The Financial Stability Implications of Leverage in Non-Bank Financial Intermediation

The present report titled „The Financial Stability Implications of Leverage in Non-Bank Financial Intermediation“ delves into the critical issues surrounding leverage within the NBFI sector and its potential implications for financial stability.
Leverage, which is employed to increase exposure or returns, can pose systemic risks if not properly managed. It can propagate strains through the financial system, leading to disruptions and stress amplification. This report identifies two primary propagation mechanisms: the position liquidation channel and the counterparty channel. The vulnerability of the system is exacerbated by factors such as the concentration and opacity of leverage, inadequate risk management, and liquidity imbalances.
Leverage in NBFI can take various forms, including financial leverage through loans, bonds, and repurchase agreements, as well as synthetic leverage through derivatives. „Hidden leverage“ refers to leverage that is challenging to identify or measure. Recent market incidents, such as the Archegos Capital Management failure and the March 2020 turmoil, highlight the need to strengthen NBFI’s resilience.
The report underscores that while insurance companies, pension funds, and investment funds represent a significant portion of NBFI assets, more than 90% of on-balance sheet financial leverage resides in OFIs, such as broker-dealers and hedge funds. Although aggregate data suggest a decline in OFI leverage since the 2008 global financial crisis, this is primarily due to changes in the NBFI sector composition rather than widespread deleveraging.
Hedge funds, particularly those pursuing macro and relative value strategies, exhibit high levels of synthetic leverage. However, the concentration of borrowing across a few prime brokers creates hidden leverage. Long-term investors also use leverage, mostly for hedging purposes. The report highlights the potential impact of leveraged strategies during periods of volatile price movements.
Data gaps hamper the assessment of NBFI leverage vulnerabilities. Possible actions to address these gaps include better utilization of existing data, improved reporting requirements, and changes to leverage assessment frameworks. Policymakers may consider measures to mitigate NBFI leverage’s financial stability consequences, such as enhancing prime broker risk management and improving liquidity preparedness.
The report concludes by emphasizing ongoing efforts by the FSB and SSBs to enhance monitoring, identification, and containment of systemic risks associated with NBFI leverage. Collaboration between authorities and market participants is crucial in addressing these challenges.