Randal K Quarles: The Financial Stability Board's roadmap for
addressing NBFI vulnerabilities
Speech (via webcast) by Mr Randal K Quarles, Vice Chairman for Supervision of the Board of
Governors of the Federal Reserve System, at the Securities Industry and Financial Markets
Association Annual Meeting, 20 October 2020.
* * *
Thank you for the invitation to be with you today. The Securities Industry and Financial Markets
Association (SIFMA) annual conference covers a broad spectrum of issues that are timely and
relevant to the current work of the Financial Stability Board, or FSB, and I am grateful for the
opportunity to be part of it.
The shocks related to COVID-19 and the associated containment measures, which I refer to as
the "COVID Event," have sharpened the FSB's focus on the role of capital provision, the
functioning of financial markets, and different aspects of nonbank financial intermediation, or
NBFI for short. The FSB's annual NBFI monitoring report estimates that the sector now accounts
for almost 50 percent of total financial intermediation globally, up sharply in the last decade. With
this growth has come greater interconnectedness. Many NBFIs rely on the banking system for
credit and backstop liquidity. The interconnectedness of our financial system means that it is not
enough to understand the vulnerabilities arising from the banking sector. We must also
understand vulnerabilities in the nonbank sector and how shocks are transmitted to or from the
nonbank sector.
To address this need for a broader perspective, last year I formed a high-level steering group of
central bankers and market regulators to oversee the FSB's work on nonbank finance and to help
coordinate with various global financial standard-setting bodies. The COVID Event in March
tested the resilience of the financial system, and the NBFI steering group has used the past few
months to begin identifying the parts of the NBFI sector that did not exhibit sufficient resiliency.
While our analysis is not final, the group is currently completing a holistic review of the impact the
COVID Event had on financial markets in March, especially dislocations in key funding markets
and credit supply, to better understand the role that vulnerabilities stemming from the NBFI
sector played.
Today, I want to share with you some of the emerging elements of the FSB's review of the
COVID Event, primarily how the shock moved through the financial system and which critical
vulnerabilities it exposed. I also want to outline further work that the FSB plans to conduct in light
of this experience, including a more in-depth assessment of how various segments of the NBFI
sector performed. Going forward, I expect the NBFI sector to be an ongoing focus of the FSB.
The Global Financial System and Economy Prior to the Shock
When COVID-19 emerged early this year, the global financial system was in several ways
fundamentally different than it was at the outset of the financial crisis of more than a decade ago.
Regulatory reforms implemented in response to that crisis, changes in technology,
developments in U.S. dollar funding, and, importantly, the growth of NBFI all contributed to a
changed landscape.
Beyond the growth of the NBFI sector, there has also been considerable change within this
sector. Business models and financial services provided by NBFIs have become more diverse.
This variation can be seen in new products, services, and financial models. New types of
markets-for example, private debt markets-and new forms of intermediation, such as fintech
credit, have sprung up. Investments by nonbank entities in certain credit products, such as fixed
income exchange traded funds and collateralized loan obligations, and participation in some
credit segments, such as mortgage and consumer finance, has grown. Change is also evident in
how the sector operates in different jurisdictions. For example, provision of credit by nonbank
fintech lenders varies greatly across FSB member jurisdictions. In sum, nonbanks now play a
larger and more diverse role in financing the real economy and managing the savings of
households and companies.
The past decade also saw an evolution in the global U.S. dollar funding landscape. While the
U.S. economy forms a smaller percentage of global gross domestic product than in the past, the
U.S. dollar still dominates international finance as a funding and investment currency, and its
widespread use has given rise to a complex and geographically dispersed network of financial
relationships. This means global economic and financial activity is highly dependent on the ability
of U.S. dollar funding to flow smoothly and efficiently between users. In contrast to bank
intermediation, market-based financing in U.S. dollars has outpaced the growth of the global
economy. Nonbank institutions-such as insurers, pension funds, and central counterparties-
have become more important users of U.S. dollar funding, though they lack access to funding
backstops, such as central bank facilities, in times of stress. Cross-border links between banks
and nonbank entities have also increased, and there has been a shift of global portfolios toward
U.S. securities and cross-border lending into emerging market economies (EMEs), much of
which is in U.S. dollars.
Changes in the functioning of financial markets have also affected how the financial system
provides liquidity and transmits price changes, and many of the recent changes stem from the
increased role of nonbank players. In markets with more standardized products, electronic
trading has grown, increasing the use of high-frequency trading and the role of principal trading
firms in providing liquidity. By contrast, other markets, such as funding markets for corporate
credit, have grown significantly in size but continue to be traded over-the-counter with low levels
of automated trading.
The COVID Shock and Its Propagation
The outbreak of COVID-19 and efforts to contain it generated simultaneous hits to aggregate
supply and demand. Voluntary and mandated quarantines, lockdowns, and social distancing
efforts lowered aggregate demand, caused large job losses, and sharply increased uncertainty.
Workplaces closed and travel was curtailed, disrupting global supply chains. Important sectors of
the global economy, such as tourism and transportation, came to a rapid stop. As the concern
about the virus spread, these effects grew. According to figures from the International Monetary
Fund, we ultimately wound up with the deepest and broadest global recession since the Great
1
Depression.
The "Dash for Cash"
As businesses scrambled to remain liquid amidst this global "sudden stop," demand for liquidity
in U.S. dollars increased globally. Commercial entities with debt denominated in U.S. dollars
sought to increase their holdings of U.S. dollars. Unprecedented asset price volatility and record
or near-record trading volumes led to significant margin calls, which amplified the demand for
cash. Some market participants may not have anticipated the size of these margin calls, and
they were forced to sell less liquid assets rapidly to meet them. Those forced sales on top of
other pricing pressures, resulted in unwanted procyclicality.
Traditional sources of cash were unable to handle the significant and sudden increase in
demand. Normally, market participants can generate cash by converting assets to cash in
secured funding markets or by issuing debt. Through late February and early March, as the
COVID Event began to unfold in Europe, these mechanisms mostly functioned as expected.
However, only a few days, the surge in demand for cash-apparently triggered by the World
Health Organization's designation of the virus as a global pandemic on March 11 and
simultaneous lockdowns in a number of countries-overwhelmed dealers and impaired price
discovery. Repurchase rates increased sharply and liquidity in securities markets declined
precipitously. Bid-ask spreads increased, in some cases to levels greater than those observed
during the global financial crisis. As traditional sources of liquidity became limited, market
participants had to either pay a premium for cash, or search for it in other ways.
A Surprise in Government Bond Markets
One alarming feature of the COVID Event involved the way in which the shock propagated
through core government bond markets. Amid increased demand for cash and short-dated
assets, institutional investors sold large volumes of longer-dated bonds-including those usually
considered as most liquid-in favor of cash. The price of government bonds relative to futures
prices decoupled, putting significant volumes of derivatives trades out of the money and thereby
increasing margin calls. Global authorities sold a significant number of government bonds,
perhaps to satisfy U.S. dollar funding needs or to stabilize foreign exchange rates. All together,
the pressure on longer-dated government bonds was sufficient to impair pricing for some of
these bonds in this normally deep and liquid market, an outcome that we would not normally
expect.
Negative Feedback Loops
The mismatch last spring in the demand and supply of cash exhibited some self-reinforcing
tendencies. As market participants became more risk averse and hoarded liquidity, they became
unwilling to provide short-term unsecured funding. Dealers reached their limits in holding large
amounts of securities-in some cases internal risk limits, in other cases limits imposed by
regulation-rendering them unable or unwilling to absorb significant asset sales from other
market participants. As companies were increasingly unable to gain access to traditional
sources of liquidity, they turned to banks and drew on credit lines, decreasing cash held by banks
that they could have used for other lending.
Stresses in debt markets also fed into one another. Widespread forced sales of securities,
combined with limited dealer intermediation contributed to increased volatility and illiquidity. In
particular, the increased volatility led to margin calls, further increasing the demand for liquid
assets. All of these pressures increased the demand for cash, which increasingly was only
available by selling assets. The volume of sales was sufficient to impair pricing in certain
markets, starting the cycle anew. The sharp reduction in market liquidity likely exacerbated asset
price declines, and it may have hindered other investors from behaving in a countercyclical
fashion by purchasing under-valued assets.
U.S. Money Market Funds
Let me focus briefly on U.S. money market funds, specifically prime and tax-exempt funds, as an
example of how some of these strains played out during the COVID Event. Money market funds
are perceived as very safe and liquid investments by most financial market participants, and yet
in the COVID event and in the earlier global financial crisis, the Federal Reserve and the U.S.
Treasury were compelled to create significant government backstops to contain runs on these
funds that had the potential to destabilize the financial system
The crux of the issue stems from the fact that investors run from these money market funds in
times of stress. In 2008, investors ran from money funds in part because of the first-mover
advantage created by their stable net asset values (NAVs); in 2020, investors appear to have run
from money funds in part because of fears of impending redemption fees or redemption
suspensions. In March of 2020, among institutional prime money market funds offered publically
2
as well as retail prime funds, the pace of outflows actually exceeded that in the fall of 2008.
Those outflows from money funds increased stress in short-term funding markets. Conditions in
markets for commercial paper and negotiable certificates of deposit (CDs) began to deteriorate
rapidly, and spreads for money market instruments jumped to levels not seen since the last
financial crisis.
Intervention
In the COVID Event, one advantage the public sector had was the experience of the global
financial crisis which helped us act quickly and decisively to halt a further intensification of the
market shock. These interventions were unprecedented in scale and scope. Central banks
around the world expanded their asset purchases, significantly increasing their balance sheets.
Central banks also implemented liquidity support, including traditional operations to fund banks,
but also through liquidity facilities to support other entities. For example, the Federal Reserve
established facilities to provide liquidity to dealers, commercial paper markets, money funds,
nonfinancial corporates, and municipal bond markets. In an effort to support the global demand
for U.S. dollars, the Federal Reserve established swap lines with central banks all over the world
to support international trade. In addition, regulators and supervisors have strongly encouraged
banks to deploy capital and liquidity buffers to support lending, made modifications to certain
regulatory requirements, or delayed the implementation of new requirements. These decisive
actions have succeeded in alleviating market strains to date.
The Path Forward
While swift and decisive policy action succeeded in calming markets, this does not mean that
our work is complete. While central bank action succeeded in restoring market functioning, this
support does not address the underlying vulnerabilities spotlighted by the COVID Event. The
COVID Event revealed a banking system that withstood this shock quite well with limited official
sector support, and a nonbank system that was significantly more fragile. By this measure, the
COVID Event demonstrates that we have work to do.
The FSB is in the early stages of this work. In November, we will deliver to the G20 Summit, and
publish, our holistic review of the COVID Event. The report will provide a diagnosis of the shock
from a financial stability perspective, including how it was absorbed and amplified. The report
also will identify areas where policy consideration may be warranted.
Recognizing the critical importance of the interconnections between the banking and NBFI
sectors, the FSB set up a working group to map the current financial system, including the bank
and NBFI sectors and the links among and between the two. This exercise will identify nodes and
channels of risk transmission in the system, which will also help policymakers identify and
understand the pathways for both amplification and absorption of risk in the financial system.
Further, the FSB's initial analysis on the beginning stages of the COVID Event has revealed a
number of issues that may have caused liquidity imbalances or propagated stress. For example,
there are signs that margin calls were larger than expected and may have stretched the liquidity
of some market participants. Questions about the functioning and resilience of the core
government funding markets also remain, especially in relation to the role of leveraged investors
and dealer capacity to intermediate in these markets.
We know already that work needs to be done to improve the resiliency of money market funds
before the vulnerabilities in these funds amplify another shock. This will require careful
consideration of financial stability, investor protection, and efficiency objectives alongside an
understanding of the benefits of money market funds that should be preserved. Additionally, other
types of open-ended funds, especially those invested in less liquid assets, also experienced
large outflows, and further work is likely needed to understand liquidity risks in these funds.
I believe that, as with the work undertaken in the aftermath of the global financial crisis, the FSB
will provide a forum for international experts to understand vulnerabilities in NBFIs, promptly
prescribe reasonable policy solutions, and monitor the implementation and effectiveness of any
agreed-upon reforms.
Conclusion
Global coordination through the FSB has helped reveal a number of issues associated with
particular types of market participants and mechanisms that may have caused liquidity
imbalances and propagated stress. Since the start of the pandemic, FSB members regularly
connected to share experiences, analyses, and concerns about coming events. In so doing, the
membership as a whole has been agile, coordinated, and quick to respond. We have seen that
decisive action helped to stabilize markets through facilitating funding to support the economy.
Addressing vulnerabilities in the financial system going forward, therefore, will require a holistic
perspective given the various linkages within nonbank financial intermediation and between
nonbanks and banks. We have gained some clarity regarding areas of the market that needed
significant bolstering and have to look closely at whether and how resilience in these segments
can be improved. Next month, when the FSB delivers our NBFI report and proposals to the G20
Summit, we will be doing what the FSB does best: leveraging the strength of our broad and
diverse membership to provide a clear path forward to strengthen the resilience of the global
financial system.
1
See International Monetary Fund, World Economic Outlook Update (Washington: International Monetary Fund,
June 2020); global growth is projected at -4.9 percent in 2020, which would leave 2021 GDP some 6-1/2
percentage points lower than in the pre-COVID-19 projections of January 2020.
2
With respect to institutional prime money market funds, outflows as a fraction of the funds' assets exceeded that
during the run in September 2008, although the March outflows were smaller in dollar terms because these
funds are much smaller now than in 2008.