NBFIs' prominent role has brought benefits by diversifying funding sources, but it has also exacerbated some liquidity imbalances that can, in extreme cases, endanger financial stability.
The heft of non-bank financial intermediaries (NBFIs) in the
financial system has grown significantly since the Great Financial
Crisis. We look at the main drivers and consequences of their ascent,
focusing on NBFIs' effect on the demand for and supply of liquidity. We
develop a framework of systemic-risk propagation through NBFIs that
allows us to provide a unified reading of market disruptions during the
Covid-19 pandemic.
Contribution
We develop a risk accounting framework that describes how NBFIs'
risk-taking capacity evolves during periods of market distress. The key
element of our setup is that fluctuations in leverage, due to changes in
margins, can rapidly affect the amount of financial intermediation
NBFIs perform. This perspective is useful to understand episodes of
sudden liquidity disruptions in markets where NBFIs are major
participants.
Findings
NBFIs' prominent role has brought benefits by diversifying funding
sources, but it has also exacerbated some liquidity imbalances that can,
in extreme cases, endanger financial stability. Our framework implies
that sharp increases in margins, especially after a protracted period of
thin margins, will tighten financial conditions for the system as a
whole. It also points to a tight link between deleveraging and "dash for
cash", as during the Covid-19 pandemic. The systemic relevance of NBFIs
raises questions about the appropriate policy strategies. In
particular, there is an important correspondence between access to
public resources and oversight.
Abstract
The heft of non-bank financial intermediaries (NBFIs) in the
financial system has grown significantly after the Great Financial
Crisis of 2008. This paper reviews structural shifts in intermediation
and how NBFIs have shaped the demand and supply of liquidity in
financial markets. We then lay out a framework for the key channels of
systemic-risk propagation in the presence of NBFIs, emphasising the
central role of leverage fluctuations through changes in margins. The
debt capacity of an investor is increasing in the debt capacity of other
investors in the system, so that leverage enables greater leverage, and
spikes in margins can lead to system-wide deleveraging. In our
framework, deleveraging and `dash for cash' scenarios (as during the
Covid-19 crisis) emerge as two sides of the same coin, rather than being
two distinct channels of stress propagation. These findings have
implications for the design of NBFI regulations and of central bank
backstops.
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