The links between banks in the euro area and the non-bank financial intermediaries sector are significant and, although they do not currently pose a major risk to financial stability, they create important vulnerabilities that could increase stress in adverse market conditions. This is stated in a joint report by the European Central Bank (ECB) and the European Systemic Risk Board, published today, BTA reported.
Non-bank financial intermediaries are institutions that offer services similar to banks (e.g. insurance, leasing, etc.) but do not have a full banking license.
The risks arising from the links between them and banks are concentrated in a small number of large systemically important banks in the euro area, whose loss-absorbing capacity is key to the stability of the financial system, the report states. Within this interaction, banking institutions perform three roles – liquidity management, provision of leverage and maintenance of market liquidity.
The performance of these functions can lead to the materialization of systemic risks through two main channels. First, if non-bank financial institutions stop or reduce their funding to banks, this can create problems, especially in periods of market stress. This funding is usually short-term and difficult to replace quickly. In the event of a sharp decline in asset prices, investors may ask for their money back, and additional collateral may be required for derivative and repo transactions. As a result, funding to banks may decrease significantly, the institutions warn.
The second risky situation is when banks extend loans to non-bank institutions that use a high level of debt (leverage), they take on indirect risk from their investment strategies. For example, hedge funds borrow funds from banks and use them for short-term trading. If asset prices fall, they may be forced to sell assets quickly, which could lead to a further market decline and losses for both them and the banks.
The report highlights the importance of data and calls for better information sharing and centralized data access mechanisms.