Vulnerabilities of NDFIs

Blog article

Recently, there has been increased attention to Non-Depository Financial Institutions (“NDFI”). For one, the changes to the Call reports, scheduled for December 2024 reporting period, include the revision and addition of certain new data items related to the reporting of credit extensions to NDFIs. This is deemed as an effort to understand the risk and exposures to these entities, which are not, or at least have not been so far, subject to the same degree of regulation and supervision as banking organizations.

In light of this, VERMEG REG DESK revisited a speech given by the chairman of FDIC, Martin J. Gruenberg, in September 2023, in which the chairman explained the risk to financial stability these entities could pose due to the vulnerabilities inherent in their business models. He said that, “When market shocks combine with these vulnerabilities, nonbank financial institutions can transmit risk into other parts of the financial system and seriously hamper the credit and financial intermediation needed to support the economy.” In the speech, Gruenberg focused on four types of NDFI activities and vulnerabilities, which are summarized below.

Open-end funds, which include mutual funds and money market funds, are collective investment vehicles that buy and sell fund shares with investors on a continuous basis. The vulnerabilities of open-end funds, in short, stem from a mismatch between the liquidity of fund investments (longer term) and the ability of investors to redeem shares in a short timeframe, which in times of stress, e.g., rapid redemption request, can create a strain on short-term funding market as happened during March 2020, i.e., the beginning of the pandemic.

Some Nonbank Financial Institutions, such as Hedge funds, exhibit high levels of leverage, increasing their vulnerability to stress events and contributing to financial instability in times of market stress. In addition, since the banks often lend to and have complex relationships with nonbanks, exposing banks and the public safety net to the risks of nonbanks and their financial activities. Hedge funds often use a strategy of high leverage and reliance on short–term funding, which can create risks to financial stability and contribute to a reduction in financial intermediation during periods of market stress.

While Nonbank companies now manage over 55% of U.S. mortgages and while nonbank mortgage originations have increased by 27 percent since 2017, these nonbank mortgage companies typically rely on short–term wholesale funding, operating with limited loss absorbing capacity: mortgage servicing rights, whose value is volatile and highly dependent on models and subjective judgement, typically represent multiples of a nonbank mortgage company’s equity capital. This, coupled with the fact that certain nonbanks such as private credit funds are increasingly lending directly to nonfinancial businesses, exposes them to elevated credit risk. However, the opaque nature of these markets can make it difficult to assess the risks.

Lending Nonbank financial institutions also hold a substantial amount of leveraged loans, which are typically made to high–risk borrowers that have a high level of indebtedness relative to their earnings or net worth, and the financing is often used for buyouts, acquisitions, or capital distributions. These loans are also frequently syndicated and sold, and they serve as collateral for securities issued by collateralized loan obligations, or CLOs. Bank holdings of CLOs, which contain leveraged loans, increased to at least $174 billion in first quarter 2023, up 13 percent from the end of 2021. While banks typically retain the highest–rated securities of CLOs, these holdings expose the banking system to disruption in the underlying leveraged loan market.

In conclusion, Gruenberg stated that nonbank financial institutions have become an integral part of the financial system and are an important source of credit to the real economy but given the lack of transparency in their operations, as well as reliance on excessive leverage and volatile funding sources, consideration should be given to the development of a more tailored process that reduces undue financial system risk while applying prudential regulation and resolution planning requirements that are fit–for–purpose in the context of a particular nonbank financial institution’s risks.

Lastly, with respect to the proposal that would implement the final components of the Basel III capital agreement, i.e., Basel III Endgame, Gruenberg acknowledged criticism that essentially argued that higher capital charges on activities in banks would cause those activities to migrate to the more lightly regulated „shadow banks“ and cause greater risk to the system. To which, he responded, “the obvious response to that is there should be appropriately strong capital requirements for those activities in the banks, complemented by greater transparency, stronger oversight and appropriate prudential requirements for nonbanks. That would be the most effective and balanced way to enhance the stability of the entire financial system.”

For the full speech is available here