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Executive summary
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at a very aggregate level and provides only a picture, from the banking sector's perspective, of the
connectedness of the latter with non-bank financial institutions but not, from the non-bank
financial institutions’ perspective, of connectedness of non-bank financial institutions with
themselves or with the banking institutions.
The study advises to accompany the broad sectoral monitoring by a monitoring of the evolution of
various asset classes or activities such as: (i) derivatives (using data from the BIS), (ii) securitised
assets (using data from AFEME), (iii) repos (using data from ICMA), (iv) securities lending (using
data from Data Explorer), and (v) central counterparties' exposures (using data from the central
counterparties).
1
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Introduction
1
1
Introduction
1.1
Background
The financial crisis severely affected the financial system with the banking sector at the centre of
the crisis, experiencing significant losses. In response to this, governments focused on providing
substantial rescue measures with the aim of restoring financial stability.
However, non-bank financial institutions (NBFI) also played an important role in the build-up and
transmission of risks leading up to the financial crisis. As a result, since the onset of the financial
crisis, policy-makers have focused on gaining a better understanding of the nature and role played
by NBFIs and their potential contribution to systemic risk. The literature identifies four key-risk
originating and transmission channels.
Firstly, NBFIs generate product risk through the production of structured products, especially
involving securitisation. The recent financial crisis has clearly shown that, due to a lack of
understanding of the risks embedded in a number of securitised assets, many banks and NBFIs
held assets that turned out to be much more risky than originally thought, such as for example
various mortgage structure products. On the eve of the financial crisis, these holdings represented
a substantial build-up of risks threatening financial stability.
Secondly, some NBFIs are highly inter-connected with banks and other non-bank financials. This
inter-connectedness implies that financial distress at the level of an individual non-bank financial
institution can transmit to other financial institutions (banks and non-banks), via counterparty risk,
generating distress at the level of the financial system as a whole.
Thirdly, some NBFIs were very large. Any financial distress at one of these institutions (the
'distressed institution') may also result in financial distress at the level of the financial system.
Market participants may be uncertain as to the
extent
to which
the distressed institution is
connected to other financial institutions and creates risks for the latter. As a consequence,
uncertainty, or mistrust, affects the financial system as a whole as many financial institutions could
pose counterparty risk.
Fourthly, in instances in which NBFIs experience distress or fail altogether, the liabilities of that
non-bank financial institution held by other financial institutions have to be written down. For
NBFIs such as pension funds and other investment funds, there are two consequences. Firstly,
there is the direct effect of the loss in value of some of the assets held. Secondly, many pension
funds will not invest in non-AAA-rated assets. Other funds may advertise to customers that they
only hold high-grade assets. Thus, if these assets are downgraded, they have to be disposed of,
which puts further downward pressure on their prices. This in turn will affect the balance sheets of
all financial institutions holding such assets.
So-called fire sales of assets also occur when some financial institutions (banks or non-banks) find
themselves liquidity constrained and dispose some of their assets rapidly. Typically, such a course
of action tends to depress the price of these assets, and thus, generate a negative feedback loop
to all institutions holding such assets if the latter are held for trading or are for sale (i.e., have to be
marked to market).
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