Drumbeat Gets Louder for Nonbank Regulations

Nonbanks have risen in stature and as key players in the global financial system, especially in the wake of the Great Recession earlier in the millennium.

However, hedge funds, private credit entities and FinTechs, along with Big Tech firms, that have become lenders of size and scope may warrant a closer look from regulators, according to bankers.

The Federal Reserve Bank of New York said in a Wednesday (May 21) blog post that banks and nonbanks can forge relationships that include nonbanks “engaging in bank-type strategies,” like when “private credit firms lend to corporations, and money market fund deposits are available on-demand (similar to uninsured deposits).”

“In high-interest-rate environments, if nonbanks find it unattractive to lend due to their high funding costs, banks can offer funds to nonbanks (by extending credit lines, for example) at a lower rate,” the post said. “This transaction is profitable for both parties: nonbanks are able to lend to risky borrowers for a profit — and part of their income returns to banks in the form of interest payments.”

Federal Reserve figures indicate that large banks’ total loan commitments to PE/PC funds are approximately $300 billion, or 14% of large banks’ total lending to nonbank financial institutions (NBFIs), as of the end of 2023. The tally was less than $10 billion in 2013.

Frameworks and Risk

Fernando Restoy, chairman of the Financial Stability Institute, delivered remarks Tuesday (May 27) at an industry conference on financial sector stability during times of macro stress.

“Importantly, there is a clear public policy case to strengthen the regulation of nonbank providers of financial services by introducing entity-specific requirements aimed at addressing the concrete risk they pose for the financial system,” Restoy said in the speech, accessible at the Bank for International Settlements.

But he cautioned in his remarks against “blindly [applying] banking regulations to nonbanks” while at the same time, “there hasn’t been sufficient policy action to introduce entity-based requirements addressing the specific risks posed by entities — such as Big Tech firms —  that uniquely combine the provision of a wide array of financial and non-financial services using shared data and technological infrastructure.”

Key risks are tied to leverage and what Restoy termed “strong interlinkages” with commercial banks.

The View From a Fed President

The comments came after a speech last week from Federal Reserve Bank of Dallas President Lorie K. Logan at the central bank’s Financial Markets Conference in Florida.

In her comments, Logan said economic shocks generally give rise to market participants’ efforts “to transfer large amounts of risk and raise large amounts of liquidity in Treasury and money markets. Such a surge in demand for intermediation requires an elastic supply of intermediation.”

Nonbanks with large and leveraged positions in the market bear watching.

“Buildups of NBFI leverage in trades such as the cash-futures basis can, therefore, be cause for concern if the risks are not managed appropriately,” Logan said.

A midyear 2024 report from the Financial Stability Board indicated that “the global financial system remains vulnerable to further liquidity strains, as many of the underlying vulnerabilities and key amplifiers of stress in the NBFI sector during recent market incidents are still largely in place. It is therefore critical to finalize and implement international reforms to enhance NBFI resilience, so that market participants internalize fully their own liquidity risk — rather than rely on extraordinary central bank and other official sector interventions — and authorities are better prepared for stress events.”

Shocks in the Treasury and commercial paper markets could have an impact on newer segments of finance, particularly stablecoins, whose reserves contain a mix of those holdings to create pegs to the dollar that are sometimes breached.