Non-Banks: A Potential Threat to Global Financial Stability

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Non-Banks: A Potential Threat to Global Financial Stability

Non-banks are a growing threat with less regulatory oversight and transparency, non-banks pose risks of credit losses, liquidity mismatch, and contagion.

The Non-Bank Sector: Accounting for Half of the World’s Financial Assets and Growing Strongly

The International Monetary Fund and the Bank of England have both highlighted the vulnerability of non-bank financial institutions as a significant risk to global financial stability. The non-bank financial sector has become an increasingly significant player in the global financial system, accounting for around half of the world’s financial assets. This sector has grown significantly since the 2008 global financial crisis, in part due to the low-interest-rate environment that has persisted in many parts of the world. The sector is diverse, encompassing entities ranging from pension funds and insurers to mutual funds and hedge funds. These institutions provide a range of financial services, including lending to households and businesses.

The Rise of Non-Banks

Non-banks that provide credit are referred to as “shadow banks,” and they now make up around 50% of the world’s financial assets. These institutions operate with less regulatory oversight and transparency than banks, and their troubles could destabilize the entire financial system or spread to traditional banks through real or perceived interconnections.

Non Banks in the United States Grow

In the United States, non-banks have become an increasingly significant force in the financial sector in recent years. According to a report by the Financial Stability Oversight Council, non-banks in the US now account for over one-third of the country’s total financial assets, up from around 25% in 2000. This growth has been driven in part by the expansion of online lending platforms, which have made it easier for non-banks to provide credit to consumers and small businesses. 

US Fintech Companies and Instability

These platforms, which are sometimes referred to as “fintech” companies, use advanced technology to assess credit risk and streamline the lending process, often providing faster and more flexible financing options than traditional banks. However, the growth of non-banks in the US has also raised concerns about financial stability. As in other parts of the world, non-banks in the US operate with less regulatory oversight and transparency than banks, and their interconnectedness with the broader financial system can create risks of contagion in the event of a crisis.

US Treasury Department Warning 

For example, in 2016, the US Treasury Department issued a report warning that the rapid growth of certain types of non-banks, such as peer-to-peer lenders and marketplace lenders, could pose a threat to financial stability if they were to experience a significant increase in loan defaults. The report also noted that non-banks are often reliant on short-term funding sources, which can exacerbate liquidity risks during times of market stress.

Read More: Concerns About US Job Market and Service Sector Growth

US Regulators Address Concerns

To address these concerns, US regulators have taken steps to increase oversight of non-banks. For example, the Consumer Financial Protection Bureau has proposed new rules to regulate the payday lending industry, while the Office of the Comptroller of the Currency has announced plans to issue special-purpose national bank charters for fintech companies. However, some experts argue that more needs to be done to ensure the stability of the non-bank sector and prevent systemic risks.

The Risks of Non-Banks: Credit Losses, Liquidity Mismatch, and Limited Regulatory Oversight

The risks associated with non-banks are varied, and some of them increase as interest rates rise. For example, the risk of credit losses is a significant concern, particularly if corporate borrowers default amid a weakening economy. Additionally, open-ended funds that allow investors to withdraw their money quickly can experience a “liquidity mismatch,” where the assets that the fund holds cannot be sold quickly enough to return money to clients.

Non-Banks: Exempt from Strict Requirements for Loss-Absorbing Capital and Liquidity

Funding for some European non-banks has become more expensive and harder to come by due to rising interest rates and an uncertain economic outlook. Furthermore, non-banks do not take deposits from customers, which means that they are mostly exempt from the strict requirements for loss-absorbing capital and liquidity imposed on banks. Most non-banks are not subject to regular regulatory tests to ensure that they can cope in a range of adverse scenarios.

Limited Tools to Mitigate Contagion Risks

Many non-banks also cannot access emergency central bank funding in times of stress, and public authorities have limited tools to mitigate contagion risks. Since non-banks lend to and borrow from banks, an ill health at a large non-bank or in a significant part of the sector could infect traditional lenders. An example of this is the collapse of US fund Archegos Capital Management, which caused around $10 billion worth of losses across the banking sector.

Risk Heightens With Volatility

Overall, non-banks pose a significant risk to global financial stability due to their size, complexity, and lack of regulatory oversight. As interest rates rise, these risks could increase, potentially leading to credit losses, liquidity mismatches, and contagion risks. Regulators must remain vigilant and continue to monitor the sector closely to ensure that it remains stable and resilient in the face of potential threats.

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Stephen Fruchs

Stephen Fruchs is a finance contributor on the Trade Oracle platform. His experience is extensive in everything from micro to macroeconomic trends. With a decade of experience in the finance space, Stephen Fruchs provides consistent economic insights into the changing stock market landscape.