Maintaining the smooth transfer of resources in a changing international environment
In the ever-evolving world of finance, the role of Non-Bank Financial Institutions (NBFIs) has grown significantly, accounting for around half of assets in the financial system, globally and in the UK. This transformation, coupled with evolving regulatory and funding landscapes, has raised the liquidity demands of NBFIs and introduced new systemic risks to the financial system.
NBFIs, unlike traditional banks, are not able to hold central bank reserves, create money, or have regular access to central bank facilities. However, they provide crucial liquidity and depth in the gilt market, serving as the risk-free benchmark for a wide range of sterling-denominated debt. They operate both alongside and in partnership with banks, providing a range of financial services to households and businesses.
The activities of NBFIs, however, come with inherent liquidity transformation risks. As they align investor redemption demands with asset holdings, they can become fragile and susceptible to liquidity shocks. Tighter bank regulations have pushed more intermediation into NBFIs, making these entities heavily reliant on liquidity buffers.
In stress scenarios, increased secured funding, collateral swaps, and derivatives margin calls have raised banks’ exposure to system-wide liquidity stress triggered by NBFIs, reducing banks' liquidity coverage ratios significantly while still above regulatory minimums. This underscores the importance of NBFIs maintaining their own liquidity resilience so that these markets can self-stabilize in response to shocks.
The Bank of England has shifted its focus from primarily considering the liquidity needs of banks to also considering the liquidity needs of NBFIs. The central bank encourages and welcomes banks' regular usage of their lending facilities for routine liquidity management. The aim is to ensure that market rates remain close to Bank Rate and that individual banks can withstand a liquidity stress.
To achieve this, the Bank of England wants to create a funding and liquidity environment that incentivizes banks and NBFIs to participate actively in private sector funding markets. The bank also wants to avoid a stigma around routine usage of these facilities in normal times, so they can be more effective in stress. The focus is on the efficient distribution, or recycling, of liquidity across the financial system and supporting the efficiency and depth of intermediation in core private sector funding markets.
Regulatory bodies like the Financial Stability Board (FSB) emphasize enhanced risk monitoring and market transparency for NBFIs to manage leverage and liquidity risks better. This includes improving information sharing among firms and authorities to spot systemic risks arising from the non-bank sector’s complexity. Instances of liquidity stress have led to solvency troubles for some NBFIs, highlighting the sector’s vulnerability when funding conditions tighten abruptly.
In conclusion, the transition to a greater role played by NBFIs accompanied by evolving regulatory and funding landscapes has raised their liquidity demands and introduced new systemic risks to the financial system. This necessitates stronger liquidity risk management by NBFIs and coordinated regulatory oversight to ensure financial stability.
[1] Bank for International Settlements, 2020. [2] Financial Stability Board, 2019. [3] European Central Bank, 2018. [4] International Monetary Fund, 2018. [5] Financial Stability Board, 2017.
- In the financial sector, data from the Bank for International Settlements in 2020 reveals that non-bank financial institutions (NBFIs) are responsible for approximately half of the assets in the global financial system, including the UK.
- AI and machine learning can provide sensible insights into the liquidity risks and transformation processes of NBFIs, helping to mitigate risks and enhance sustainable finance investing.
- Given the vulnerability of NBFIs during liquidity stress and tightening funding conditions, as highlighted in the Financial Stability Board's 2017 report, public policy should prioritize improved risk management, monitoring, and market transparency for such institutions.
- The European Central Bank's 2018 report suggests that a more robust liquidity policy, focused on enhancing the liquidity resilience of NBFIs, is essential for maintaining financial system stability.
- In response to the growing role of NBFIs and the associated risk, regulatory bodies like the Financial Stability Board (FSB) encourage the use of sustainable finance policies, which can help reduce risk and promote the long-term financial wellbeing of businesses and the economy.
