2. A lack of liquidity could exacerbate financial market stress

Liquidity risks can come in different shapes and forms. In its 2023 Financial Stability Report, the IMF highlights several types of NBFI vulnerabilities linked to liquidity.

NBFIs tend to have a liquidity mismatch by holding relatively illiquid assets while sometimes allowing investors to redeem shares daily. This practice is not new as pre-2008, shadow banks were already making use of such a mismatch. The recent evolution in the sector highlights an increase in the liquidity mismatch of the assets held by NBFIs. Looking into the vulnerability measure capturing weighted average funds owning an asset and defining liquidity as the portfolio-level bid-ask spread across funds, the following graph from the IMF clearly highlights this point. It shows the spike in vulnerability to liquidity mismatches as Covid hit but also the more recent increase. While not as significant as the spike seen during the pandemic, recent trends are a reminder that the sector is still vulnerable to changes in liquidity, which can often worsen in times of stress

Average liquidity mismatch has increased since the Covid crisis

The liquidity mismatch index, which spiked in 2020 and again over 2022, is now showing a decline

Furthermore, the combination of financial leverage and lack of market liquidity can lead to a decline in asset prices and a deterioration of funding liquidity (liquidity spiral). For most NBFIs, there is a risk that investors withdraw funds, especially when asset values drop, although for some there may be notice periods to negotiate. For example, hedge funds traditionally have a lockdown period under which there can be no withdrawals. If enough forced selling occurs, it adds to the pressure on the asset side, resulting in something of a death spiral.