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You Don’t Need a Banking Crisis for a Financial Meltdown

The most visible recent manifestations of global financial distress have been in banks—Silicon Valley Bank, Signature and First Republic in the U.S.,

Credit Suisse

in Europe. This is giving rise to a comforting myth (or cynical lie, if you’re so inclined) that the damage from the current monetary tightening cycle is containable and now contained, a product of management and supervisory lapses at a handful of institutions.

If you believe that, best to whistle past the International Monetary Fund’s latest Global Financial Stability Report, a portion of which was released this week. The conclusion is that banks, for all the risks they still face, represent a smaller portion of the global financial system than they did at the time of the 2008 panic and that proliferating nonbanks present a new array of financial dangers.

Nonbank financial intermediaries—insurers, pension funds, hedge funds, money-market funds, asset managers and plenty of others—now hold some 50% of global financial assets, the IMF notes, up from 40% in 2008. The growth has been fueled in part by the heavier regulatory burden placed on banks in that period, which made it harder for banks to play their customary role as intermediaries.

And that, more or less, is the limit of anyone’s knowledge about this situation. Because nonbanks can be as different from each other as they are from banks, they defy any straightforward regulatory oversight. This thwarts efforts to gather comprehensive data on their activities. Enormous lacunae, especially concerning nonbanks’ uses and abuses of leverage, persist and probably always will. Yet what one can infer is suggestive of enormous risks.

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The first red flag is that nonbanks have been at the heart of most of the financial accidents to hit various parts of the world in the past six months or so. Improperly hedged British pension funds triggered a fire sale in the market for U.K. government bonds, or gilts, last September. In October, a tremor in South Korea’s commercial-paper market culminated with concerns about insurers.

Nonbanks even are implicated in the banking kerfuffle that hit the U.S. last month: Panicky venture-capital funds appear to have accelerated the run on deposits at

SVB.

The IMF notes two other causes for concern that stand out. One is that nonbanks appear to be growing more entwined with banks across borders. The proportion of banks’ claims and liabilities attributable to nonbank financial intermediaries outside the banks’ home countries has grown to 22% and 20% in 2022 respectively, from 17% and 15% in 2015.

The other is that nonbank portfolios are coming to resemble each other, with similar institutions crowding into similar sorts of assets. A recent paper from the New York Fed illustrates how this works in the U.S., with life insurers loading up on corporate bonds, money-market funds on sovereign debt and hedge funds on equities, for instance.

These trends together amplify the risk nonbanks pose to one another in a panic, and the risk they pose collectively to the traditional banking system on a global scale. Especially if fire-selling in a crisis sets in motion a sudden collapse in asset values—as British pension funds overexposed to U.K. gilts discovered last year.

The IMF, predictably, argues for more regulation. Its biggest howler is the suggestion that to stabilize financial markets in a nonbank panic, central banks should extend their lender-of-last-resort protection to such institutions. Various central banks already have done this in various panics, and it does make the pain stop. But this “solution” merely converts the nonbank problem into a bank problem by extending the central-bank backstop that used to be the sine qua non of a real bank.

Rather, this situation demands an entirely new approach to financial regulation. The error after 2008 was to believe it matters whether or not a financial intermediary is a “bank,” such that if we properly regulate intermediaries chartered as banks we can protect the economy from a financial system gone awry.

The reality is that the risk adheres to any institution engaged in financial intermediation in sufficient volume, whatever you choose to call it. Our problem is that more than a decade of unprecedented low interest rates and quantitative easing distended global finance. That stricter bank regulation pushed more of that capital into nonbanks is a symptom, not a cause, of our current peril.

If we now overregulate the nonbanks, we’ll soon find ourselves with a new cohort of non-nonbanks. What no one in any government will readily admit is that the only effective regulatory solution is monetary discipline. Meanwhile Treasury Secretary

Janet Yellen

keeps reassuring us that the banks are sound. She may even be right about that, but don’t assume it will matter.

Journal Editorial Report: Biden officials are sending damaging mixed signals on policy. Images: Getty Images/Pool via AP Composite: Mark Kelly

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