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Banking & finance
OpinionComment
Agustín Carstens
Agustín Carstens

Macroscope | Financial intermediaries must be kept in check to avoid a repeat of the 2020 turmoil

  • Nonbank financial intermediaries have become intertwined with the rest of the financial system and their activities can affect the real economy, yet they remain poorly regulated
  • Closer monitoring can reduce the likelihood of financial stress – and the need for central banks to step in

Reading Time:3 minutes
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A board at the trading floor of the New York Stock Exchange shows plummeting stock indices on March 3, 2020. The spread of Covid-19 has wreaked havoc on global markets, triggering an economic recession. Photo: AP
Agustín Carstens

Investment funds and asset managers are playing an ever more crucial role in the financial system. They provide funding in areas that traditional banks do not cover, manage and share risks, and enhance innovation and economic growth.

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Lightly regulated from a prudential perspective – historically reflecting the fact that they do not take deposits – these nonbank financial intermediaries (NBFIs) have become tightly intertwined with the rest of the financial system. When things go wrong, their activities can undermine financial stability and hurt the real economy. It is time to give policymakers more oversight of these firms and their activities and bring them into the circle of system-wide regulation.
The turmoil of March 2020 was a salutary reminder of how NBFIs, representing almost half of global financial assets, can trigger and amplify market stress. As many NBFIs retreated from markets hammered by pandemic worries, liquidity dried up and markets froze amid deleveraging and feedback loops. These dynamics threatened financial stability, requiring massive emergency help from central banks.
The key vulnerabilities behind the instability are liquidity mismatches and hidden leverage, which interact with risk management practices. These issues are discussed in the Bank for International Settlements’ latest BIS Quarterly Review, which seeks to inform the policy debate by looking at various aspects of the US$200 trillion NBFI ecosystem.

Liquidity mismatches are common for prime money market and open-ended funds that hold illiquid investments but promise to convert their shares into cash on demand. At times of stress, this gives investors an incentive to get out before others. Faced with this demand in March 2020, funds hoarded liquidity rather than falling back on their buffers. As they sold assets, liquidity conditions deteriorated further, leading to a collapse in system-wide funding liquidity.

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Stresses can spill over borders. NBFIs in some Asian emerging market economies, which have become significant creditors in global markets, were hit hard when US dollar funding dried up. The strains were particularly severe for institutions with dollar investments and local-currency debt, and who hedge the risk with short-term instruments such as FX swaps, themselves a source of hidden debt.

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