part of its medium-term priorities^xi the FPC will consider how to improve MBF risk identification, functioning and resilience and will be assessing the suitability of the regulatory perimeter.

In Europe, the ECB has published a report exploring key linkages between banks and the non-bank financial sector. In addition, the European Commission in 2024 will consult on the review of Securities Financing Transaction Regulation (SFTR) with the objectives of improving transparency and monitoring of risks from NBFIs.

In the US, the Federal Reserve Board recently released its 2024 stress test scenarios together with its first set of hypothetical scenarios. The latter are distinct from the stress test and will provide “aggregate banking system results against different economic and financial conditions”. Two of the hypothetical scenarios test the largest US banks’ vulnerabilities to market shocks, including the simultaneous failure of the five hedge funds with the largest counterparty exposures for each bank included in this exercise.

Approach 2: Developing a macroprudential framework for risk mitigation

The European Commission has recently published a report on the macroprudential review for credit institutions and the systemic risk relating to NBFIs. The Commission considers it “necessary to develop additional policy tools including at macroprudential level, to limit excessive credit growth and to strengthen the overall resilience of the financial sector to withstand systemic shocks”. The Commission will assess existing macroprudential tools to identify any gaps and whether further tools need to be developed and will run a consultation on this topic in 2024. This work will then underpin policy development in 2024-2029.

In the US, the Financial Stability Oversight Council issued updated guidance which sets out procedures for considering whether an NBFI could pose a threat to US financial stability and therefore needs to be subject to Federal Reserve supervision^xii which paves the way for significant supervisory engagement with any designated firm to mitigate identified risks.

In the UK, the BoE is considering the adoption of additional macroprudential resilience standards for NBFIs and developing backstops such as a new lending facility for NBFIs, initially insurance companies and pension funds (ICPFs), to support them at times of stress^xiii. The BoE expects that this new central bank backstop tool will be capable of lending directly to NBFIs against high quality assets to address future crises that could imperil UK financial stability. The tool is currently in a design phase, the outcome which will partially depend on what emerges from the BoE’s SWES exercise. The BoE will also reach out to a wider set of NBFIs to assess how the access to the tool may be expanded beyond ICPFs over time.

The Central Bank of Ireland published a discussion paper on the approach for macroprudential policy for investment funds aiming to advance the debate around potential development of macroprudential framework for funds.

Approach 3: Recalibrating the microprudential toolkit to regulate NBFIs

The FSB conducted a stocktake on the availability and main features of the existing policy toolkit which confirmed that there is a broad range of microprudential and investor protection tools that could be used to mitigate some systemic risks. However, the FSB noted that regulators’ experience with using NBFI policy tools for systemic risk mitigation is limited. The FSB also considers that sometimes these tools may not be sufficient to address all systemic risks, in particular when private incentives and financial stability goals do not align. The FSB will assess whether the repurposing of existing tools would be sufficient to address this or if additional tools will be needed.

Moreover, the FSB is coordinating a number of workstreams internationally, including in relation to management of non-bank leverage^xiv, addressing liquidity demand from margin calls in a stress, and liquidity mismatches in money market funds and open ended funds (we have published on this here). The FCA has also conducted a review of fund liquidity management frameworks which we discussed here.

The FSB has also examined the ability of banks and NBFIs to absorb large spikes in liquidity demand in a stressed environment and issued a set of policy proposals to enhance the resilience of liquidity provision. The FSB and standard-setting bodies (SSBs) will carry out further work to assess vulnerabilities stemming from “hidden” leverage in NBFIs, to enhance the functioning and resilience of short-term funding markets, and of liquidity provision in core bond markets. Finally, the FSB will develop additional metrics and tools to monitor NBFI vulnerabilities and enhance its analysis through targeted deep dives.

The Chair of the Basel Committee on Banking Supervision has also recently noted that the Committee will be consulting this year on updated supervisory guidance with regard to NBFI risk management.

Approach 4: Recalibrating banks’ CCR management

Supervisors, like nature, abhor any vacuum which creates risks to their objectives and are therefore using the tools immediately available to them to respond to the risks they have identified relating to NBFIs. In practice this has meant increasing scrutiny of banks’ CCR management practices and using the large exposures regime to mitigate potential contagion from NBFIs. This features in the ECB's and the UK’s Prudential Regulation Authority’s (PRA) banking supervisory priorities for this year, and is highlighted in the UK’s Financial Conduct Authority’s (FCA) wholesale banks portfolio letter and in countless speeches across the EU and the UK.

In 2023, the FCA and the PRA wrote to banks identifying shortcomings in CCR management processes. A recurring supervisory concern is that banks have not acted quickly or effectively enough to improve risk management and controls where supervisors have identified weaknesses in the past.

Supervisors have also expressed concerns that market shocks of the past two years and broader challenges in the external environment could lead to transformed and interconnected risks that test banks’ (and specifically investment banks’) business models and risk management frameworks. In particular, the FCA found poor management of client relationships and inadequate knowledge of clients’ business profiles could lead to unknown concentrations and underestimation of client risk. In its 2024 priorities letter for international banks, the PRA reiterated that CCR and secured financing risk will remain key priorities in 2024, in particular focusing on exposures to NBFIs, and that it will be assessing correlations across financing activity with multiple clients.

Shortcomings in CCR management frameworks are a "prioritised vulnerability" in the ECB's banking supervisory priorities for 2024-2026. The ECB expects banks to fix deficiencies in CCR frameworks and effectively identify and mitigate risk build-ups. In particular, the ECB highlighted material shortcomings in banks’ customer due diligence, risk appetite definition, default management processes and stress-testing frameworks. ECB’s joint supervisory teams (JSTs) will follow-up with banks on the progress of remediation and will continue to monitor banks’ exposures and adequacy of risk management practices.

The ECB has also published the outcome of its review on sound practices in CCR governance and management, specifically focusing on banks’ exposure to NBFIs. The review contains 43 sound practices across CCR governance, risk control, stress testing, and default management. The ECB expects banks to “go beyond mere compliance with regulatory minimum requirements when designing their risk management and control approaches to CCR.” Supervisors are likely to conduct further gap assessments and targeted reviews in this area.

Conclusion

In November 2023, in an interview, Andrea Enria, Chair of the Supervisory Board of the ECB spoke about banks’ exposure to NBFIs being high on the ECB’s agenda and that some NBFIs should come under the remit of regulation and supervision. To achieve this, regulators need to work together to develop a globally consistent approach which will consider both idiosyncratic and systemic risks potentially posed by NBFIs.

The development and implementation of such an approach, should it proceed, will undoubtedly be complex and time consuming. In the meantime, banks and non-banks need to be able to navigate the multitude of regulatory initiatives within each of the four approaches effectively to understand the effect on their firm. CCR in banks, in particular, is one of the tools readily available to mitigate the perceived risks arising from NBFIs. This in turn explains why banks are experiencing increased supervisory scrutiny of their risk management frameworks, in particular in relation to more leveraged counterparties. Banks can prepare by calibrating their CCR frameworks to improve counterparty due-diligence, risk management, risk appetite and stress testing to address increasing supervisory expectations. We will build on this with a note that sets out in more detail the actions that banks can take in this regard.

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