Interconnections between EU banks and the non-bank financial intermediation sector could create systemic risks in periods of market stress, according to a new joint report by the European Central Bank and the European Systemic Risk Board.
The report says links between banks and non-bank financial intermediaries — a broad set of institutions such as investment funds and other finance companies that operate outside traditional banking — are significant but do not currently pose “acute” risks to financial stability, the ECB informed in a statement on Thursday.
Vulnerabilities identified in the analysis are concentrated in a small number of large euro area global systemically important banks, or G-SIBs, which are the biggest banks considered critical to the financial system, the ECB and ESRB said.
The organisations set out three main ways banks interact with non-banks: managing liquidity, providing leverage — borrowing to increase investment exposure — and market-making, which involves buying and selling financial assets to support trading.
Where the risks could emerge
One risk channel involves short-term funding provided by non-bank entities to banks, which could be withdrawn quickly in periods of market tension, the report said.
A broad fall in asset prices could trigger investor redemptions from non-banks and margin calls on derivatives and repo trades — short-term borrowing secured against assets — potentially leading to a widespread drop in non-bank funding for banks.
A second channel stems from banks’ lending to non-bank entities that use leverage, which can expose banks to losses linked to the non-banks’ trading strategies, the report said.
Hedge funds and securities firms can borrow from banks through repo transactions to fund short-term trading, and a sharp asset price shock could force positions to be unwound and assets sold quickly, causing losses for both banks and non-banks.
The report also says lending to leveraged non-banks investing in illiquid long-term assets could leave banks exposed to credit losses if those assets are hit by shocks.
The findings draw on granular transaction and exposure-level data, but the analysis is constrained by gaps and fragmented access to information, the ECB and ESRB said.
Data on exposures and transactions outside the EU are “largely missing”, reducing visibility of risks to the EU financial sector, they added.
