Practices, but also accounting rules, have their influence on the behaviour of banks and the non-banking sector, two complementary but competing segments. Regulation also has its role. Hence the need to think about regulation for non-banks.
The financial system, which matches the financing capacities of some with the needs of others, consists of banks and financial markets. These two components of the system have partly identical and partly separate roles. Both help finance economic players. Market finance has seen a sharp increase in its share worldwide since the great financial crisis. It now accounts for around 50% of financing in general, and 30% in the corporate sector. It is also useful that investment funds, asset managers and institutional investors, major players on the financial markets, take part in financing. Because banks alone cannot guarantee the full amount to be financed.
Markets accept risks denied by banks
In addition, they can provide capital to companies that find getting finance from banks more difficult, including start-ups and innovation in general. Explanations: the credit risk of these sectors is generally too high for banks, which must protect the deposits entrusted to them. Investment funds may accept that they may lose more, if on average capital gains on companies that will survive and succeed are greater than losses, with the final risk being taken by end investors who accept it.
The two types of player in the financial system are also different in terms of financial stability. Firstly, because banks record the historical value of the loans they grant on their balance sheets. They must provision for the risk on a statistical basis, but also on a case-by-case basis depending on their assessment of a possible deterioration in each borrower’s ability to repay. However, changes in average opinions on risk quality are not taken into account and do not result in any accounting changes.
A different approach to risk
The approach is completely different for funds: they must record the change in the market value of their financial investments at each point in time, in accordance with fair value accounting rules. This leads to a significant difference in behaviour between banks and funds. Banks choose to grant credit based on their analysis of the borrower’s ability to repay over time. For their part, funds choose to buy bonds, for example, based on what they think about changes in the market’s majority view on the value of the risk premium allocated to the borrower. Why lend if they think the value of the bond will fall in the near future, even if they are not ultimately worried about non‑repayment? Unless strongly conditioned by the prospect of securitisation of the loans granted or the resale of risks by CDS, banks’ behaviour is therefore much more stable by nature than that of funds, whose valuation mechanisms are much more volatile, since they are much more related to self-referential behaviour on the markets.
On the other hand, funds do not take on financial risks themselves. Credit, interest rate and liquidity risks are in fact left in the hands of end investors, households or companies. In the case of banking intermediation, banks bear these risks on their own income statements. And they do so in a professional, regulated and supervised manner. This allows households and businesses not to take these risks if they do not have the competence or the desire to do so.
Increased risk-taking from very low rates
Banks and non-bank financial intermediaries such as funds are therefore both very useful, both competitive and complementary. But the portion granted to each in the global financial system plays a major role in overall stability or instability. We should add a fundamental point, which the major central banks are currently addressing. Since the financial crisis of 2007-2009, the regulation of banks has increased significantly, notably through the required capital adequacy ratios (more equity for identical risks) and the setting of restrictive ratios limiting liquidity risk. There is no such regulation for non-bank financial intermediaries.
However, the monetary policy of very low interest rates for a very long time has gradually led financial players, on behalf of savers, to seek returns by increasingly taking on risk. In terms of credit risk -including increasingly high leverage effects- with squashed risk premiums. And in terms of liquidity risk, by further extending the maturities of credit securities and lowering the expected level of their liquidity. This has made fund assets significantly more vulnerable, as highlighted by all the studies of organisations responsible for supervising financial stability around the world. The risk can thus be pushed out of the banking system and onto non-bank financial agents, without control.
Beware of moral hazard!
The violent financial crisis of March 2020, triggered by the expected impact of the pandemic, was fortunately brought swiftly under control by the central banks. They acted very strongly and very quickly. In this regard, it demonstrated the resilience of banks, but also the vulnerability of many funds. Central banks had to buy very large amounts of securities from funds in difficulty, including high yield. They had to prevent a catastrophic chain of events, due in particular to sudden withdrawals from end investors that these funds could not absorb without incurring excessive losses or without a major liquidity crisis.
Prudential and macro-prudential regulation cannot do everything, but it is essential to mitigate the natural procyclicality of finance and to prevent the risk of financial instability as much as possible. It must now be extended and adapted to non-banking financial intermediaries. It is also essential to combat moral hazard, because without preventive regulation and with bail-outs during major crises, risk-taking may be ever higher, with no limit or almost, thanks to a free option given by central banks against serious incidents. Finally, the proportion between banks and non-banks in the financial system as a whole must also be subject to adequate analysis and policies to determine the most favourable balance for both growth and financial stability.