There has been a hole in the American financial regulatory system with its light- to no-touch regulatory environment for large nonbank financial institutions. A March proposal by a panel of regulators that nonbanks should be regulated only by their activities in business sectors could make that hole yet bigger.
The dangers of this regulatory chasm have only deepened since the passage of the Dodd-Frank Act, the law intended to protect us from another 2007-like crisis, as it put banks under more regulatory scrutiny. Yet Congress didn’t leave nonbanks entirely out of regulatory oversight. The law created an entity, the Financial Stability Oversight Council (FSOC), to monitor the stability of the U.S. financial system. FSOC is in charge of designating large nonbanks as systemically important. But it has yet to maintain its designation of even one “SIFI” — and now it proposing that individual nonbanks could only be designated as SIFIs if systemic risk can’t be addressed through an activities-based approach.
It’s no surprise that the imbalance created by heavily regulated financial institutions doing the same activities as financial institutions with no regulation is a boon to the non-regulated sector. The Financial Stability Board said recently that the nonbank financial sector — which it defines as everything outside of central banks, banks, insurance corporations, pension funds, public financial institutions or financial auxiliaries — grew by 7.6 percent to $116.6 trillion in 2017, amounting to 30.5 percent of total global financial assets. In the U.S. mortgage industry, nonbank lenders accounted for 44 percent of U.S. lending by the top 25 originators in 2018 compared to 9 percent in 2009, according to Inside Mortgage Finance. It is these sorts of metrics that caused “shadow banking” to become a key pillar of discussion in the 2016 Democratic primaries: the call for enhanced regulation of nonbanks resonated with those who were deeply concerned about the lasting impact of such institutions over their individual economic security.
It would be prudent for the Administration to actively engage with policymakers to shine a spotlight on this regulatory chasm. But FSOC’s move in March, which follows a 2017 Treasury report recommending the same treatment of nonbanks, signals what could be a regulatory retreat.
Loosening the regulatory standards through which nonbanks are monitored will only do harm. To give an example of the potential impact, leveraged lending, an exploding market of loans for highly indebted companies, is a risky market with significant nonbank activity. In May, the Federal Reserve said this market grew by 20 percent in 2018 and poses a real vulnerability to the financial system. Once dominated by banking organizations, leveraged loans being made outside the banking sector now dominate. Meanwhile, terms for these loans over the last several years have deteriorated with “covenant-lite” loans (which lack lender protections because borrowers have fewer restrictions) making up the majority.
As a result, we have a less well-regulated, important credit market where banks and others are being pushed to compete on terms that are historically weak. Some may feel this is safer. They might argue that the country is better off since these risks are contained outside the banking system, but this is a dangerous line of thinking that ignores the serious systemic implications if a large financial institution fails. The implications are compounded if the failed nonbank itself is highly leveraged by funding from investors with short-term expectations and the ability to withdraw. The economy itself is made more vulnerable by the provision of highly leveraged financing to business sectors that are more vulnerable to cyclical downturns.
Banks are exposed to nonbanks in a variety of ways; the banks may be lenders to the nonbanks or to the customers of, and investors in, the nonbanks, and banks can have other ties to such nonbank entities, through the payments system, trading book, and/or other businesses like investment banking or funds management. Given the interconnectedness of the financial system, material losses by nonbank financial institutions will affect the banking sector — the only question being whether it’s a high-tide or tsunami impact.
As we all know, in a crisis, all risks converge. Accordingly, if any financial sector of the economy is seriously destabilized, the banking system may need to pick up the pieces to avoid being taken into a downward vortex. This is all the more reason for the utilization of SIFI designations on nonbanks. We should be actively working to reduce the reach of nonbank tentacles into the interconnectedness of the financial system. When wielded effectively (and appropriately), SIFI designations can successfully reduce a nonbank’s threat to financial stability.
Nonbanks comprise the biggest part of the private-sector financial economy and include entities with trillions of dollars in assets, but FSOC signaled institutions don’t need individual regulation. This is hard to square with where Congress thought it was going with Dodd-Frank. The longer these institutions remain unregulated, the more the American financial system is vulnerable to their difficulties.
We know there will be another crisis. The only question is when. So the window to plug this gaping hole in the U.S. regulatory system is fast closing.
Gene Ludwig is founder and CEO of Promontory Financial Group and a former Comptroller of the Currency.