Non-banks and banks are interwoven, says ex-RBI official

Financial regulations should reflect the interconnectedness of banks and non-banks, a former senior official of the Reserve Bank of India has said.

In an interview with Central Banking, Viral Acharya, who served as the RBI’s deputy governor from 2017 to 2019, argues that risks associated with non-bank activities continue to exist within the banking system itself.

Drawing on his previous research, Acharya says non-banks get a significant amount of liquidity from the banking system. He cites Blackstone’s private credit fund, which he says has about half of its balance sheet in the form of credit lines from the largest banks.

“As far as liquidity is concerned, banks are still one of the key providers to non-banks,” the former deputy governor says.

Acharya, who now teaches economics at New York University, says the increasing capital requirements for banks are a key reason for this phenomenon. By providing credit lines to non-banks, he says, banks can transfer away those activities that come with high capital surcharges while retaining some of the returns.

“It could be better to let the asset be warehoused with a non-bank but provide a credit line, because then you can collect a fee on the credit line,” he says. Acharya adds that banks are repackaging risks in a manner that is efficient for their capital requirements.

He notes that central banks and regulators around the world are increasingly aware of the connections between banks and non-banks, and that some are recognising the regulatory arbitrage. He believes there is far more appreciation of the need to investigate banks and non-banks together and not separately.

Acharya recommends two strategies. The first would be to conduct a stress test on the whole financial system involving both banks and non-banks – though this would require a slightly different approach. A typical bank stress test, he says, simulates a macroeconomic shock, whereas non-banks usually face market-specific shocks, which are much more fast-moving.

The second strategy would involve the central bank providing an emergency backstop to non-banks while asking them to pre-position liquidity. This, Acharya says, would be akin to how the larger banks are treated and is becoming the regulators' preferred option.

“I would say the regulators are now moving in the direction of acknowledging that non-banks are systemically important and ensuring that liquidity backstops are available to them in advance,” he says. “But they are not thinking as hard about how to then manage the risks of the non-banks.”

Acharya thinks that in some cases this is due to regulators lacking the power to directly oversee non-banks. A workaround, he suggests, would be to increase the capital and liquidity requirements for banks correspondent to their exposure to non-banks. Banks would then change the way they price the credit lines and loan terms offered to non-banks.

However, he argues that regulators will eventually need to fight for the power to monitor non-banks if they want to extend the liquidity facility to them.

“I think they [the regulators] have to start having the political conversation of having regulatory and supervisory powers over non-banks,” he says. “They have to be able to gather data, because it does not make sense to give access to public liquidity to entities whose risks are not actually being gathered.”