The growing presence of non-bank financial institutions (NBFIs) helps to develop financial markets, yet it can also impact a country’s vulnerability to cross-border spillovers. The risk of cross-border spillovers is especially acute for NBFIs’ dollar positions.
Other potential sources of spillovers include currency and liquidity mismatches on NBFIs’ balance sheets, NBFIs’ use of leverage, and herding. Evidence about whether the greater involvement of NBFIs has aggravated the procyclicality and intensity of cross-border spillovers is mixed.
Large global NBFIs, from advanced and emerging market economies alike, invest in dollar assets either in the United States or elsewhere. Unless dollar assets can be used as collateral in repo transactions, they are typically funded by converting domestic currency into dollars in FX spot markets and hedged through FX forward and swap markets. The hedging counterparty is typically an internationally active bank. The bank in turn hedges its own currency risks by borrowing dollars from money market funds (MMFs) through the issuance of commercial paper or similar instruments.
Unhedged FX exposures or maturity mismatches between holdings and hedges can generate distress if exchange rates move sharply. The short-term nature of FX forwards and swaps exposes investors to rollover risk, which can amplify spillovers during periods of stress. If an NBFI is unable to roll over its FX swaps, it may require foreign currency funding from other sources such as repo or the unsecured money market funding. In the worst case, the NBFI may need to sell foreign currency assets if it cannot fund them in the same currency, hedge the currency risk in a short time or operate with lower hedge ratios. The impairment of sources of funding on a systemic scale could lead to fire sales.