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Non-banks need higher capital, liquidity buffers says BIS

Investment funds should be subject to tougher rules more like those applied to banks as they could destabilise markets in times of market crisis, claims the Bank for International Settlements (BIS) in its latest quarterly review.

The Basel, Switzerland-based BIS, which provides a forum for central banks, notes that non-bank financial institutions (NBFIs) – including hedge funds, mutual funds, money market funds, pension funds and insurance companies – have grown rapidly and now collectively account for half of global financial activity.

Policymakers have not kept pace with this growth in regulating NBFIs as they have increasingly filled the gap created by the withdrawal of more heavily regulated banks to ease capital requirements, claims the BIS review. “A systemic approach to regulating NBFIs is the key to better addressing their structural vulnerabilities, notably liquidity mismatches and hidden leverage, and building adequate shock-absorbing capacity,” the review comments.

“When leverage is an issue, less stress-sensitive margining practices and, above all, higher and usable capital buffers will help.”

Tested by Covid

Central banks injected emergency liquidity into markets in March 2020, when the first wave of Covid-19 created a global pandemic and economies went into lockdown, threatening a freeze for money market funds.

“Such repeated occurrences suggest that the status quo is unacceptable,” says BIS General Manager Agustin Carstens in the review. “Fundamental adjustments to the regulatory framework for NBFIs are called for, to make it fully fit for purpose.”

The review also focuses on open-ended bond funds and recommends that regulators should strengthen lines of defence to reduce systemic risk in times of market volatility. It notes that as the impact of the pandemic spread in 2020, bond funds dumped assets to keep up with investor redemptions, thereby worsening already-poor liquidity and pricing pressure.

Conditions improved only after authorities had moved to backstop bond markets. “This episode has sparked a discussion about bond OEFs’ resilience, the comprehensiveness of their liquidity management tools, especially in times of stress, and the tools’ adequacy for financial stability more broadly,” economists Stijn Claessens and Ulf Lewrick write in the report.

Among several recommendations, Claessens and Lewrick suggest that liquidity buffers could be expanded during times of ample funding and released during periods of stress. More stringent regulation could ensure that liquidity mismatches are adequately managed.

“Regulation that takes a macro-prudential perspective of the sector could support financial stability by ensuring that tools internalize the effect of spillovers arising from bond OEFs’ actions,” the authors add. 

Industry resistance

The BIS’s recommendations will not be welcomed by the funds industry, which has resisted calls for it to be regulated like banks and retorts that there were stresses across the financial system in 2020 and that stricter regulation would make some of them unviable.

But global regulators have already set out recommendations for money market funds, and the BIS recommendations will influence thinking among central banks and securities watchdogs over what measures, if any, are needed for the broader NBFI sector.

“Given the increasing role that the NBFI sector plays in the market ecosystem, it is now important to apply a macroprudential approach to it as well," the BIS review states.

“The ultimate objective is to build individual NBFIs’ war chests in good times in order to mitigate collective retrenchment in times of stress.”

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