Bank-NBFI linkages create financial stability risks for euro area

European banks engage with the non-bank financial intermediation (NBFI) sector through three interwoven roles: providing liquidity management, offering leverage, and acting as market-makers.

These interactions can create systemic risk spillovers and amplify shocks.

The report highlights that euro area banks are aggregate net debtors to the NBFI sector, indicating that funding and liquidity vulnerabilities are key consequences of these linkages in Europe.

NBFI entities fund approximately 15 percent of bank balance sheets in the euro area, with a significant portion being short-term funding.

This short-term nature, combined with the homogeneity of NBFI funding providers and limited substitutability, could pose challenges for banks during periods of market tension.

The report details how liquidity management by NBFI entities creates vulnerabilities in the banking system, particularly through short-term deposits, unsecured and secured debt securities, and securities financing transactions.

Banks' credit exposures to NBFI entities using leverage for trading or investing in illiquid assets are increasing.

Roughly a quarter of total bank credit exposure targets potentially leveraged NBFI entities.

Reverse repo lending to hedge funds, often in US dollars for short-term trading, is the largest vulnerability, having doubled in four years.

While collateralised, asset price shocks could force unwinding and fire sales.

Exposures to NBFI entities investing in illiquid long-term assets, like real estate funds, also pose credit loss risks if property values fall.

Banks' derivatives market-making activities further connect them to the NBFI sector, enabling risk management but also creating deeper interdependencies.