Economic Policies, Trade Integration and Sustainable Job Creation:
A View from the Mediterranean Countries
The regulation of non-bank finance:
the challenges ahead'
Speech by Deputy Governor of the Bank of Italy
Luigi Federico Signorini

With the completion of Basel 3, the post-crisis overhaul of banking regulation is essentially
over; with a limited number of exceptions, the only issues remaining for the next few
years will be the implementation of reforms and the evaluation of their effects, intended
or otherwise, over time. Banks, however, do not comprise the entire financial sector.
Arguably, non-bank financial intermediation has taken on an increasing role in the global
financial system and poses new challenges to regulators. The attention of international co-
ordinating bodies such as the FSB is therefore now mainly, and rightly, directed towards
what used to be known by the vaguely derogatory name of 'shadow banking' but is now
more neutrally termed 'non-bank financial intermediation'. The aim of this speech will
be to explore the emerging risks from non-banks, to describe the (not insignificant, but
still inchoate) regulatory response so far, and to speculate about a possible agenda for the
medium-term future.
Global non-bank finance concerns everybody, even countries where banks continue to
play a dominant role in the internal financial system, like Tunisia - or Italy, for that
matter. In a globally interconnected financial system, no country stands alone; none
can remain isolated from market shocks and turbulence whose ultimate source may be
in faraway parts of the globe. This is a key point for emerging market and developing
economies. Witness the recent experience of the 'taper tantrum', when a number of
emerging economies faced external financial conditions that had tightened abruptly and
higher generalised risk premia in reaction to a policy decision taken by the US authorities.
On that occasion the countries affected found that the negative repercussions on their
economy stemming from the generalised repricing of assets could not be mitigated
through policy actions (either by relying on floating exchange rates or through capital
flow management measures). It has also become apparent that a low degree of financial
deepening may actually increase the sensitivity of emerging asset markets to external
shocks.
The issue with non-bank finance, it will be argued, is not the stability of individual
intermediaries-micro-prudential risk. As the risk connected to managed assets is borne
almost entirely by the ultimate investor, rather than by the manager itself, it is not,
or not mainly, the possible default of the manager that should concern regulators. On
the other hand, the actions of asset managers may affect the financial system and the
general economy through their systemic consequences on market developments. The
key questions are then whether, to what extent and under what conditions non-bank
intermediation can amplify market movements and determine instability. It is, therefore,
essentially a macro-prudential question. Understanding and measuring such risks will
require data, research and careful reflection; tackling them is likely to require new or
reinforced supervisory tools and, quite possibly, a broader mandate for supervisory
authorities.
Why do we need a macroprudential framework for the non-bank financial sector?
We shall start by briefly reviewing certain macro-stability issues and the reasons why
they may have become more significant than in the past. I shall focus on three main
issues of concern: (i) pro-cyclicality, (ii) the size of non-bank financial institutions, and
(iii) systemic liquidity risks ('runs') and leverage risks.
Let me tackle the pro-cyclicality issue first. The collective behaviour of asset managers, insurers
and pension funds can lead to undue amplifications of market volatility.1 Empirical analyses
show that institutional investors' trading may cause substantial temporary price effects,
both at the asset level and at the aggregate level.2 During downturns, trades by institutional
investors in financial distress may turn into fire sales, and a temporary price effect may be
further magnified so as to put severe pressure on market liquidity.3 This amplification effect
can have wide-ranging negative repercussions on the banking sector, on households' savings,
on firms' funding, and ultimately on the entire economy. A clear example was the outbreak of
the financial crisis, when a complex network of connections through derivatives and shadow
banking activities turned $500 billion of losses on sub-prime mortgages into $4 trillion of
write-downs on assets at global level.4
1
See for example Chan L. and Lakonishok J. (1995), 'The behavior of stock prices around institutional trades', Journal of
Finance 50: 1147-1174; Keim D. and Madhavan A. (1997), 'Transactions costs and investment style: an inter-exchange
analysis of institutional equity trades', Journal of Financial Economics 46: 265-292; Jones C. and Lipson M. (1999),
'Execution costs of institutional equity orders', Journal of Financial Intermediation 8: 123-140.
2
See Mitchell M., Pulvino T. and Stafford, E. (2004), 'Price Pressure around Mergers', Journal of Finance 59(1): 31-63;
estimates vary considerably. For example Edelen et al. (2001) find a 0.86 per cent price reduction on a single day on
average (Edelen, R.M. and Warner J.B. (2001) 'Aggregate price effects of institutional trading: a study of mutual fund
flow and market returns', Journal of Financial Economics 59: 195:220). Coval et al. find a 2 per cent price reduction on
a monthly basis (Coval, J. and Stafford, E. (2007), 'Asset fire sales (and purchases) in equity markets', Journal of Financial
Economics 86: 479-512).
3
Shleifer A. and Vishny, R. (2011), 'Fire sales in finance and macroeconomics', Journal of Economic Perspectives
25(1): 29-48.
4
IMF (2009), 'Crisis and Recovery', World Economic Outlook, April; Mishkin, F.S. (2011), 'Over the cliff: from the
subprime to the global financial crisis', Journal of Economic Perspectives 25(1): 49-70.
Second, a size problem also exists in the case of non-bank financial institutions, albeit of a
different nature than in that of banks. Asset managers, insurers and pension funds provide
agency services and hence they bear little credit, market or liquidity risks on their balance
sheets compared with banks; the risks are borne by their clients. For example, BlackRock,
the largest asset management company in the world, has around $6.3 trillion of assets
under management, but only $220 billion (3.5 per cent) of its own. Clearly there is no
'too-big-to-fail' problem as in the banking industry. The problem of size here concerns
the externalities produced by the asset managers' portfolio allocation.5 The failure of a
'too-big-to-fail' asset manager may create systemic financial instability through its effects
on markets. In the extreme event of a failure of a large asset manager, the massive sale
of assets in its portfolio may dry up market liquidity, depress asset prices and heighten
their volatility. These externalities will have an impact on other institutional investors.
For example, they may reduce the liquidity and capital buffers of banks and insurance
corporations, or cause significant outflows from other asset managers. Furthermore,
increasing size and concentration in the asset management industry also increases the
potential for investor herding and for correlated market movements, which can in turn
result in financial bubbles and heightened volatility, and which are not justified by market
fundamentals.
Third, non-bank institutions also carry risks similar to those for banks. Open-end funds
providing liquidity transformation services are prone to the risk of 'runs' akin to deposit-taking
institutions. Investors in open-end funds have the ability to redeem their shares (usually
on a daily basis), while funds invest in relatively illiquid securities, such as high-yield
corporate bonds and emerging market assets. Shareholders have an incentive to sell their
shares when they expect large redemptions since they anticipate that the liquidation value
of shares declines as other investors sell theirs. This decline in value could happen for
various reasons: for example, the asset manager may use cash buffers and sell relatively
more liquid assets first. Asset managers providing securities lending activities to their
clients engage in maturity/liquidity transformation, when the cash collateral is reinvested at
term and into less liquid, higher-yield securities, and can take on significant leverage risks,
including by engaging in synthetic leverage via derivatives (e.g. swaps to increase duration
risk). Furthermore, asset managers acting as agent lenders also provide their clients with
indemnification,6 bearing own risks against which no regulatory capital is allocated. At the
global level, mutual funds and other retail investment funds account for around €6 trillion
in securities made available for lending (44 per cent of the total value of securities made
available for lending at the global level).7 There is no precise information on the amount of
indemnification provided on assets available for lending, but we know that the largest asset
managers are mainly involved in providing indemnification services, and that the scale of
exposures can be as large as that of some global systemically important banks. Note also
that differently than for banks, the risks for non-bank financial intermediaries are to a large
extent not on the balance sheets, making their monitoring and control more difficult.
How large are these risks?
We do not have a clear answer to this question, as we are still in the process of developing
adequate tools to measure them. But there are reasons to argue that the significance of the
risks associated with non-bank financial in8termediation has increased in recent years.
First, there are quantitative reasons. In the last decade, assets under the management
of non-bank financial intermediaries have almost doubled. In 2016, the latest date for
which data are available at the global level, they represented a little less than half of the
total assets of the financial sector.8 Non-bank credit intermediation was around one third
of total bank assets. The growth of non-bank finance has been significant in Europe too:
total assets managed by euro-area investment funds have more than doubled in the last
decade, from €5.7 trillion at the end of 2008 to €13.8 trillion at end June 2018. The
investment fund sector now accounts for nearly 20 per cent of the total assets managed
by the euro- area financial sector.9
Second, the asset management industry is significantly more concentrated today than a
few decades ago. In the United States, the top 10 managers owned about 5 per cent of
the US stock market in 1980, whereas in 2016 they owned about 23 per cent.10
There are further qualitative reasons. The portfolio of asset managers, insurers and
pension funds are often highly diversified but less diverse, i.e. their investments are
often largely overlapping. This is the outcome of a global quest for risk diversification.
A multitude of investors diversifying their investments must end up with the same
portfolios when the number of assets they can invest in is finite. While diversification
helps institutional investors to reduce the risks of their investments, shocks tend to
spread more easily across different institutions when portfolios overlap.11 In Europe, for
example, investment funds invest more than three fourths (80 per cent) of their assets in
securities which are also held by insurers and pension funds. Market stress can be more
easily transmitted across markets and asset classes.12 The risks and costs of fire sales in
the event of market stress may end up being less easily diversifiable at the macro level.
While investment funds, and to a certain extent insurers and pension funds, tend to
diversify their portfolios across countries and sectors, banks invest a larger share of their
assets in domestic securities. This simply reflects13 the different investment strategies of
different financial intermediaries. Banks specialise in resolving asymmetric information
issues, so they end up with greater knowledge of specific markets and borrowers than
other investors. They have a comparative advantage from investing in the markets that
they know better.
Like asset correlations, business activity correlations can vary over the cycle, turning all
positive or intensifying in bad times. There is also evidence that there are fewer contrarian
investors in the market, or that investors traditionally considered as contrarian may
behave pro-cyclically in episodes of severe market stress.14
Another sign of increasing risks is given by the fact that asset managers' activities have become
structurally more correlated over the years, owing to the diffusion of common investment
strategies across different business activities. New technologies (HFT, algo-trading and
robo-advisors) and financial products (ETFs) have made intermediaries more procyclical
and quicker to react to market news. The growth of electronic and automated trading has
given rise to a series of flash episodes in markets that are among the largest and most liquid
in the world.15
What policy instruments are available to limit such risks?
There are some policy instruments to mitigate such risks. For example, most jurisdictions
have measures in place that preserve the stability of mutual funds and limit the consequences
of a sudden run on the part of their investors, such as liquidity requirements, rules
restricting the amount of illiquid assets that can be held by open-end funds, redemption
suspension and redemption gates.
However, the policy framework is still under construction; most importantly, the
approach has been mainly microprudential. There is a need to step up analytical thinking
and craftsmanship in policy-making, starting by enhancing the policymakers' ability to
assess the relative importance of the different transmission mechanisms, using tools such
as macro/systemic stress tests. The fact that we do not yet have a clear idea about how the
policy instruments function does not mean that we should not start to experiment with
them. A reference can be made for instance to stress testing techniques in bank supervision:
stress test methodologies were not advanced before the crisis,16 but the financial crisis
highlighted the importance of forward-looking capital adequacy assessment, and stress
tests were then effectively employed as a supervisory tool in that perspective and have
subsequently been included in the regular supervisory policy toolkit in many countries.
A specific issue that will play an important role in future policy debates is how to address
liquidity shortage situations for non-bank financial intermediaries. If a large asset
manager's stressed liquidity condition puts the correct functioning of markets at risk,
should central banks step in and provide liquidity? If so, who should the recipients of
this liquidity be: the stressed asset manager or the market? Under what conditions? The
experience during the recent financial crisis, when a number of central banks expanded
the scope of their lender of last resort coverage (for example, the Fed provided liquidity
to mutual funds, the Bank of England started providing liquidity support to selected
broker-dealers and central counterparties and similar arrangements were made by the
Bank of Japan) should be a starting point for a systematic approach to these issues.
The institutional framework: which authorities should be involved in the supervision
of non-bank financial intermediaries?
The expanded scope of the activities of non-bank financial intermediaries and the need for
a better understanding of the risks posed for financial stability prompts a reflection on the
adequacy of the institutional supervisory framework. In most countries, non-bank financial
intermediaries are under the purview of securities and market regulators. These authorities
traditionally have a mandate to safeguard investor protection and market integrity rather
than to limit systemic risks. Should this change? In particular, should financial stability find
a way into market supervisors' mandates? Should these authorities develop macroprudential
policy instruments designed to mitigate systemic risks stemming from non-bank finance?
This process will require an adaptation of culture as well as new laws. Central banks must
be involved, particularly in view of the 'macro' and financial stability perspective, and of
their role in the provision of liquidity; for them too, rules, skills and practices will need
to evolve further. Coordination between all the authorities involved will be important in
order to ensure that supervision is carried out with a macroprudential perspective.
FSB work on risks to financial stability from non-bank intermediation
At the international level the FSB, where central banks, banking and market regulators
are all represented, is the natural forum to analyse and assess financial stability risks
stemming from non-bank finance. The FSB has recently taken some preliminary
important steps in these areas.
First, the FSB has been publishing annually what used to be known as the 'Shadow Banking'
monitoring report, and has recently been retitled 'Non-bank financial intermediation' monitoring
report, although it would probably take more than a terminology change to transform shadow
banking into 'resilient market-based finance'. The FSB has worked to improve its coverage by
broadening the geographic scope of the data and refining its analysis of risks. The latest report,
published in March 2018, also included data from China for the first time.
As to the policy area, in 2017 the FSB issued policy recommendations to address structural
vulnerabilities in asset management and to mandate the relevant Standard Setter Body
(IOSCO) to implement them. This work has led to the development of policy tools for
asset managers in the area of liquidity risk management as well as of leverage measures for
investment funds to facilitate monitoring for financial stability purposes and to enable
comparisons across funds at a global level.
The FSB has also made some initial progress in studying the impact of large investors'
strategies on market liquidity, starting with a 'simulation exercise' on fund redemptions.
This line of inquiry is important. Differently from the case of banks, it is not the
resilience of individual institutions that needs to be tested, but rather the presence of
shock amplifiers in the market. This is why potential investment-strategy loops are of
interest to the FSB.
Difficult choices have been made, some of which have possibly led to setbacks. Some
examples concern the abandonment of the early attempt to develop a list of systemic
non-bank financial intermediaries, together with the preference for relying on an
activity-based approach rather than an entity-based approach in addressing the risks
from non-bank finance. These were difficult judgments to make. On the one hand, the
activity-based approach has its own merits as it allows some activities to be subjected to
the relevant rules regardless of which entities are undertaking them. On the other hand,
relying solely on an activity-based regulation could leave significant risks unchecked:
high levels of concentration and interconnectedness (e.g. large asset managers and CCPs)
are good reasons to develop an entity-based regulation for non-banks as well.
The FSB will continue to carry out work in this area, focusing on continued monitoring
and on the operationalisation of the agreed reforms. The improvement of systemic stress
testing will also be an important goal for the FSB, especially as regards enhancing its
ability to assess the relative importance of the different transmission and amplification
mechanisms of risks and refining its analysis of the behaviour of institutional investors,
especially with respect to their willingness to act as contrarian investors in times of
market stress.
Conclusions
These works and debates matter not only in countries where the non-bank financial sector
is large. In a globally interconnected financial system, countries with small non-bank
financial sectors are often the most vulnerable to these risks. In light of the rapid expansion
of asset management activities, the authorities need to be provided with instruments to
prevent or mitigate consequent systemic risks, especially for situations where the measures
available to asset managers alone would not be sufficient.
Managers of individual funds have a mandate to act in the best interests of their own
investors and may not be in a position to act in the interest of financial stability.
Supervisors of individual funds may not have the information or means necessary to
properly assess different funds' contribution to systemic risk. Thus, a macroprudential
approach to the supervision of non-bank financial intermediation should be developed.
Different authorities need to work together for a better understanding of the risk of fire
sales, spillovers to other financial counterparties and disruptions in credit intermediation,
and to design and test potential tools to prevent and mitigate systemic risk.
Designed and printed
by the Printing and Publishing Division of the Bank of Italy