The sector is facing three main vulnerabilities

Non-Bank Financial Intermediaries were thrust into the spotlight once again this year following the recent turmoil in the banking sector. The main concerns arise from the lighter regulations and consequent lack of data and estimation of their risk exposure. While it remains difficult to clearly assess the sector’s exact exposures, international institutions identify three main risk factors stemming from the current state of the sector namely: financial leverage, liquidity risk and interconnectedness.

1. High financial leverage in times of lower interest rates

Low interest rates in recent years and asset price volatility incentivised investors to use leverage to boost returns. However, the level of vulnerability from leveraging has proved to be difficult to estimate both for authorities and market participants. The significant lack of data makes a concrete estimation of the risk challenging. Furthermore, the IMF has stressed that financial leverage used by NBFIs comes in many forms, such as the use of repurchase agreements, margin borrowing in prime brokerage accounts, or synthetic leverage associated with the use of various financial derivatives (like futures and swaps).

The recent focus on the use of leverage comes from the increased risk of financial distress due to the higher vulnerability to sudden changes in asset prices as interest rates increase rapidly. This may force NBFIs to de-lever, amplifying the initial price decline, with the gilt crisis being a case in point. The graph below from the IMF highlights well the recent increase in the use of synthetic leverage (where banks and NBFIs are lumped together), hence the growing vulnerability to sudden interest rate shocks.

The proxy for synthetic leverage shows an increase in leverage use by banks and NBFIs since 2016

The use of leverage dropped between 2018 and 2020 before spiking again until 2021 and stabilising today