Bank regulation shifts systemic risk to nonbank sector
A new Federal Reserve study develops a structural network model to analyze how bank regulation impacts nonbank financial intermediation and systemic risk. It finds that nonbank fragility is the dominant driver of fluctuations in bank-NBFI funding.
Capacity vs. reliance: The core drivers
The paper introduces a structural network model comprising banks, nonbank financial institutions (NBFIs), and non-financial firms, linked by credit and funding relationships.
This model decomposes changes in bank-NBFI interconnectedness into two channels: a capacity channel, reflecting bank balance-sheet constraints, and a reliance channel, capturing NBFI funding dependence on banks.
Using confidential U.S. supervisory data, the authors estimate key structural parameters.
They find that fluctuations in bank-NBFI intermediation are primarily explained by the reliance channel, with variations in NBFI fragility emerging as the dominant driver.
This suggests that while bank balance-sheet constraints shape the overall scale of financial intermediation, observed funding volumes are largely governed by the composition of NBFI funding, particularly its reliance on banks.
The marginal cost of expanding bank balance sheets rose markedly post-2021, while NBFI fragility spiked during the pandemic.
Unintended consequences of tighter regulation
Following the Global Financial Crisis, regulatory reforms significantly increased bank capital requirements, enhancing the banking sector's resilience.
Concurrently, financial intermediation, especially credit provision to non-financial firms, has increasingly shifted towards NBFIs, including insurance companies, asset managers, and hedge funds.
This shift raises concerns about the evolving structure of systemic risk, particularly whether tighter bank regulation inadvertently pushes activity into less-regulated nonbank sectors, potentially increasing systemic risk through greater interconnectedness.
Federal Reserve Vice Chair for Supervision Michelle W. Bowman has highlighted these unintended consequences, arguing that stricter requirements can constrain bank credit and redirect activity to less-regulated intermediaries.
The study provides a structural framework to analyze these mechanisms.
Amplification through funding interconnectedness
The model demonstrates that NBFI intermediation can amplify shocks through funding interconnectedness, particularly when NBFI reliance on bank funding exceeds their liquidation capacity.
This mechanism occurs because NBFIs unable to fully repay bank funding reduce recoveries relative to direct lending, magnifying losses.
The research thus contributes to the debate on financial networks as amplifiers versus risk-sharing mechanisms, offering a clear condition for when bank-NBFI linkages amplify losses in stress scenarios.
This highlights that systemic risk depends not only on the scale of intermediation but also on its composition and the interaction of leverage and liquidation frictions within the nonbank sector.