Speech by Ashley Alder, Chair, delivered at the Managed Funds Associations’ Global Summit
Speaker: Ashley Alder, Chair
Event: MFA Global Summit, Le Bristol, Paris
Delivered: 16 May 2023
Note: This is a drafted speech and may differ from the delivered version
- Non-Bank Financial Intermediation (NBFI) is shorthand for much of the diverse and often complex investment and funding markets which aren’t covered by the prudential regulatory frameworks applicable to banks. As public and private debt ballooned amid years of low interest rates and quantitative easing, NBFI grew to represent about 50% of global financial assets.
- Regulators and market participants have access to lots of data to assess risks in the open-ended fund (OEF), Money Market Funds (MMF) and Central Counterparty (CCP) segments of NBFI. However, they don’t have enough data to measure key risks in private investments and funding markets.
- The priority for NBFI regulation should be a global effort to improve the data needed to enable regulators to spot risks in private markets and supervise them credibly.
- This should include a good understanding of hidden on or off – balance sheet leverage, a better assessment of liquidity risks, and better information on exposures between private markets and traditional banks.
I would like to explore the global debate on what used to be called “shadow banking”, but which is now labelled “non-bank financial intermediation”, or “NBFI”. I should begin by pointing out that this change in terminology was made a few years ago because the name “shadow banking” was seen as being too pejorative.
After all, non-bank markets involve large areas of conventional and economically useful financial activity. Many of the firms represented in this room will be involved in these markets. Having said that, I don’t think the name change from shadow banking to NBFI was much of an improvement.
But we are stuck with it for now, and this year the The Financial Stability Board (FSB) and International Organization of Securities Commissions (IOSCO) aim to land on a set of concrete policy outcomes for NBFI that could also have implications for hedge funds, alternatives, and private markets in general.
We are also closely involved in this work. We Co-Chair - with the French Autorité des Marchés Financiers (AMF) - the IOSCO group which is now developing NBFI policy proposals with the FSB.
NBFI and its economic significance
To start with the basics, NBFI is shorthand for much of the diverse and often complex investment and funding markets which aren’t covered by the prudential regulatory frameworks applicable to banks. Of course, these frameworks – such as Basel III – are only designed to govern balance sheet risk in deposittaking firms.
But NBFI covers a vast range of other businesses and activities operating in what might loosely be called market – based finance. This extends to OEFs, MMFs, hedge funds, private equity, pension funds, and even insurers and commodity firms.
The essential characteristic of all NBFI firms is that none take customer deposits. This means that their business models don’t involve the type of maturity transformation – and the specific risks which this gives rise to - on which bank regulation is focussed. Of course, the risks that lurk in some bank business models have become headline news in recent weeks amid a series of failures. More on this later.
The economic significance of NBFI should not be underestimated. As public and private debt ballooned amid years of low interest rates and quantitative easing, NBFI grew to represent about 50% of global financial assets.
One explanation for this shift is that government and corporate debt markets simply grew too large and complex for banks to deal with alone, an outcome that has also been affected by the ways in which bank balance sheets have been constrained by post – 2008 crisis regulation. At the same time the investment funds industry and private markets grew extremely quickly to take up the slack.
The NBFI policy programme
The current NBFI policy programme has its roots in a fairly common opinion held by many central banks and bank regulators that the rules put in place after the 2008 crisis, covering capital, liquidity and resolution, had solved the too big to fail problem for large banks, had minimised the moral hazard associated with bank bail–outs and limited systemic risk.
But it was also felt that many of these risks had migrated from better - regulated banks to NBFI, where similar macro-prudential regulatory standards didn’t operate to address financial stability concerns. The view was that NBFI firms were only subject to investor protection rules, and needed an urgent fix to increase their resilience to financial shocks.
This is the essence of the international NBFI policy programme. The basic aim is to expand financial stability regulation into investment markets. For example, an unusually large number of redemptions in a fund holding illiquid investments, such as real estate or bonds, is seen as potentially equivalent to a destabilising run on a bank. This is why the dash for cash episode back in March 2020 became such a focus for NBFI reform.
Hence suggestions from regulators for liquidity buffers for funds, enhanced liquidity risk management rules, and potential leverage limits, haircuts and margins. As many of you will know AIFMD already requires that managers must demonstrate that the leverage limits set by them for each fund are reasonable and that they always comply with those limits.
However, it is essential that policy makers recognise that investment funds and other NBFI entities are structurally very different to banks, and carry out very different economic functions.
These differences are apparent from the fact that risks in NBFI are often distributed across the balance sheets of end investors rather than being concentrated in NBFI entities. In addition, many NBFI entities act as agents or fiduciaries without assuming balance sheet risk and, apart from MMFs, NBFI investment vehicles do not promise “deposit-like” protection. And of course there is no equivalent to deposit insurance.
They also operate in investment markets where price discovery is a central feature, and where asset prices factor in market risk, liquidity risk, duration risk and default risk.
This means that approaches to bank regulation are of limited relevance to the design of frameworks which might ensure increased resilience within the NBFI sector. NBFI is intrinsically more elastic, which is not a bug, but rather an intrinsic feature of extremely diverse global investment markets.
The current focus of international efforts
So far, not much international work on NBFI has been about their activities in private markets or alternatives. Policy development has instead concentrated on OEFs, with a focus on redemption and liquidity mismatches; MMFs, which invest in illiquid short-term funding markets (STFMs), and derivatives CCPs, focussing on potential pro-cyclicality resulting from large, unexpected margin calls.
All of these reform efforts aim to limit the potential for fire-sales triggered by a cascade of self- reinforcing investor sales into shallow asset markets in response to a stress event.
Why have international efforts focused so much on these entities and activities rather than private markets? I believe it’s because they all share two things in common. First, all of them – OEF’s, MMFs and CCPs - are in fact closely regulated.
Secondly, regulators and market participants have access to lots of data to assess risks in these entities. It’s a far easier proposition to concentrate on entities where there is good information, rather than try to examine risks in far more obscure private markets.
It’s also interesting to reflect on the fact that a key concern of the NBFI policy discussion has centred on potential runs on bond funds amid an interest rate shock. As I said earlier, many had been of the view that banks had been made sufficiently resilient through post- crisis reforms to withstand an interest rate tightening cycle. But look at what we have witnessed over the past couple of months – a series of bank crises.
It’s also striking that, so far at least, we have not seen any major problems in the funds industry or in CCPs. In fact, many bank depositors in US regional banks moved funds into government MMFs as places of relative safety.
The latest banking crisis was centred on a rapid loss of confidence by depositors and clients in some bank business models as higher interest rates worked through the system. And solutions on both sides of the Atlantic involved a combination of government and central bank backstops, write downs of equity and debt, and sales to big banks. Which suggests that moral hazard may continue to be an unavoidable problem.
NBFI risks: recent events
But the fact that the public funds industry seems to have weathered far tighter financial conditions does not mean that we can be complacent about NBFI risks. This is because there have in fact been a number of severe problems in recent months, all taking place in essentially private non-bank investment markets.
Take Archegos, a private fund transacting with regulated prime brokers using total return swap (TRS) derivatives. Take the London Metal Exchange, a regulated trading venue where off – exchange over the counter (OTC) transactions involving banks and commodity producers contributed to market disfunction in nickel markets. And take liability-driven investment (LDI), which centred on the role of repo financing and derivatives intended to hedge long term pension fund liabilities.
For LDI, a severe spike in bond yields triggered a spiral of collateral calls, and forced sales led to serious market dysfunction. This created risks for UK financial stability and market integrity.
This required immediate action from UK regulators to enable fund liquidity to be improved, leverage to be reduced, and to prevent outcomes that could have created further losses for these LDI funds.
The proximate trigger of this event was of course external to the financial system, but the inherent vulnerabilities which amplified the crisis are all too familiar.
The key point is that opaque private markets exhibit vulnerabilities which make it hard to spot and contain problems, including those that may give rise to broader financial crises.
These vulnerabilities include very limited or fragmented regulatory coverage of firms and activities, as well as a lack of risk data being reported to regulators, or being made available to the market. Add to this a cocktail of concentration risks, liquidity risks and synthetic leverage risks, including the use of uncleared bilateral derivatives employing different margining practices.
Examining risks through a different lens
This suggests that NBFI risks should be examined through a different lens than that used to date. OEFs, CCPs, and MMFs are closely regulated, produce quality risk data and, unlike banks, they can use a range of tools to manage investor runs and other risks. For example, OEFs can deploy price-based mechanisms such as swing pricing to eliminate first mover advantage, and resort to gates and suspensions to relieve untoward redemption pressure.
I believe that the right way to assess NBFI risks in private markets should involve three main elements.
- a good understanding of hidden on or off – balance sheet leverage
- a better assessment of liquidity risks
- far better information on exposures between private markets and traditional banks
Among other things this means looking far more closely at investment strategies which involve synthetic leverage obtained via uncleared derivatives contracts. This is where surprise margin calls can result in fire sales when prices gap or liquidity evaporates.
We also need to look at activity which falls outside regulatory or public data reporting requirements, and wholly or partly outside the regulatory perimeter. We also require better insights into large, obscure private markets which are in practice tightly intertwined with the real economy, such as commodities trading.
The problem is that right now we just don’t have enough data to measure key risks in private NBFI markets. And without data, it’s hard for supervisors to oversee how risk management operates in firms and private markets. Archegos and LDI were all good examples of where data was patchy at best, as was risk management within firms.
So, I believe that the priority for NBFI regulation should be a global effort to improve the data needed to enable regulators to spot risks in private markets and supervise them credibly.
This would inevitably be a major undertaking. As I have mentioned there is currently very limited data disclosure or reporting from private markets. Even where we have data, its difficult to see the full picture due to issues with data aggregation.
There are also difficulties when interpreting data to obtain meaningful measures of leverage, liquidity and other risks. Of relevance here are questions about whether assets held in private markets are being valued or marked to market properly as the interest rate cycle turns.
Better data and better data sharing
Nevertheless, there have been recent attempts to capture and analyse relevant data. The FSB is currently conducting a deep dive on NBFI leverage, with a focus on prime brokers, hedge funds and family offices. And IOSCO has been carrying out surveys of leverage in funds, although the resulting data is of very limited value on an aggregate level.
As to derivatives trade repositories, a joint FSB and IOSCO project has completed an analysis of data on equity swaps, recognising that trade repository (TR) data did not provide us with early warning of severe concentration risks in the case of Archegos.
The U.S. Securities and Exchange Commission (SEC) has also announced a decision to adopt amendments to form private funds (PF), with Gary Gensler saying “Private funds today are ever more interconnected with our broader capital markets. They also nearly have tripled in size in the last decade. This makes visibility into these funds ever more important”.
It is clear that action is needed.
We need to enhance reporting from NBFIs, while being conscious of the burden on firms and confidentiality issues for public reporting, and we need better frameworks to assess leverage, both hidden and synthetic.
We also need to ensure NBFI entities more fully disclose their relevant exposures to prime brokers, banks and other regulated firms providing finance or acting as derivative counterparties. Disclosures should be sufficient to enable banks to accurately assess levels of leverage and concentration risks amongst their clients.
All these data requirements are a prerequisite to enable credible stress testing and other risk management disciplines to operate properly across private non-bank activities.
Recommendations included in our recent guidance and recommendations for LDI managers provide a good example of the way forward.
We saw significant deficiencies in risk management across the LDI sector, including stress testing, communications and client servicing, and operational arrangements. Cumulatively, these contributed to market dysfunction and the consequent threat to financial stability.
Although published in response to LDI, our recommendations are relevant to all NBFI firms and sectors.
Regulators also need full visibility of data across different jurisdictions, which for the UK means continued close and positive supervisory cooperation with our counterparts in the EU, both at a national level and with the European Supervisory Authorities.
International regulatory cooperation
This cooperation is crucial in areas in which judicial activity is complex and cross- border.
For example, public statements made at the time of the LDI crisis, in cooperation with the Central Bank of Ireland and Luxembourg’s CSSF, demonstrated the importance and strength of supervisory coordination with our international counterparts.
We have signed several bilateral and multilateral MoUs with European authorities that put our commitments to cooperate on a formal footing and allow us to continue sharing information. We stand ready to continue working with our EU partners, and hopes that the UK Treasury and the European Commission will shortly be able to sign the MoU on regulatory cooperation in financial services.
The bottom line is that we can only manage risks in NBFI and other global markets through close cooperation and data sharing among regulators, international standard setting bodies and wider market participants.
I hope that I have been able to give you a useful insight into the very active NBFI policy debate, including how the focus might shift to the identification of the essential data needed to manage the risks which exist within non-banks and the private markets in which they operate.