Evan Siddall is chief executive officer of Alberta Investment Management Corp. Previously, he worked alongside former Bank of Canada governor and chair of the Financial Stability Board Mark Carney on postfinancial-crisis reforms.
During the Great Financial Crisis of 2008-09, society paid a heavy price for having allowed financial institutions to become “too big to fail.” Now that the issue has been addressed through reforms, a new one has seemingly emerged: In the face of fears about the rise of “shadow banks,” regulatory sabres are being rattled among global financial regulators about non-bank financial institutions, or NBFI.
The term NBFI captures a wide range of enterprises and therefore defies a common regulatory approach. It is not monolithic and includes such varied enterprises as pension fund investment managers such as AIMCo, insurance companies, investment banks, broker dealers, hedge funds, mortgage investment companies – and still others. However, this diversity should rather be seen as a source of strength, not as a vulnerability.
NBFIs provide stability and balance in the financial system. That borrowers can secure loans through several non-bank models provides a wider range of competitive financing sources that strengthens our financial system. For example, my colleagues estimate that private lending by NBFIs over the past two years has replaced as much as US$1-trillion in merger-and-acquisition financing activity, as banks have been sidelined.
These developments, together with reforms after the financial crisis, most notably those strengthening bank minimum capital and liquidity requirements, have made the world a much safer place financially. In the past year, markets largely shrugged off the respective collapses of Credit Suisse, Silicon Valley Bank and First Republic. That would have been unthinkable 15 years ago.
Fears about increases in lending by NBFIs are overblown and regulatory backlash therefore risks undoing one of the intended consequences of recent regulatory reforms: slowing the growth of big banks.
These big banks, which are subject to heavier regulations, call lending by NBFIs “regulatory arbitrage,” as nefarious a term as “shadow banking.” In his annual letter, JP Morgan Chase chief executive Jamie Dimon bemoaned the declining market share of banks in the financial system. He decried NBFI’s regulatory arbitrage and accused them of “dancing in the streets” because of it.
That’s rich, since the implicit government guarantee of banks that the reforms have ended was the likely the greatest regulatory arbitrage in history. Let us not forget the US$15-trillion in bailouts, government guarantees of bank liabilities and special central bank liquidity schemes that saved a global economy brought to its knees.
Indeed, that “heads I win, tails you lose” moral hazard benefited JP Morgan the most of any bank, as the largest such institution by far.
Banks are more heavily regulated, for good reason. Their core business is maturity transformation: Borrowing short-term deposits from savers to fund long-term loans to companies, mortgagees and others. They are also highly levered, often up to 14 to 1. Bank runs, a crisis of confidence, can turn a solvent, functioning bank into one that has to shut its doors overnight.
While banks are an essential accelerator of economic growth, their susceptibility to bank runs is a key source of financial instability. Government-sponsored deposit insurance therefore helps reduce the risk of bank runs. As a consequence, banks must submit to more stringent regulation.
That’s the deal, Jamie, and you know it.
Nevertheless, the more NBFIs look like banks – for example, with open-ended short-term funding, high levels of leverage, significant derivative exposures – the more liquidity they should hold and be required to hold. The Bank of England’s systemic stress test of NBFIs made sense after a liquidity squeeze that was triggered by sharp declines in British government bonds (Gilts) in 2022.
That is why while private lending accounts for less than 10 per cent of our investing and we carefully target our use of derivatives. AIMCo constantly measures our own 60-day “stressed liquidity coverage” to protect against exactly these financial catastrophes. The Canadian “Maple 8″ pension fund investors also communicate regularly with the Bank of Canada to anticipate and manage financial market stresses.
We are still paying the huge bills from the bailouts of 2008 and 2009 that severely damaged people’s trust in our financial system. A rush to regulate non-bank institutions seems tempting in light of the regulatory oversights that precipitated the problem 15 years ago. But critics need to understand that regulatory progress since then has created a more stable, resilient and trustworthy financial system, the rise of NBFIs included.