Shadow Banks Increasingly in Regulators’ Sights

“Non-banks are the new banks”, as Farah Khalique notes in her article for Global Risk Regulator (a publication from the Financial Times) on regulatory focus shifting towards ‘shadow banks’. These non-bank financial institutions (NBFIs) now stand behind nearly half of the world’s financial assets, and turmoil in the past few years has shown the extent of the risk they pose to traditional banks.

In November 2020, the Financial Stability Board (FSB) called for action to “strengthen the resilience of non-bank financial intermediation”, arguing that the stress on the financial system would have “worsened significantly” if not for central bank intervention. In April 2023, the Financial Stability Oversight Council (FSOC) released proposals to make it easier to classify shadow banks as systemically important financial institutions (SIFI). US Treasury Secretary Janet Yellen said that easing this hurdle will allow the council to address emerging risks to financial stability before it became too late.

What does this mean for financial risk management?

Non-banks are now considering the FSOC’s proposals, while voices from traditional parts of the industry continue to raise their concerns about the risks these non-banks present. In the long term, the demand for tightening regulation of this part of the sector will not ease in light of the interconnectedness of the financial sector.

FRA Director Matt Rees – formerly responsible for providing assurance on fraud risk management in a major international bank – is quoted in the article, giving his view on how risk management will need to evolve within both non-banks and commercial banks:

^{“Pension funds, insurance companies and hedge funds, among other non-banks, will need to step up their risk management… This will require co-ordination across the sector with a simultaneous increase in regulatory supervision and enforcement.}

^{For commercial banks it is critical their risk management practices are enhanced to ensure that their exposures to the NBFIs are identified and the associated risks are assessed and mitigated. This will include better understanding of their clients’ business models, such as positions, exposures and investing strategies.”}

Read the full article in Global Risk Regulator here (subscribers only).

FRA Insight

A deeper look at the risks at hand and what can be done, with Matt Rees.

The banking industry has faced increasingly stringent regulations aimed at minimizing risks of catastrophic banking failure. As a result, the Non-Bank Financial Institutions (NBFI) sector has grown to provided financing to businesses that are either too costly or too risky for commercial banks to handle. However, the sheer scale of the NBFI sector, coupled with its diverse range of institutions that, in contrast to commercial banks, are not allowed to accept customer deposits, poses significant risks.

The relatively lower level of regulation imposed on NBFIs creates the potential for serious problems. These risks include threats to financial stability, such as disorderly institutional failure due to imbalances in liquidity between funders and creditors. Additionally, the complexity of financial structures and inherent leverage within NBFIs further exacerbates these risks.

There are both direct and indirect linkages between NBFI and commercial banks. These connections can range from established commercial relationships to shared markets or bank investments in NBFIs. Such interdependencies can transmit stresses between the two sectors, emphasizing the need for coordination and risk management in both NBFIs and commercial banks.

Regular stress testing has been a crucial tool used by global banking regulators to ensure that commercial banks are adequately equipped to handle a variety of theoretical crises. Moving forward, stress tests should incorporate scenarios associated with NBFI failure to effectively model and manage increasingly plausible scenarios.

The Basel Committee on Banking Supervision (BCBS) is currently planning to enhance its risk management guidance, which overall appears to be a sound approach. The focus will be on ensuring that commercial banks have a clear understanding of their exposures to the NBFI sector. This will involve gaining better insights into individual clients and aggregating their dealings to determine the bank's total exposure. Consequently, improved and more comprehensive reporting to and review by well-populated risk management committees may also be required.

By strengthening risk assessment and management practices, both NBFIs and commercial banks can navigate the challenges posed by the expanding NBFI sector more effectively.