There is an interesting article published Sept. 29 on the IMF Blog, written by Mr. Jay Surti, that I wanted to highlight following Filipinos growing reliance on nonbank financing.
The article, titled ‘Explainer: Five Megatrends Shaping the Rise of Nonbank Finance,’ starts off with the observation that half of all financial assets worldwide are now held and intermediated by companies that are not classified and regulated.
The global financial crisis of 2008, he wrote, froze the financial system. Banks pulled back credit, families tightened their belts and companies laid off workers, leading to an extremely difficult moment for the financial services industry.
Today, he pointed out, the landscape of finance has changed, with different types of investors and firms providing businesses, consumers and governments with credit and liquidity.
More than a billion more people now have access to credit from new tech-based lenders. Families also have more options to finance purchases and to diversify retirement portfolios. Equity, fixed income and derivatives markets, he said, have all seen strong growth.
However, he noted, these developments have not been driven by banks, but by ‘nonbank’ financial institutions that have stepped up, increasing their share of global credit and finance from 43 percent during the 2008 crisis to nearly 50 percent by 2023, based on recent data.
Half of all financial services worldwide, Mr. Surti wrote, are now offered by companies that are not classified and regulated as banks.
Nonbank financial institutions, he said, encompass very different kinds of enterprises, and exact definitions vary. Broadly, the sector includes financial companies that provide credit, trading and investment services, but do not take deposits from the public or have accounts with the central bank.
That means, they are not covered by safety nets like deposit insurance and liquidity assistance which banks have access to in exchange for comprehensive prudential regulations.
Given the nonbanks’ size and importance, Mr. Surti warned, their growth also brings risks.
He cited the classic ‘run on a (non)bank’ scenario. Like banks, open-ended and money market funds make long-term investments, but promise customers the ability to withdraw at any time. During the early-COVID ‘dash for cash’ in 2020, Mr. Surti cited, some were running out of cash (a liquidity crisis) and needed help from central banks, including the Federal Reserve. While governments did not lose money, they did take on risk for these nonbanks.
Another scenario he cited is the ‘margin call plus contagion’ scenario. Borrowing on margin to make bigger bets enhances profits, but also raises risks. Some hedge funds and family offices (wealth managers focused on one or more wealthy families), he said, borrow large amounts of money with little collateral to bet on events like stocks or bond price swings.
In times of stress anywhere in the financial system, he said, the institutions the nonbanks borrow from often go from requiring too little collateral to requiring too much, amplifying risks for everyone.
If these bets go wrong, he warned, the nonbanks may collapse, triggering losses and illiquidity for their creditors and broader market stresses.
Thus, he highlights the need to protect the public by ensuring that the government gets more and better data. Nonbanks, he said, borrow heavily from banks and others in the financial system, yet their disclosure and reporting requirements are quite light.
Neither market participants nor financial regulators have a comprehensive view of the macro-financial stability risks arising from the sector.
Taxpayers, he said, are often called in to help out in times of stress, so they deserve to know more about the risks nonbanks take. When transaction information can’t be public for competitive reasons, it should be visible to regulators – and shared across borders.
The data gathered by government, he suggested, should be used to improve risk analysis. Regulators, he said, can also do more with the data they already have to map connections between banks and nonbanks, and among nonbanks. Using new models and technology can help them gain a better understanding of global financial risks.
Governments should also utilize risk analysis to strengthen supervision, Mr. Surti said, noting that as risks are better understood, national and international regulators can more quickly spot and intervene forcefully to make global finance less vulnerable to shocks.
Nonbanks, Mr. Surti explained, are a diverse group that needs to be better understood and to ensure that their riskiest activities are appropriately regulated to reduce potential risks to the financial system and economic activity while allowing space for dynamism and innovation in the provision of financial services.
Among the megatrends driving the growth of nonbanks, he said, are governments turning to new lenders, enhancing liquidity and holding down rates – new nonbank buyers for bonds such as US Treasuries provide additional liquidity, helping markets operate efficiently, which can help hold down the interest on national debt that taxpayers ultimately pay.
Mid-sized businesses, he said, have gained more access to funding, supporting economic activity, employment and financial resilience.
Private credit funds can provide funding for businesses that may be too large or risky for banks to lend to, but too small to issue their own bonds. Many such funds are managed by private equity firms, which in turn get financing from banks and other nonbanks.
These nonbanks – typically insurers, pension funds, sovereign wealth funds and endowments – that provide funding to private credit funds tend to have lower leverage and funding that is more stable over longer terms compared to banks.
So, they don’t have to pull funds back as quickly during times of stress, increasing the financial system’s resilience.
Credit, he noted, is available in a wider variety of amounts and durations, from longer-term auto loans, to ‘buy now, pay later’ loans, and small mobile money loans. Fintech lenders have driven this trend by pioneering new sources of data for underwriting and making servicing cheaper through automation, enabling firms to make smaller loans to more people. In emerging and developing economies, they have made mobile payments available to more people, and with a broader set of financial services following behind.