BIS Quarterly Review: Widening the regulatory circle for non-bank financial firms

• Non-bank financial intermediaries (NBFIs) have grown significantly. Their activities can amplify market stress and undermine financial stability.

• A macroprudential regulatory approach is needed to address the structural vulnerabilities in NBFIs, most notably liquidity mismatches and hidden leverage.

• Concerns about a new virus variant late in the period under review¹  curtailed investors' risk appetite. Financial conditions tightened in several emerging market economies where inflationary pressures persisted.

Non-bank financial intermediaries (NBFIs) now account for nearly half of global financial assets. They provide a valuable source of alternative financing but also give rise to new channels of financial instability. Addressing these gaps will require a system-wide approach, the Bank for International Settlements (BIS) said in its latest Quarterly Review.

The Quarterly examines elements of the NBFI ecosystem, including investment funds, asset managers and institutional investors. It looks at how market volatility in March 2020 exposed gaps in regulation and highlights risks posed by NBFIs in Asian emerging market economies and in fast-growing areas such as sustainable finance and the crypto universe.

The Quarterly sheds light on challenges in the ongoing policy discussion about NBFI regulation, given their increasing role in intermediating debt and sharing risk and given they can hamper the transmission of monetary policy to the broader economy. The publication includes a foreword by General Manager Agustín Carstens, who outlines the need for a multi- pronged policy response drawing on the experience of regulatory reforms in the wake of the Great Financial Crisis.

Those reforms strengthened banks and reduced their systemic impact. It is time to apply a macroprudential approach to NBFIs as well. One element of the response should be better information through stronger monitoring, enhanced regulatory reporting and public disclosures. Another would be to ensure that NBFIs build war chests in good times in order to mitigate collective retrenchment in times of stress. Ultimately, a more consolidated supervisory perspective would be necessary.

Agustín Carstens, General Manager of the BIS

The Quarterly also examines recent financial market developments. Overall, investors' risk appetite proved resilient in advanced economies during the period, even amid changing inflation expectations. Nevertheless, concerns about a new virus variant curtailed the stock market gains in late November. Financial conditions continued to tighten for many emerging market economies, where authorities faced persistent inflationary pressures.

Five features analyse various aspects of NBFIs:

• Sirio Aramonte, Wenqian Huang and Andreas Schrimpf analyse decentralised finance (DeFi), a new form of crypto intermediation that uses automated protocols on blockchains and stablecoins to facilitate fund transfers. Even though links with traditional finance are currently contained, DeFi warrants closer monitoring because of high leverage, limited shock-absorbing capacity and built-in interconnectedness.
• Stijn Claessens and Ulf Lewrick discuss the systemic risks and policy implications of open-ended bond funds. During recent episodes of stress, elevated redemptions spread across funds, suggesting the need for macroprudential tools to bolster their resilience.
• Patrick McGuire, Ilhyock Shim, Hyun Song Shin and Vladyslav Sushko analyse the increased use of short-term foreign exchange hedging instruments in several emerging Asian economies in relation to their outward portfolio investment. This exposes institutional investors and asset managers to US dollar funding disruptions.
• Sirio Aramonte and Fernando Avalos examine how private capital markets have become a global force in all aspects of firm financing and restructuring. Among emerging market economies, their footprint is particularly strong in Asia.
• Michela Scatigna, Dora Xia, Anna Zabai and Omar Zulaica explore the market's role in the transition to a more sustainable and fairer economy. They find that bonds from firms with larger carbon emissions trade at marginally higher yields and that social bonds are issued at a premium (socium) relative to conventional bonds.

¹ 13 September to 29 November 2021.