In a recent speech, John Schindler, secretary general at the Financial Stability Board (FSB) discussed the authority’s priorities for non-bank financial intermediation (NBFI) oversight.
Through ongoing surveillance, the FSB has been highlighting vulnerabilities associated with liquidity mismatches and leverage in NBFI. Both vulnerabilities are sensitive to a tightening of financial conditions and a slowing of economic activity. (The banking sector is not unique in that sense.)
One focus is on “key amplifiers” of liquidity stress, which are types of NBFI activities and entities that may contribute to the transmission and amplification of shocks due to their size, structural characteristics and behavior in stress. On the liquidity demand side, this includes activities that give rise to liquidity mismatches between daily or frequent redemption possibilities on the liability side and not enough liquid assets on the asset side.
This is particularly prevalent in some types of non-bank entities, such as certain money market funds and open-ended funds. It also includes derivatives and securities activities that can give rise to unexpectedly large margin and collateral calls, currency mismatches associated with external funding, and the unwinding of levered positions that can exacerbate liquidity strains.
On the liquidity supply side, this includes factors that reduce the ability of bank and non-bank liquidity providers to absorb large spikes in liquidity demand, as well as other impediments stemming from the structure of core wholesale funding markets, which are characterized by limited standardization, low levels of automated trading and turnover, and heavy reliance on dealer intermediation.
“We have not been simply studying these vulnerabilities. We have come quite a ways in just a few years in making policy recommendations, and our members have been diligently implementing those recommendations. Our proposals to address systemic risk in NBFI largely involve repurposing existing micro-prudential and investor protection policy tools, rather than creating new ones,” said Schindler in the speech.
Liquidity supply
An area of policy work focuses on enhancing the resilience of liquidity supply in stress. In April 2022, the FSB published an analysis of vulnerabilities stemming from the reliance of non-US firms, especially in emerging markets, on US dollar funding and identified potential ways that authorities in those markets could address them. It’s also identified steps that individual authorities could take to increase the use of central clearing and of all-to-all trading platforms to enhance liquidity for bond and repo transactions. And, it’s examining the structure and liquidity provision in core funding markets, including the role of different investors and factors that limit their resilience in stress.
Hedge funds
Amongst non-bank investors, hedge funds display high synthetic leverage in aggregate, obtained through securities financing transactions and derivative positions. Within the hedge fund sector, there is a group of funds, typically pursuing macro and relative-value strategies, with very high levels of synthetic leverage.
In addition, large hedge funds usually spread their borrowing across several prime brokers, which helps diversify their funding sources but can also make leverage in the financial system harder to identify. Furthermore, a few prime brokers dominate the provision of lending to hedge funds, and this concentration could amplify shocks and propagate them through the financial system.
Leverage that is difficult to identify or measure by market participants or public authorities is referred to as “hidden leverage”. In some cases, leverage is hidden because no data are available to assess its presence or its magnitude. In other cases, leverage can be hidden because available data are not sufficient or adequately used to assess vulnerabilities.
The limited availability of data, problems in aggregating existing data, and difficulties in estimating meaningful measures of leverage may lead to an underestimation of overall leverage in NBFI and to the inability to identify large and concentrated positions. In addition to hampering vulnerabilities assessments, this impedes mitigating measures from being put in place by market participants and regulators.
The FSB will soon begin work to consider potential policy recommendations for mitigating the financial stability risks from NBFI leverage and will deliver a progress report to the G20 in September.