It’s a nice pleasure to affix you this afternoon and share some ideas on attainable avenues for addressing vulnerabilities within the non-bank monetary sector. I’ll give attention to three most important areas. I’ll begin by outlining why a macroprudential strategy to non-banks issues from a central banking perspective, touching upon financial coverage and monetary stability concerns. I’ll then spotlight some examples of the important thing externalities which emerged within the non-bank monetary sector on the onset of the coronavirus (COVID-19) pandemic. Lastly, I’ll share some concerns on the best way ahead for a macroprudential strategy to non-bank monetary intermediation (NBFI).
Why a macroprudential strategy to NBFI issues from a central banking perspective
The non-bank monetary sector has grown significantly in measurement over the previous decade, and it has develop into more and more related for funding the true economic system. Within the euro space, the monetary belongings of non-bank monetary establishments have greater than doubled because the international monetary disaster. Accordingly, this sector has develop into an necessary supply of funding for the true economic system, with its share of general credit score to non-financial firms rising from about 15% to 30%. This has clear advantages for non-financial firms looking for to diversify their sources of funding throughout bank-based and market-based finance. From a central banking perspective, it additionally has implications for each monetary stability and financial coverage.
Let’s first think about monetary stability. Structural vulnerabilities and the more and more interconnected nature of the non-bank monetary sector each pose a substantial danger to the broader monetary system and the true economic system. We highlighted a few of these dangers in our newest evaluation revealed within the ECB’s Monetary Stability Evaluate, together with rising liquidity mismatch, growing period danger and rising proof of pockets of excessive leverage in sure funds. Specifically, the funding fund sector is now extra uncovered to credit score danger, period danger and liquidity danger than it was earlier than the pandemic. Holdings of BBB and sub-investment grade bonds now signify greater than half of funding fund portfolios.
Non-banks are additionally essential for the transmission of financial coverage. But, for financial coverage to be transmitted easily, it can be crucial that non-banks can present a secure supply of finance throughout the monetary cycle. Extra broadly, in keeping with the conclusions of our latest technique evaluation, monetary stability is a precondition for value stability and vice versa. To that finish, efficient macroprudential insurance policies are wanted to maintain monetary stability dangers at bay and thereby complement financial coverage within the pursuit of its value stability goal.
Vulnerabilities in non-bank finance and attainable externalities
Throughout the market turmoil in March 2020, it turned clear that components of the non-bank monetary sector weren’t sufficiently resilient to soak up the shocks going through them. These shocks then spilled over to different sectors of the monetary system. Cash market funds and the much less liquid company bond funds got here beneath stress, as they confronted giant redemptions concurrently a decline in underlying market liquidity. As traders shed a few of their belongings and corporates scrambled for money, there was a danger that mounting liquidity pressures would amplify market stress and result in a wider lack of confidence. Well timed interventions by central banks helped to include the stress and calm monetary markets.
However, there have been vulnerabilities in non-bank finance that created unfavourable externalities throughout the market turmoil on the onset of the pandemic in March 2020. Let me provide you with some examples.
First, whereas company bond funds have been usually in a position to meet elevated redemptions, their response to outflows added to promoting pressures and the broader demand for money, thereby amplifying liquidity stress in monetary markets. Present disaster administration instruments weren’t efficient in slowing down the outflows or mitigating the influence of asset gross sales on underlying markets. Though the shock triggered by the COVID-19 pandemic was unprecedented, issues about liquidity mismatch in some open-ended funds had been raised lengthy earlier than the pandemic, together with by the ECB and the ESRB.
Second, whereas cash market funds (MMFs) have been an necessary supply of liquidity in unsecured short-term markets, such funding proved unstable throughout the March 2020 market turmoil. MMFs considerably lowered their holdings of short-term financial institution debt in response to outflows. This undermined the pricing and liquidity within the main market of financial institution business paper, contributing to the rise within the euro interbank supplied charge (EURIBOR) – a key reference charge within the euro space – with the potential to have an effect on borrowing charges in different sectors of the economic system.
Third, the numerous improve in margin calls in derivatives markets throughout the March 2020 turmoil additionally exacerbated the liquidity stress, as sure non-bank monetary establishments needed to liquidate belongings to satisfy these margin calls. Some non-banks had been utilizing cash market fund shares to retailer and handle money, due to this fact the necessity to meet margin calls finally spilled over to MMFs.
Externalities may also come up from the usage of non-bank leverage, the place the interlinkages with the banking system are often extra direct. Take the latest instance of Archegos, a household workplace which used derivatives to lever up and which triggered vital losses for a few of the largest international banking teams.
The way in which ahead for strengthening the NBFI regulatory framework from a macroprudential perspective
To this point, the macroprudential coverage framework has centered totally on the banking sector. The framework for the non-bank monetary sector, in the meantime, is to a big extent missing a macroprudential perspective. Which means there are fewer safeguards within the non-bank house and, during times of benign market situations, dangers can develop largely unchecked. However as market situations deteriorate, there’s a danger of non-banks amplifying shocks. As I’ve defined, that is what we noticed throughout the early levels of the pandemic, when the position of MMFs and open-ended funds contrasted with that of the banking sector. As a substitute of amplifying the shock, the banking sector helped to soak up it.
This episode additionally underlines the necessity for authorities to take a complete strategy to strengthening the macroprudential coverage framework for non-banks. Such a framework ought to undertake a system-wide perspective with a give attention to constructing resilience ex ante, somewhat than counting on ex publish measures. It ought to goal to make sure that non-banks can present a secure supply of funding in each good instances and dangerous. And it must be developed with the flexibleness to reply to dangers as they evolve, given the various set of entities and actions within the non-bank monetary sector.
By way of the worldwide coverage agenda, we’ve seen appreciable progress on MMF reforms over the previous 12 months. The Monetary Stability Board, for instance, has lately issued coverage proposals to deal with vulnerabilities in MMFs. The ESRB can even quickly publish a suggestion on cash market fund reforms and the European Fee will evaluation the EU cash market fund regulation in 2022.
The following steps ought to embody enhancing insurance policies for open-ended funding funds and margining practices in addition to tackling dangers from non-bank leverage. Insurance policies for the broader funding fund sector ought to tackle liquidity mismatches as a key precedence. Enhancements to margining practices ought to give attention to growing transparency, lowering extreme margin procyclicality and guaranteeing that non-banks are higher ready for margin calls. And you will need to perceive and deal with the dangers related to leverage within the non-bank monetary sector. To observe and tackle vulnerabilities arising from the usage of leverage, globally constant leverage metrics are wanted.
Let me conclude. The non-bank sector’s position in financing the euro space economic system has elevated considerably over time. By way of strengthening European capital markets, this can be a welcome growth. Trying forward, a extra complete macroprudential framework will help this position even additional: it can assist be sure that non-banks are extra resilient and, in flip, a extra secure supply of funding for the true economic system in each good instances and dangerous. It also needs to cut back the necessity for extraordinary central financial institution interventions sooner or later, thereby serving to to alleviate issues associated to extreme risk-taking and ethical hazard.