For warning signs of the next global financial crisis, watch the activities of both banks and nonbanks
“Nonbank financial intermediation and financial stability: A perfect storm in the making?”
That’s the rather alarmist title of a new Group of Thirty (G30) report. Documenting the rapid growth of credit provision by nonbank financial institutions (NBFIs) relative to banks—particularly since the 2008 global financial crisis—it suggests that financial stability risk has migrated from the tightly regulated banking sector to a sprawling ecosystem of pension funds, insurers, mutual funds, hedge funds, venture capital firms, private credit funds, and other nonbank lenders.
Documents such as the G30 report and the International Monetary Fund’s latest Global Financial Stability Report have been useful in highlighting the growing and important role of NBFIs in the financial system, especially their role in diversifying funding sources and broadening access to finance. However, such reports risk misleading the public on NBFIs by being imprecise or a bit sensational in catchy headlines implying risk has shifted from banks to NBFIs.
It is important to analyze the specific entities and activities that pose a risk to global financial stability—rather than get distracted by comparing banks to NBFIs as the guiding theme of analysis.
Focus on fundamental risk factors
As mentioned in the G30 report, financial crises tend to be triggered by two fundamental risk factors: instability of funding bases and high levels of leverage. Basically, financial entities or activities relying on unstable funding to invest in illiquid but high-yielding assets can run into liquidity crises if their clients withdraw their deposits or redeem their shares in those entities—so-called liquidity mismatches. Thanks to today’s online banking and investing, such events can take place very suddenly and quickly. In addition, entities or activities using high levels of leverage—which magnifies potential losses, leading to margin calls by credit providers and fire sales of assets—can exacerbate market sell-offs.
The original failures and sell-offs could then become contagious as financial institutions, including banks and NBFIs, have exposures to the failing entities—in other words, interconnectivity risk. In addition, if these losses surprise market participants, who suddenly realize that previous assumptions about the financial health of entities or the quality of an asset class are wrong, that could trigger sharp market price movements.
The shift of lending and counterparty exposure risk from banks to NBFIs has been a complicated phenomenon, reducing vulnerability in certain areas while creating new sources of risk in others.
Identifying risks in financial entities and activities
Focusing on the activities that increase financial risk, a few observations can be made.
As they’ve demonstrated time and time again, banks remain risky institutions as they engage in high leverage finance, which is intrinsic in the fractional reserve banking system, and depend on unstable funding bases. Indeed, the G30 report highlights the risk to banks due to their interconnections with NBFIs. Banks have also increased their participation in the leveraged loan market, which has already experienced elevated loan defaults.
According to the G30 report, more than 30 percent of the assets in the NBFI sector (at $260 trillion or more than half of total global financial assets) now belong to pension funds and insurance companies—entities which enjoy stable funding bases given that they fulfill their clients’ long-term financial needs by employing long-term investment strategies. Basically, growth in these industries relative to other types of financial institutions tends to enhance the stability of the financial system.
Risky entities in the NBFI sector
On the other hand, hedge funds—whose assets under management are estimated to have reached $5.25 trillion—have become dependent on the overnight repo market to fund their highly leveraged investment positions. The repo market is fragile, vulnerable to tightening conditions triggered by economic, political, and market events—pushing up overnight funding rates and causing losses for highly leveraged entities and investment strategies. As a result, the hedge fund ecosystem has increased the risk of instability in the financial system.
Moreover, certain entities in the NBFI sector—in particular, hedge funds—have engaged in highly leveraged investment strategies compared to banks, pension funds, and insurers whose core businesses are better regulated and supervised. Specifically, many hedge funds have carried out arbitrage or basis trades, employing high leverage to benefit from small movements in relative prices of cash versus derivatives (i.e., futures or swap contracts) positions. Unexpected price movements can cause significant losses, forcing the unwinding of positions and deepening sell-offs. In fact, several recent episodes of market turmoil were triggered by hedge funds unwinding their cash versus derivatives positions in the US Treasury security market.
It is also important to keep in mind that some pension funds and insurance companies, while enjoying stable funding, can engage in leveraged activities, especially through their subsidiaries, raising the risk profile of the whole group. Examples include AIG, whose financial product subsidiary was a significant player in the credit default swap market that blew up in the 2008 financial crisis, and UK pension funds, which relied on gilt derivatives for their liability-driven investment strategies and suffered major losses in the 2022 gilt market crisis. Without exposure to derivatives giving rise to emergency margin calls and forced selling, UK pension funds would have been in a better solvency situation, as the sharp rise in gilt yields during the crisis reduced the value of their liabilities by much more than their assets.
Contagion and surprise risks
Furthermore, contagion—or interconnectivity—risk has increased with the participation of institutions (including money market mutual funds, banks, and principal trading companies) in the repo market, becoming net lenders to hedge funds. Thus, hedge funds’ losses can propagate through the repo ecosystem. Beyond lending, more activities with hedge funds—for example, providing prime brokerage services to them—would increase the counterparty exposure risk of financial institutions, whether banks or NBFIs.
Additionally, financial reporting and disclosure requirements sometimes contribute to surprise risk. For example, banks are not required to conduct mark-to-market valuations of the securities in held-to-maturity accounts, and therefore, they are not required to report market losses in these accounts in their financial statements. However, when they need to sell these assets at market prices, realizing losses, this could come as a surprise to market participants, triggering reactive sell-offs that could become contagious. Examples include the Silicon Valley Bank failure in 2023. On the other hand, the surprise risk due to a lack of mark-to-market reporting has to be balanced against the fact that mark-to-market accounting requirements, while enhancing transparency, could propagate selling pressure throughout financial markets.
More generally, a sudden realization that previous assumptions about the quality of an asset class are unsubstantiated could lead to severe market adjustments—as in the case of subprime mortgage-backed instruments in the global financial crisis of 2008.
In short, in assessing current risks to global financial stability, attention should focus on activities vulnerable to funding stability and leverage risks, and on potential crisis amplifiers driven by interconnectivity risk and potential surprises about asset quality. Those activities can be undertaken by any financial institution, including both banks and NBFIs. Repeating the simplistic statement that the next global financial crisis will be due to the shift of lending from banks to NBFIs could mislead market participants, diverting attention from fundamental risk factors.
Hung Tran is a nonresident senior fellow at the Atlantic Council’s GeoEconomics Center and senior fellow at the Policy Center for the New South. He is a former executive managing director at the International Institute of Finance and a former deputy director at the International Monetary Fund.
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