A “perfect storm in the making” sounds more like a sensational newspaper headline than an alert from a quasi-official group of financial experts, and yet, it forms part of the title of a recent report published by the Group of Thirty warning of growing risks in the financial system.
Established in 1978, the G30 is an independent global body comprising economic and financial leaders from the public and private sectors and academia. It is not given to alarmist predictions.
Hung Tran, a former senior official at the International Monetary Fund and the Institute of International Finance, highlights key details from the report in a recent Atlantic Council blog. He says it documents the rapid growth of credit provision by nonbank financial institutions or NBFIs relative to banks, particularly since the 2008 global financial crisis
The report indicates that “financial stability risk has migrated from the tightly regulated banking sector to a sprawling ecosystem of pension funds, insurers, mutual funds, hedge funds, venture capital firms, private credit funds, and other nonbank lenders”, Tran writes.
He points out that documents like the G30 report and the IMF’s latest Global Financial Stability Report have been useful in highlighting the growing and important role of NBFIs in the financial system, especially their role in diversifying funding sources and broadening access to finance.
But he says it’s important to analyse the specific entities and activities that pose a risk to global financial stability, noting that financial crises tend to be triggered by two fundamental risk factors: instability of funding bases and high levels of leverage.
He says financial entities or activities relying on unstable funding to invest in illiquid but high-yielding assets can run into liquidity crises if their clients withdraw their deposits or redeem their shares in those entities.
“Owing to today’s online banking and investing, such events can take place very suddenly and quickly. In addition, entities or activities using high levels of leverage — which magnifies potential losses, leading to margin calls by credit providers and fire sales of assets — can exacerbate market sell-offs,” Tran warns.
“The original failures and sell-offs could then become contagious as financial institutions, including banks and NBFIs, have exposures to the failing entities — in other words, interconnectivity risk. In addition, if these losses surprise market participants, who suddenly realise that previous assumptions about the financial health of entities or the quality of an asset class are wrong, that could trigger sharp market price movements.”
This is cause enough for concern over NBFIs but as Tran observes, they also apply to banks themselves. “Banks remain risky institutions as they engage in high leverage finance, which is intrinsic in the fractional reserve banking system, and depend on unstable funding bases.”
The G30 report highlights the risk to banks due to their interconnections with NBFIs. Banks have also increased their participation in the leveraged loan market, which has seen elevated loan defaults.
The report, Tran says, points out that over 30% of assets in the NBFI sector — which stand at US$260 trillion or more than half of total global financial assets — now belong to pension funds and insurance companies, entities which have stable funding bases.
“On the other hand, hedge funds — whose assets under management are estimated to have reached $5.25 trillion — have become dependent on the overnight repo market to fund their highly leveraged investment positions.”
Tran says the repo market is fragile, vulnerable to tightening conditions triggered by economic, political, and market events, driving up overnight funding rates and causing losses for highly leveraged entities and investment strategies. As a result, the hedge fund ecosystem has increased the risk of instability in the financial system.
