SESSION V: Where Do Banks End and NBFIs Begin?

ABSTRACT: Banks and non-bank financial intermediaries (NBFIs) are commonly viewed as substitutes, with banks inside and NBFIs outside the perimeter of banking regulation, and with the recent expansion of the NBFI sector implying a contraction of the banking sector. In combination with the belief that regulation post the Great Financial Crisis (GFC) significantly strengthened the banking system, this view implies that regulators must now focus on systemic risks emanating from NBFIs. We argue instead that the bank and NBFI sectors have interwoven businesses and risks, arising from their endogenous evolution in response to changing economic, financial, and regulatory environments. Therefore, bank risks are better described as having transformed rather than as having migrated to NBFIs. From this alternative perspective, systemic risk regulation must consider the two sectors holistically, rather than separately, and must recognize that banks – in their special role as liquidity providers – are effectively responsible for supporting NBFI intermediation activities through stress conditions. We support our perspective through a variety of data, case studies, and analyses: (i) The Federal Reserve System's new “From Whom to Whom” data show banks and NBFIs finance each other, with NBFIs especially dependent on banks. (ii) Case studies and data show that NBFIs are analogous to bank special purpose vehicles (SPVs) in that banks
remain exposed to credit and funding risks that have seemingly migrated to NBFIs, and that such exposure can be on balance-sheet or off balance-sheet via banks’ provision of significant contingent liquidity to NBFIs. (iii) Theoretical work on fire-sale externalities suggests new mechanisms for risk propagation and amplification via bank-NBFI funding linkages. (iv) Empirical work confirms bank-NBFI linkages through the co-movement of their abnormal equity returns and market-based measures of systemic risk. The paper concludes with implications for macroprudential regulation.