Non-banks as a source of systemic risk

Shocked by COVID-19, economies dominated with non-banks will once more get more severely hit.

Non-banks raise leverage out of the financial supervision and, thus, make financial system more vulnarable during economic downturns. The US financial system, in particular, is exposed to the off-balance sheet risks such as financial guarantees and insurances created in the securitization process.

Nonbanks have the competitive advantage against banks since they are exempt from the banking requirements in terms of capital and liquidity. Yet these exemptions raise their exposures to financial risks.

Regulators should include the nonbanks within the context of the capital and liquidity requirements. Since securities increase the interdependence among the firms, a more holistic approach should be improved to analyze and monitor the systemic risk instead of individually focusing on each financial institution.

How can non-banks trigger systemic risk?

The expansion of the asset backed securities (ABSs) created a major way of financial intermediation outside the banking sector. Thus, nonbank institutions intermediated and guaranteed ABS products.

While ABSs are profitable in normal times, they cause severe losses in the crisis. Once a panic turns into a crisis, many borrowers loose their jobs and unable to pay their monthly credit installments. So collaterals backing the securities are converted into cash. For mortgage type of securities, backing instruments are borrowers' houses. Thousands of people loose their houses in addition to their jobs. When a huge amount of houses is sold simultaneously, house prices decline causing collaterals not to be able to pay for the whole loan amount. So guarantors of the assets need to cover the excess of loss from defaults.

Collapse of mortgages triggers the fail of other types of ABSs such as asset-backed commercial papers (ABCP). Due to the liquidity shortage in the financial markets, businesses that cannot roll over debt, go bankrupt. As a result, nonbanks, as the guarantors of the ABCPs, undertake a heavy burden once again.

In case nonbanks are not covered under the lender of the last resort mechanism, a liquidity shortage causes their failure that destabilizes the whole financial system triggering a contagion effect. After the 2008 global financial crisis, nonbanks are allowed to directly reach the Fed's liquidity sources. Thanks to the lessons learnt, this time, the Fed rapidly provided liquidity to the entire financial system.

How should systemic risk be regulated

As the nonbank financial sector grows, a greater percentage of lenders and borrowers are matched outside the banking system. Therefore, credit, maturity and liquidity risks are also transferred from banks to new institutions such as guarantors and trusts. So, the related products of these new institutions should be covered by the banking regulations.

Another concern from the regulator point of view is in terms of ABS guarantee or insurance accounting. A guarantee or insurance is not written on the liability side of the balance sheet. Thus, the insurer or guarantor is able to be very high leveraged. Therefore, capital and liquidity requirements should cover off-balance sheet liabilities as well.

Securitization causes the systemic risk to spread much more quickly, increasing the interconnectedness among financial and nonfinancial firms. Especially over the counter transactions increase the exposures to the counter party default risk. Therefore, regulatory bodies should particularly monitor bilateral financial transactions.

Conclusion

Shadow banking emerged and expanded as a result of the need for secure and liquid assets. Securitization (Jobst, 2008) became the leading mechanism of the nonbanks providing maturity transformation (Armour, 1999) in a secure and liquid way.

Unfortunately, the liquidity and safety features of securities are out of service in the crisis time. In traditional banking, depositors used to run from the banks withdrawing their balances. Nowadays, since securities represent a considerable rate of the liquid assets, they are the first ones converted into cash. Hence, a run from securities hits the security markets disabling the match between supply and demand. In consequence, the nonbanks guaranteeing and investing in ABSs write off great losses. Furthermore, their failure destabilizes whole financial system unless they are provided necessary liquidity by central banks.

Within the context of systemic risk precautions, regulators should cover the nonbanks in the banking regulations. Off-balance sheet liabilities should be taken into account while calculating the capital and liquidity requirements. Lastly, the complex financial relations resulting from ABSs should be analyzed periodically.

References

Andreas Jobst, 2008, Back to basics - what is securitization? Finance & Development 45, 48.

Armour, John, Dan Awrey, Paul Davies, Luca En riques, Jeffrey Gordon, Colin Mayer and Jennifer Payne, 1999, Principles of Financial Regulation (Oxford: Oxford Universit. Press), pp. 275-289.

Pozsar, Zoltan, 2011, Institutional Cash Pools and the Triffin Dilemma of the U.S. Banking System, International Monetary Fund Working Paper 11/19.