SPEECH
Towards a stronger non-bank financial sector
Speech by Luis de Guindos, Vice-President of the ECB, at the
Association for Financial Markets in Europe (AFME) and Official
Monetary and Financial Institutions Forum (OMFIF) 3rd Annual
European Financial Integration Conference
Frankfurt am Main, 23 May 2023
In recent years, the global economy has been hit by a series of unprecedented shocks - including a
pandemic, the outbreak of war, and an energy crisis. And with geopolitical tensions on the rise, we may
see the frequency of such shocks even increase.
The prospect of an increasingly shock-prone economy means that it has never been more important to
ensure the financial sector is resilient to challenges that come its way. And today, I would like to share
some thoughts on financial integration in the euro area, focusing on the important role of the non-bank
financial sector in the euro area financial system.
The importance of the financial system for the economy
A strong and integrated financial system is essential to support the growth and resilience of the euro area
real economy.
Well-developed and broad capital markets can help to efficiently allocate capital to the most innovative and
productive companies, thereby contributing to economic growth. Market-based finance also allows
companies to diversify their funding sources and facilitates increased cross-border funding. This can result
in greater risk-sharing across the euro area and contribute to overall financial resilience. Investment funds,
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for instance, play an important role in financial integration.[ However, if we are to strengthen the euro
area financial sector's capacity to attract and intermediate funding for euro area companies, we must
make further progress on the banking union and continue to develop the capital markets union (CMU).
The CMU seeks to integrate national capital markets into a genuine single market, in turn making
financing more accessible to EU companies and transforming Europe into an even more attractive place to
save and invest. Consequently, this means scaling up market-based financing in the EU, leading to a
larger role for the non-bank financial sector than is already the case.
The changing role of market-based finance in the euro area
It has been almost ten years since the Financial Stability Board published its policy recommendations on
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strengthening the oversight and regulation of the non-bank financial sector.[ And since then, we have
seen the sector grow significantly.
In the euro area, the combined total assets of investment funds, money market funds (MMFs), insurance
corporations, pension funds and financial vehicle corporations have doubled since the global financial
crisis from €15 trillion to €31 trillion.
The sector has become increasingly important in financing the euro area real economy in recent years. As
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a share of credit granted by all financial institutions[ ], credit granted by non-banks to euro area non-
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financial corporates has almost doubled since 2008, from 15% to 26% at the end of last year.[
The growing role of non-banks offers the benefit of diversifying sources of finance and can thereby help to
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ensure a smooth provision of funding to the real economy.[ Evidence also suggests that a higher share of
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non-bank finance can help economies to recover faster from recessions,[ when banks' ability to lend may
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be impaired.[
Crucially, however, the benefits of this diversification rely on making sure that the non-bank financial sector
provides a stable source of funding, ensuring robust financing for companies in both normal and stressed
market conditions.
Liquidity and leverage - lessons from recent market events
As the market footprint of non-bank financial institutions increases, new risks and vulnerabilities can arise.
Let me discuss three in particular.
First, the strong growth of the non-bank financial sector - especially the asset management industry -
over the past 15 years has been accompanied by an increase in liquidity mismatches.
A key contributing factor is that investors in open-ended funds - which account for the largest part of the
investment fund sector - can typically redeem their shares on a daily basis without prior notice. This
creates a liquidity mismatch especially in funds that invest in relatively illiquid assets, such as high-yield
corporate bonds.
Liquidity demand has become more procyclical as a result, especially during periods of financial market
stress. During the pandemic, we saw how liquidity mismatches in open-ended funds increased demand for
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market liquidity, which amplified stress in financial markets.[
The second vulnerability in the non-bank financial system relates to financial and synthetic leverage, which
can amplify shocks and create spillover risks for banks.
We saw an example of this with Archegos Capital Management, which defaulted on its losses from
leveraged equity trades in March 2021. The fact that Archegos used total return swaps to generate
synthetic exposures highlights another challenge in identifying leverage, as leverage can be embedded in
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derivative exposures.[ While the Archegos default had only a limited impact on the broader financial
system, the event nevertheless highlighted possible contagion channels to banks through the provision of
synthetic leverage by prime brokers.
The third vulnerability in the non-bank sector results from an insufficient preparedness to meet large
demand for liquidity, especially from margin calls - as the recent stress episode in the UK pension fund
sector has highlighted.
In the United Kingdom, pension funds had made extensive use of leveraged strategies to hedge long-term
interest rate risk and free up capital to generate higher returns in their investment portfolios.
Many smaller pension funds had pooled their hedging activities in liability-driven investment (LDI) funds.
But a sudden increase in UK government bond yields in September 2022 led to large valuation losses and
margin calls, which meant these funds had to deleverage and raise additional cash from their pension fund
trustees.
As a result, pension and LDI funds were forced to sell assets, including gilts, which amplified gilt market
movements and liquidity stress. And in response, the Bank of England had to intervene on financial
stability grounds through temporary purchases of long-dated UK government bonds.
While these new risks and vulnerabilities are evident, the non-bank financial sector has remained largely
stable in recent months, despite the stress in the banking sector that emerged in March.
Fund investors shifted their exposure from higher to lower risk assets, especially from high-yield corporate
to government bond funds. Portfolio de-risking has also been evident in insurance corporations and
pension funds, as higher interest rates have reduced incentives for the non-bank financial sector to search
for yield.
But there are no grounds for complacency here. Structural vulnerabilities from liquidity mismatches and
leverage remain elevated despite recent de-risking. Moreover, bank and non-bank financial institutions can
be closely interconnected through funding channels, ownership linkages and common risk exposures.
The non-bank financial sector remains particularly exposed to asset price corrections and credit risk
should corporate sector fundamentals deteriorate substantially. In addition, non-banks' exposure to
property markets has increased markedly in recent years, rendering institutions vulnerable to ongoing
price corrections in real estate markets. Fragile risk sentiment and elevated vulnerabilities in parts of the
non-bank financial sector could amplify negative shocks.
Strengthening the resilience of non-bank financial intermediation
Given the vulnerabilities in the non-bank financial sector, it is vital to further enhance its resilience, also
from a systemic perspective.
To date, the macroprudential policy framework has mainly focused on the banking sector, while the policy
framework for non-bank financial institutions still needs to be enhanced. This means that there are fewer
safeguards for non-banks, and risks can grow largely unchecked.
With this in mind, let me highlight four areas where I see a need for further regulatory efforts in the non-
bank financial sector.
First, we need to reduce the risks of mismatch between funds' asset liquidity and their redemption policies.
Funds need to ensure that their redemption policies are closely aligned with the liquidity of their portfolio
assets.
For instance, funds that invest in illiquid assets, such as real estate or private debt, should have
commensurate redemption notice periods to mitigate liquidity risk. At the same time, funds that offer daily
redemptions should be required to invest in sufficiently liquid assets and maintain high liquidity
management standards to enable them to meet redemption requests under both normal and stressed
market conditions.
This should be complemented by enhancing the availability and use of anti-dilution liquidity management
tools to pass on the costs of redemptions to redeeming investors. Moreover, higher liquidity buffers would
be useful to manage increased liquidity needs during periods of market stress, including from margin calls.
Second, we must renew our efforts to reform the MMF sector in the EU.
After the market turmoil in March 2020, proposals to enhance the resilience of the MMF sector were
developed at the international and European level. These focused on removing regulatory threshold
effects, strengthening MMF liquidity requirements, and improving the availability and usability of liquidity
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management tools.[ In the EU, however, reforms of the MMF Regulation have not progressed to date.
They should be pursued as a matter of priority, while ensuring a globally consistent approach.
Third, it is essential to address risks from non-bank leverage from various perspectives.
A key priority should be to develop a globally consistent approach to addressing risk from both financial
and synthetic leverage in the non-bank financial sector. Further improving data quality and coverage and
information sharing are central to assessing leverage-related risks across non-bank financial sector
entities and activities. This work should be complemented by identifying gaps in policy frameworks
globally, especially where financial entities are not subject to adequate leverage rules.
Fourth, there is a need to enhance margining practices and liquidity preparedness to meet margin calls.
Since the March 2020 market turmoil, the non-bank financial sector has been repeatedly confronted with
periods of high market volatility and surging liquidity needs from margin calls.
Increasing the transparency and predictability of initial margin models and assessing their responsiveness
to market stress can help reduce the procyclical demand for liquidity. In addition, ensuring robust liquidity
risk management and contingency planning frameworks would mitigate risks associated with inadequate
liquidity preparedness.
More generally, we must recognise the cross-border dimension of activities and regulatory developments
in the non-bank financial sector and the importance of global coordination. For example, the new guidance
recently proposed by the US Financial Stability Oversight Council facilitating the designation of non-banks
as systemically important demonstrates that these issues are being considered outside of Europe. It is
vital that work to identify and address systemic risks is carried out jointly across countries, taking a
macroprudential perspective rather than solely focusing on the soundness of individual entities.
Conclusion
Let me conclude.
In the past decade, we have seen the role that non-banks play in financing the euro area economy
become increasingly important. While this is a welcome development in terms of promoting financial
integration and supporting economic growth, it also entails increased risks for the financial system.
Interconnectedness between the banking and the non-bank financial sector remains high, increasing the
scope for contagion.
Given these growing risks, the policy action undertaken to date is becoming ever more insufficient. Indeed,
there seems to be a general inertia in the adoption of policy recommendations on non-banks. That has to
change. The lack of policy action today may mean the materialisation of risks tomorrow. In particular, a
more comprehensive macroprudential framework should be a priority to ensure that non-banks are more
resilient and able to provide a stable source of funding to the real economy in both good and bad times.
Thank you.
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2.
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3.
"All financial institutions" excludes the Eurosystem.
4.
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euro area", Financial Integration and Structure in the Euro Area , ECB, April, Box 2.
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Giuzio, M. and Lenoci, F. (2023), "Corporate loans vs market-based finance: substitutes or
complements?", Financial Stability Review, ECB, May (forthcoming).
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8.
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