Monitoring Banks’ Exposure to Nonbanks: The Network of Interconnections Matters
The first post in this series discussed the potential exposure of banks to the open-end funds sector, by virtue of commonalities in asset holdings that expose banks to balance sheet losses in the event of an asset fire sale by these funds. In this post, we summarize the findings reported in a recent paper of ours, in which we expand the analysis to consider a broad cross section of non-bank financial institution (NBFI) segments. We unveil an innovative monitoring insight: the network of interconnections across NBFI segments and banks matters. For example, certain nonbank institutions may not have a meaningful asset overlap with banks, but their fire sales could nevertheless represent a vulnerability for banks because their assets overlap closely with other NBFIs that banks are substantially exposed to.
Financial Fragility without Banks
Proponents of narrow banking have argued that lender of last resort policies by central banks, along with deposit insurance and other government interventions in the money markets, are the primary causes of financial instability. However, as we show in this post, non-bank financial institutions (NBFIs) triggered a financial crisis in 1772 even though the financial system at that time had few banks and deposits were not insured. NBFIs profited from funding risky, longer-dated assets using cheap short-term wholesale funding and, when they eventually failed, authorities felt compelled to rescue the financial system.