The latest quarterly review published in December by The Bank for International Settlements (BIS) delivers a warning that the finance industry is laying the foundations for the next big crash.
It contains a report that highlights the role of non-bank financial institutions (NBFIs) which may account for half of all the world’s transnational and intra-country financial flows. There’s no precise definition of an NBFI; they are corporate entities that accept and make financial transfers that aren’t legally defined as banks.
They include private equity firms, hedge funds, insurance companies, asset management firms and decentralised finance (DeFi) institutions that create automated smart contracts on distributed ledger technologies, involving mainly permissionless mechanisms and anonymous transactions. DeFi is the source of crypto assets, which are designed to evade regulation of any sort.
NBFIs are booming. It’s the result of the retrenchment of banks after the 2008 financial crisis coupled with more intrusive regulation of them that the crisis brought about. Those seeking above-average returns increasingly avoid banks and place their money with the growing number of NBFIs instead. Banks in turn have developed capacities that in effect mirror those of NBFIs
The BIS notes that the finance market crash brought about by the Covid shock exposed the role of NBFIs globally, but particularly in some Asian market economies.
“When things go wrong, NBFIs can trigger or amplify market stress,” BIS general manager Agustin Castens says in the foreword to the report. “And they affect how monetary policy is transmitted to the economy, how it is implemented on a day-to-day basis, and even how it is calibrated and communicated.”
This is a massive issue for national regulatory agencies and supranational bodies like the BIS and the IMF.
“… NBFIs have risen to prominence in policy discussions because they can be, and have been, a source of financial instability,” Carstens says. “In March 2020 and in previous episodes of similar market turmoil, the NBFI sector amplified stress through inherent structural vulnerabilities, notably liquidity mismatches and hidden leverage. With system-wide stability under threat, massive central bank support was necessary to restore the calm. Such repeated occurrences suggest that the status quo is unacceptable. Fundamental adjustments to the regulatory framework for NBFIs are called for, to make it fully fit for purpose.”
Carstens closes with an ominous warning.
“The policy challenges are daunting,” Carstens says “Addressing them is urgent and, indeed, many efforts are under way, nationally and internationally.”
This might suggest that the BIS has far-reaching recommendations. Readers of the report will be left disappointed. There are only three:
- Gather more information about the NBFI sector
- Encourage NBFI’s to increase their shock-absorption capacities
- Close gaps in NBFI supervision.
One of the most compelling parts of the 2008 financial crisis was the extent to which regulators and practitioners refused to recognise how distorted banking behaviour was. Almost until the last moment, they were counseling positive thinking.
A similar mood is enveloping the finance industry in the winter of 2021. Capital and property markets are at record highs. Banks and other financial intermediaries have never had it so good.
Why would anyone want it to end? And is anyone going to listen to the BIS before it’s too late?