This week, the IMF warned of “vulnerabilities” among so-called non-banking financial institutions, saying that global financial stability could depend on their resilience. The Bank of England drew attention to this problem last month.
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Global investors polled by Bank of America pointed to a group of US non-banks as the most likely source of the credit crunch.
What are non-banks and how risky are they?
These are financial firms other than banks that provide all types of financial services, including lending to households and businesses. Non-banks range from pension funds and insurance companies to high-risk mutual funds and hedge funds.
Non-banking assets account for almost half of all global financial assets.
After the crisis, interest rates reached their lowest level, when many depositors and investors turned to non-banks in search of higher profits. As regulators imposed more and more restrictions on bank lending, certain types of borrowers, such as riskier consumers, increasingly turned to nonbanks for funding.
Non-banks that provide loans are known as “shadow banks”, although the term is often used inaccurately to refer to all non-banks.
Shadow banks make up about 14% of global financial assets and, like many non-banks, operate without the same level of regulatory oversight and transparency as banks.
What are the risks?
One of the risks is the possibility of credit losses if corporate borrowers of non-banks begin to declare defaults in the face of a weakening economy.
Another risk is related to the so-called “liquidity mismatch”. Open-ended funds allow investors to withdraw their money quickly, but often have cash associated with assets that cannot be sold quickly enough to return the money to clients.
A rush sale of, for example, government bonds by several funds will reduce the value of those bonds, resulting in losses for other bondholders, which may well include banks. This has already happened when UK pension funds, using the so-called liability-based investment approach, were forced to sell UK government bonds, which collapsed due to a number of circumstances.
“Direct and indirect links between banks and non-banks are not the only sources of system-wide risk. Trust is of the utmost importance in banking, and simply understanding that the banking sector can be linked to struggling non-banks can trigger a wider financial crisis.” writes CNN.