Interconnectedness between the banking and the non-bank financial sector remains high, increasing the scope for contagion, said Luis de Guindos, vice president of the European Central Bank (ECB) in a recent speech.
“Given these growing risks, the policy action undertaken to date is becoming ever more insufficient. Indeed, there seems to be a general inertia in the adoption of policy recommendations on non-banks. That has to change,” he said. “The lack of policy action today may mean the materialization of risks tomorrow. In particular, a more comprehensive macroprudential framework should be a priority to ensure that non-banks are more resilient and able to provide a stable source of funding to the real economy in both good and bad times.”
On the Capital Markets Union (CMU):
The CMU seeks to integrate national capital markets into a genuine single market, in turn making financing more accessible to EU companies and transforming Europe into an even more attractive place to save and invest. Consequently, this means scaling up market-based financing in the EU, leading to a larger role for the non-bank financial sector than is already the case.
The strong growth of the non-bank financial sector – especially the asset management industry – over the past 15 years has been accompanied by an increase in liquidity mismatches. Investors in open-ended funds – which account for the largest part of the investment fund sector – can typically redeem their shares on a daily basis without prior notice. This creates a liquidity mismatch especially in funds that invest in relatively illiquid assets, such as high-yield corporate bonds. Liquidity demand has become more procyclical as a result, especially during periods of financial market stress.
“We need to reduce the risks of mismatch between funds’ asset liquidity and their redemption policies. Funds need to ensure that their redemption policies are closely aligned with the liquidity of their portfolio assets,” he said. “We must renew our efforts to reform the MMF (money market fund) sector in the EU.”
Lessons from market events:
- Financial and synthetic leverage can amplify shocks and create spillover risks for banks (Archegos)
- Insufficient preparedness to meet large demand for liquidity, especially from margin calls (LDI funds)
“It is essential to address risks from non-bank leverage from various perspectives,” he said, highlighting the following actions:
- develop a globally consistent approach to addressing risk from both financial and synthetic leverage in the non-bank financial sector
- further improve data quality and coverage and information sharing are central to assessing leverage-related risks across non-bank financial sector entities and activities.
- identify gaps in policy frameworks globally, especially where financial entities are not subject to adequate leverage rules
- enhance margining practices and liquidity preparedness to meet margin calls
- increase the transparency and predictability of initial margin models and assess their responsiveness to market stress
- ensure robust liquidity risk management and contingency planning frameworks to mitigate risks associated with inadequate liquidity preparedness.