The European Central Bank and the European Systemic Risk Board have published a joint report warning that growing links between banks and the non-bank financial intermediation sector create vulnerabilities that could amplify stress in adverse market conditions.
The report, entitled “Financial stability risks from linkages between banks and the non-bank financial intermediation sector”, finds that interconnections between EU banks and the non-bank financial intermediation sector are significant and, while they do not currently pose acute threats, they may generate systemic risks under strained market conditions.
According to the findings, these vulnerabilities are highly concentrated in a small number of large euro area global systemically important banks, underlining the importance of their resilience in absorbing shocks and preventing wider financial instability.
The study highlighted that the risk-bearing capacity of euro area G-SIBs is crucial for cushioning shocks within the financial system and limiting the amplification of stress.
Moreover, the report identified three key roles played by banks in their interactions with non-bank financial intermediaries, namely liquidity management, the provision of leverage and market-making activities.
It explained that these roles may give rise to systemic risks through two principal transmission channels that are closely interlinked.
The first channel relates to the risk that a loss of short-term funding from non-bank entities could create funding challenges for banks during periods of market tension.
The report further stated that the short-term nature of such funding, the homogeneity of funding providers and the limited scope for substitution could intensify liquidity pressures if non-bank entities withdraw funding simultaneously.
It added that a negative and systemic price shock in asset markets could trigger redemption requests to non-bank financial intermediaries and margin calls on derivatives and repo transactions.
This could in turn lead to a broad-based decline in funding from the non-bank financial intermediation sector to banks, increasing strain on bank balance sheets.
The second channel stems from bank lending to leveraged non-bank financial intermediaries, which indirectly exposes banks to the trading strategies pursued by these entities.
“Hedge funds and securities firms borrow from banks via repo transactions and use leverage for short-term trading,” the ECB said in its report.
“These linkages may increase vulnerability to asset price shocks, potentially leading to unwinding of positions and asset fire sales,” it added.
It explained that “such dynamics could amplify market movements and generate losses for both banks and NBFI entities”.
“Lending to leveraged NBFI entities which invest in illiquid long-term assets could be vulnerable to shocks affecting those assets, potentially leading to credit losses for banks,” it continuted.
Drawing on granular transaction and exposure-level data, the report provided new insights into the scale and structure of bank-NBFI linkages across the European Union.
However, the ECB and ESRB cautioned that data gaps and fragmented data access significantly constrain the depth of analysis.
In particular, exposures and transactions taking place outside the European Union are largely missing from available datasets, limiting visibility over risks to the EU financial sector, they explained.
The institutions emphasised that improved information sharing and a centralised mechanism for data access could help address these shortcomings and enhance monitoring of systemic vulnerabilities.
While the report concluded that current risks are not acute, it stressed that the complex and concentrated nature of bank-NBFI linkages means that shocks could be amplified if market conditions deteriorate.
