FSB launches plan to rein in non-bank leverage

The Financial Stability Board (FSB) has today (December 18) unveiled proposals to tackle high and opaque leverage in the non-bank sector, starting what is likely to prove a long reform process.

The consultation’s nine recommendations are designed to be flexible in order to fit in with different regulatory and market structures around the world. They cover the identification and monitoring of vulnerabilities, steps to address leverage in core markets, counterparty credit risk management, the principle of “same risk, same regulation” and cross-border co-operation.

John Schindler, FSB secretary general, told journalists today that years of growth in the non-bank financial intermediary (NBFI) sector had raised the “complexity and interconnectedness” of the financial system. Non-banks have also been important vectors of recent market stress, he noted. Yet, many of the firms acting in the NBFI sector are lightly regulated.

“The recommendations should be seen as a comprehensive package that reflect the complexity of financial stability risks related to NBFI leverage in different jurisdictions, and the heterogeneous nature of NBFI entities, activities and market structures,” he said.

The FSB has been working to address risks in the non-bank sector for many years. It has already rolled out measures designed to increase the resilience of non-banks’ liquidity management that have been adopted in some major jurisdictions.

However, the work on leverage will face significant hurdles before it can make it into regulators’ rulebooks. Schindler said that although the proposals had been designed so jurisdictions could “pick and choose” what works locally, some jurisdictions might need to update regulatory mandates. This could involve changes to legislation.

With an incoming US administration that has declared its hostility to regulation, that looks like a big ask – at least in the US, which plays host to the most systemically important non-bank sector in the world. The European Union has also been slow to implement aspects of the FSB recommendations on liquidity management.

Schindler argued there was still political backing for the FSB’s work. He said the fact that the G20 had asked the FSB to tackle challenges related to leverage “suggests there is broad political support” for this work.

A second major challenge is the patchy data that is available on the non-bank sector. The FSB publishes an annual monitoring report, the latest edition of which showed that assets held by non-banks hit a record high in 2023. However, detailed information on non-bank exposures is scarce in many jurisdictions, and some areas of the sector, such as private equity and private credit, are particularly opaque.

Schindler said most authorities around the world acknowledged that the data was not good enough to enable them to fully understand the nature of non-bank leverage. Firms build leverage in complicated ways, he said, sometimes using borrowing to unlock further leverage and thereby building up layered exposures that are difficult to track: “Complexity is a huge issue here.”

Nine recommendations

The FSB’s first three recommendations target issues with data. The first urges authorities to establish domestic frameworks to identify and monitor vulnerabilities. Recommendation two proposes global collaboration on monitoring. The third recommends that authorities review the “granularity, frequency, and timeliness” of existing non-bank disclosures and consider enhancing them.

Recommendations four and five focus on core financial markets, especially government bond markets, where stresses were acute during the Covid-19 crisis. Authorities should broaden legal and regulatory frameworks as needed to provide the “necessary policy measures”, the FSB says. They should also apply activity-, entity- and concentration-based measures depending on the “nature and drivers of identified risks”.

Recommendation six calls for the “timely and thorough” implementation of guidelines set by the Basel Committee on Banking Supervision relating to counterparty credit risk management by banks, as many banks are leverage providers to non-banks. Recommendation seven calls for better disclosures of the links between leveraged non-banks and their leverage providers.

The eighth recommendation sets out the principle of “same risk, same regulation”. A challenge in regulating leverage is that it can be constructed in different ways, either through direct borrowing or through “synthetic” leverage built up using derivatives. Firms may also obscure the extent of their leverage – for example, by borrowing from many different providers – which makes it hard to judge the aggregate exposure.

Where authorities identify “incongruence” in the regulatory treatment of different types of leverage, the FSB says they should co-operate with global standard-setting bodies to address the issue.

The final recommendation emphasises cross-border co-operation. “Authorities should engage proactively with their peers to facilitate co-ordinated crisis and/or policy responses, to the extent legally and operationally feasible,” the FSB says.