Thank you very much for giving me the opportunity to speak with you this afternoon.
I would like to share with you today some thoughts on the financial stability risks posed by nonbank financial institutions (nonbanks).
Nonbank financial institutions are critical intermediaries in the U.S. financial system, alongside traditional banking organizations. The Financial Stability Board of the G-20 countries estimates assets of U.S. nonbank financial institutions totaled roughly $20.5 trillion in 2021, compared to $23.7 trillion in assets held by U.S. insured depository institutions. This represents around 30% of nonbank assets globally.1
Prior to the bank failures and broader market stress we experienced this past spring, the U.S. had experienced two significant economic stress events in recent years: the Global Financial Crisis of 2008 and the COVID–19 pandemic beginning in 2020. While very different events, both had a significant impact on the global economy and financial sector. Both necessitated extraordinary fiscal and monetary policy support to avoid a financial collapse. In response to each event, both banks and nonbanks benefitted from this extraordinary public support.
Yet, notwithstanding multiple rounds of fiscal and monetary policy support to both banks and nonbanks in crisis circumstances, the regulatory landscapes in which they operate remain quite different. Since nonbanks do not have direct access to the public safety net, they are generally not subject to the same degree of regulation and supervision as banking organizations. As a result, they often have less transparency in their operations, as well as reliance on excessive leverage and volatile funding sources.
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. This includes banking organizations, which often interact directly with nonbanks by providing funding to support nonbank activity. The resulting interconnections may amplify market stresses through feedback between the two sectors.
In my view, careful attention needs to be given to these issues.
In my remarks today, I will discuss what is meant by the term nonbank financial institution, some of the risks posed by the institutions encompassed by that term, and options for beginning to address the financial stability risks they pose.
Definition of Nonbank Financial Institutions
To begin, it is important to define what is meant by the term “nonbank financial institution.” The Financial Stability Board provides a broad definition of a nonbank financial institution to mean any financial institution that is not a central bank, a licensed bank, or a public financial institution such as the World Bank. It also provides a narrower definition that is further limited to include financial institutions involved in credit intermediation activities that may pose financial stability risks, such as through maturity or liquidity transformation, leverage, or regulatory arbitrage.2
For purposes of my remarks today, I will focus on several categories of nonbank financial institutions that play large roles and can present significant risks to the financial system. These include open-ended mutual funds and money market funds, leveraged investment vehicles such as hedge funds, and nonbank lenders. There are many other nonbanks that play important roles in our financial system, such as financial technology (or FinTech) firms, securitization vehicles, and insurance companies, to name a few. If this list sounds familiar — it should — in the aftermath of the Global Financial Crisis, these nonbank financial institutions were commonly referred to as "shadow banks."
Nonbanks in the Global Financial Crisis and the Pandemic
Nonbank financial institutions were major contributors to the financial instability that led to the Global Financial Crisis of 2008.3 According to the findings of the U.S. Financial Crisis Inquiry Commission, certain nonbanks contributed significantly to the crisis because they were allowed to freely operate in the capital markets with insufficient regulation, no transparency requirements, and no limits to their reliance on leverage.4 In addition to providing public support to the traditional banking system, the Federal Reserve also was compelled to utilize Section 13(3) of the Federal Reserve Act to provide emergency lending facilities on an expansive and open institution basis to support nonbank financial institutions.5
The systemic risks nonbanks pose to the financial system were again evident when the COVID-19 pandemic first hit the United States in early 2020. Liquidity vulnerabilities similar to those that fueled the Global Financial Crisis resulted in severe market dislocations in March 2020.6 As this series of events unfolded, it resulted in significant outflows from money market mutual funds and liquidity pressures on other nonbanks, such as highly leveraged hedge funds, which further pressured U.S. Treasury and short–term funding markets. This caused extreme volatility throughout the financial markets that was further magnified by the high levels of leverage and fragility at some nonbanks. In response, the Federal Reserve once again utilized emergency lending facilities in order to support nonbanks and stabilize the financial system.7
The experience with nonbank financial institutions through these two crises underscores the financial stability risks they can pose, the resulting claim they have on public support, and the urgent need to give careful consideration to how to address those risks.
Open-End Mutual Funds and Money Market Funds
I would like to start with a discussion of open–end mutual funds and money market funds, both of which are key components of the nonbank landscape and play important roles in the provision of credit to the U.S. economy. 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. Many open–end funds are participants in important funding markets and, at times, have contributed to market stress, as demonstrated most recently in March 2020.8
One of the structural vulnerabilities that arise from certain open–end funds is the potential mismatch between the liquidity of fund investments, which may be longer term, and the ability of investors to redeem shares in a short timeframe.9 This potential liquidity mismatch, particularly in times of stress, in some types of open–end funds can give rise to a desire by investors to redeem shares more expeditiously, including taking a “first mover advantage.”
In March 2020, open–end funds experienced heightened liquidity pressure and valuation challenges as they faced large redemption requests. The Federal Reserve's emergency lending programs were put into place to help restore confidence and proper market functioning,10 providing support for key markets that open–end funds invest in.11
Mutual funds may invest in a range of financial products including fixed income and equity securities. Money market funds, which are a type of open–end fund, serve an important role in short–term funding markets by purchasing high–quality, short–term debt securities to provide yields reflective of short–term interest rates for investors. But money market funds also exhibit structural vulnerabilities that can create or transmit stress to short–term funding markets in the event of rapid redemptions. For example, while government money market funds saw significant inflows during March 2020, prime money market funds that invested in corporate debt faced significant outflows amid increasingly illiquid markets.12 These outflows resulted in a significant strain on financial and nonfinancial borrowers that were reliant on issuing commercial paper and led to these borrowers drawing down their revolving credit facilities, thus creating more strain on the providers of these credit facilities.13 Significant credit and liquidity support was again needed from the Federal Reserve to mitigate the impact and return order to financial markets during this time.14
As part of addressing challenges that emerged from past crises, the U.S. Securities and Exchange Commission (SEC) recently proposed amendments to its current rules for open–end management investment companies to better prepare open–end funds for stressed conditions and to lessen the dilution of existing shareholders' interests. The amendments call for enhanced liquidity risk management, the implementation of liquidity management tools, and more timely and detailed reporting of fund information.15 Additionally, in July 2023, the SEC finalized a rule designed to improve the resilience and transparency of money market funds by increasing minimum liquidity requirements, removing provisions allowing for temporary suspension of redemptions, requiring certain funds to implement a liquidity fee framework, and enhancing fund reporting.16
Leveraged Investment Vehicles and Bank Interconnections
Some nonbank financial institutions continue to exhibit high levels of leverage, increasing their vulnerability to stress events and contributing to financial instability in times of market stress. In addition, 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.
According to the Bank for International Settlements, “While the types of NBFIs and the size of banks’ exposures to NBFIs vary across jurisdictions, these exposures are growing in size and have the potential to cause further financial stability concerns.”17 In the United States, bank lending to nonbanks has grown rapidly over the past five years, and grew at an annual growth rate of 22% in 2021 compared to an annual growth rate of 8% in 2017.18 During times of stress, nonbank liquidity providers may be particularly vulnerable, impeding their ability to sufficiently intermediate markets.19
Hedge funds are a type of nonbank that often employ 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.
The Financial Stability Oversight Council (FSOC) Hedge Fund Working Group found that hedge funds were among the three largest sellers of Treasury securities by category in March 2020 along with foreign institutions and open–end mutual funds, and that they materially contributed to the Treasury market disruption during this period.20
Treasury markets typically act as a 'safe haven' in periods of stress. However, in March 2020 this market experienced stressed conditions as investors attempted to sell highly liquid assets to meet cash needs arising from requirements to meet redemption requests and margin calls, as well as to unwind leveraged positions.21 For example, financial turbulence and elevated volatility led to issuance of large margin calls by central counterparties, impacting the liquidity of clearing member banks and their clients. Unexpectedly large margin calls can affect market participants differently depending on the size of their positions and level of liquidity preparedness, with greater impact on financial companies with leveraged positions, such as hedge funds.22
Moreover, risks taken by leveraged nonbank financial institutions are interconnected with the banking sector through lending arrangements and derivative transactions. As mentioned, bank lending to nonbanks has increased notably in recent years, leading FSOC to recommend in its 2022 Annual Report that the U.S. banking agencies closely monitor bank exposures to nonbanks and assess how banks manage their exposure to leverage in the nonbank financial sector. As an example of the risk nonbanks can pose to banks, Archegos Capital Management—a family office employing leveraged strategies also used by hedge funds—transmitted material stress to a number of large financial institutions. The collapse of Archegos Capital Management illustrates the underappreciated and deeply embedded risks in the U.S. and global banking systems from nonbank financial institutions that need to be addressed.23
Non–Bank Lending and Financial Services
I want to touch briefly on the impact nonbank financial institutions are having on the broader provision of financial services. The 2022 FSOC Annual Report discusses how certain nonbanks are increasingly providing traditional banking services.24 This is particularly true in the case of mortgage finance, business lending, and certain consumer finance activities.
An example, as noted in the 2022 FSOC Annual Report, is the increasing shift of mortgage servicing activity out of the banking sector and into nonbank mortgage servicing companies. Nonbank companies now manage over 55 percent of U.S. mortgages compared to just 11 percent in 2011 – a five–fold increase in a decade. Nonbank mortgage originations have increased by 27 percent since 2017 and now account for approximately two–thirds of all mortgage originations.25 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.
Additionally, certain nonbanks, such as private credit funds,26 are increasingly lending directly to nonfinancial businesses. This activity has accounted for a growing segment of business lending with estimates of the market at roughly $1.2 trillion globally as of year–end 2021, up from roughly $600 billion five years earlier.27 The opaque nature of these markets can make it difficult to assess risks as they build, a potential concern for lending activity that is typically characterized by elevated credit risk.
Nonbanks, including FinTech firms, are becoming increasingly active participants in consumer financial services as well. Some new nonbank entrants into consumer financial services offer their products entirely or mostly online. Significant nonbank providers of consumer financial services include firms that partner with banks to offer credit cards or take deposits.
Bank–like services operated outside the regulated banking environment, such as those just described, can pose opaque risks and interconnectedness that could adversely affect the safety–and–soundness of banks or result in consumer harm. If a nonbank financial institution conducting these activities is sufficiently large or otherwise serves critical functions, systemic risk issues could be implicated. It is important that the FSOC has renewed its efforts to review the risks in these sectors and to consider whether our current regulatory authority is sufficient to address them.
Nonbanks and Leveraged Lending
It is worth mentioning that nonbank financial institutions also hold a substantial amount of leveraged loans. Leveraged loans 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.28 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 2021.29 While banks typically retain the highest–rated securities of CLOs, these holdings expose the banking system to disruption in the underlying leveraged loan market. Banks also have a variety of exposures to nonbank financial institutions that hold or arrange CLO securities. These interconnected risks may expose banks to stress in the underlying leveraged loan market in ways that are difficult to measure.30 The 2022 interagency Shared National Credit Program review found that credit risk associated with leveraged lending remains high.31 The report noted that many leveraged loans have weak structures that often reflect some combination of high leverage, aggressive assumptions about repayment, or weak covenants.
These weak structures have not been tested by a prolonged downturn in the economic cycle or through a normal business cycle. Given these facts, the opaque interconnected exposures between banks and nonbanks that hold leveraged loans are concerning and also worthy of attention.
In the aftermath of the Global Financial Crisis, Congress included in the Dodd–Frank Act a set of authorities for regulators to use in response to the systemic risk posed by nonbank financial institutions. This includes the ability of the FSOC to instruct the Office of Financial Research to collect information on nonbanks, designate systemically important nonbanks to be supervised by the Federal Reserve, and designate systemically important financial market utilities and payment, clearing, and settlement activities for additional risk–management requirements. These authorities may serve as a basis to address the systemic risk concerns presented by nonbank financial institutions – namely the lack of transparency, prudential supervision, and controls on the use of leverage.
In February 2022, the FSOC issued a statement on nonbank financial institutions, announcing the re–establishment of its Hedge Fund Working Group, the establishment of a new Open–end Fund Working Group, and a statement of support for the efforts underway by the Securities and Exchange Commission to reform money market funds and strengthen the short–term funding markets.32 In addition, the 2022 FSOC Annual Report encourages regulators to coordinate closely to collect data, identify risks, and strengthen oversight of nonbank companies involved in the origination and servicing of residential mortgages, and FSOC renewed a working group to review the risks and possible regulatory responses.33
In April 2023, the FSOC published for comment a proposed analytical framework to explain how the Council typically identifies, assesses, and addresses potential risk to financial stability. This framework, which details common vulnerabilities and transmission mechanisms through which shocks can arise and propagate through the financial system should inform the FSOC's work to review the nonbank issues I have discussed today.34
In addition, in April 2023, the FSOC proposed new guidance for how it would review whether to use its authority to designate nonbanks as subject to heightened supervision and resolution planning requirements. The revised guidance would remove several constraints to FSOC designation, while retaining a multistage, deliberative process with opportunities for firm engagement.
It is worth keeping in mind that nonbank financial institutions are not banks. In the past, one of the impediments to the FSOC's nonbank designation process has been the perception of its binary nature. That is, once a nonbank receives an FSOC designation, it moves from little or no prudential regulation to full regulation in the same manner as a financial holding company.
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.
Further, and I would particularly underscore this point, availability of information about the risks undertaken by a variety of nonbanks is severely lacking. Financial transparency and the transmission of information between market participants helps ensure a robust, safe financial system. The FSOC, the Office of Financial Research, and individual FSOC agencies should work together to establish a reporting framework to ensure that the FSOC has appropriate information to assess the financial stability risks of nonbanks and the activities in which they engage, and to ensure that public reporting is sufficient for market participants to appropriately understand the counterparty risks associated with individual nonbank financial institutions.
Before closing, I would like to make one final point. As you know, the federal banking agencies recently issued a proposal that would implement the final components of the Basel III capital agreement. This proposal seeks to increase the strength and resilience of the banking system by promoting strong levels of capital at the largest banking organizations available to absorb losses. I look forward to receiving feedback during the comment period.
Some have criticized the proposed higher capital requirements for large banks, arguing 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. 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.
In conclusion, nonbank financial institutions have become an integral part of the financial system and are an important source of credit to the real economy. Banks and nonbanks need to be seen as an interconnected whole and overseen accordingly. A comprehensive strategy utilizing the authorities of individual agencies and the FSOC is needed to address the financial stability risks posed by nonbank financial institutions.
The experience through financial crises in 2008 and 2020, in which extraordinary public support was provided to nonbanks on an open institution basis, underscores the urgency of this issue.
5 For example, the Federal Reserve provided liquidity directly to key credit markets through the Commercial Paper Funding Facility (CPFF), the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF), the Money Market Investor Funding Facility (MMIFF), and the Term Asset-Backed Securities Loan Facility (TALF). See https://www.federalreserve.gov/monetarypolicy/bst_crisisresponse.htm; https://www.newyorkfed.org/medialibrary/media/research/epr/2013/0713adri.pdf; and http://fcic-static.law.stanford.edu/cdn_media/fcic-reports/fcic_final_report_full.pdf.
11 For example, programs like the Primary and Secondary Market Corporate Credit Facilities (PMCCF and SMCCF) enabled the purchase of corporate bonds issued by certain U.S. companies, helping to ease credit conditions. Similarly, the Commercial Paper Funding Facility (CPFF) provided liquidity to U.S. issuers of commercial paper.
12 Prime money market funds generally hold a variety of taxable short-term obligations issued by corporations and banks, as well as repurchase agreements and asset-backed commercial paper. See https://www.sec.gov/files/mmf-statistics-2023-07.pdf
14 This included establishment of the Money Market Mutual Fund Liquidity Facility which made loans to eligible financial institutions secured by assets purchased from money market mutual funds. See https://www.federalreserve.gov/monetarypolicy/mmlf.htm
26 Private credit funds generally provide direct lending and/or invest in debt instruments of private borrowers and issuers.
28 S78 Fed. Reg. 17766 (March 22, 2013).