Financial Stability Board Warns on Nonbank Leverage Risks

The Financial Stability Board said in a new report that nonbank financial institutions (NBFIs), spanning hedge funds and private credit entities, among others, were tied to $218 trillion in total assets as recently as 2022 — roughly half the world’s financial assets.

“Leverage in NBFI can be an important amplifier of stress: If not properly managed, it creates a vulnerability that, when subject to a shock, can propagate strains through the financial system and create risks to financial stability,” the FSB said.

Watching Counterparty Risk

The FSB identified counterparty risk as a concern, where the “counterparty channel involves the default or distress of leveraged entities, which can impose direct losses on their counterparties, leading to a cascade of financial stress resulting in forced liquidations.” 

A leveraged entity “would likely default if its available liquid resources were insufficient to meet its counterparties’ collateral or margin calls, or if mark-to-market losses entirely eroded the leveraged entity’s capital” which then would prompt a withdrawal of financing.

For the regulators and for the banks — which extend borrowing through loans, bonds, repurchase agreements and other instruments — there’s a recommendation from the FSB that “authorities review the adequacy of existing counterparty disclosure practices made privately between leveraged nonbanks and leverage providers and, where appropriate, consider  developing, in partnership with industry, mechanisms, standards and/or guidelines to enhance the effectiveness of these disclosure practices.”

The Challenges

But the report also noted “significant gaps” in having the data on hand to gauge risk, as NBFI leverage can either be on-balance sheet (through, say, bonds) or off-balance sheet (with stakes in investment vehicles that are also leveraged). 

“Entity-level reporting may not be sufficiently granular or detailed for authorities to identify leveraged concentrated exposures within their markets. There are additional, specific data challenges relating to nonbanks undertaking cross-border activities, and to nonbanks that are not subject to entity-level regulatory reporting requirements,” the FSB stated. The board also recommended that leverage limits be considered on NBFIs.

As PYMNTS reported earlier this year and as the Fed noted in its own report on financial stability and nonbank risks, the central bank contended, “It is crucial to strengthen policies that mitigate nonbank leverage and other vulnerabilities,” adding, “Enhanced nonbank reporting requirements could help supervisors develop a systemwide and cross-sectoral perspective of risks and distinguish poorly governed and excessive risk-taking institutions from those that contribute more positively to financial intermediation.”

Part of the know-your-business (KYB) endeavors for banks and businesses in assessing risks of partners and counterparties involves taking stock of leverage (and the capital position of these borrowers) and addressing the data opacity noted by the regulators. 

Among recent announcements, First AML, which offers an anti-money laundering (AML) platform,  announced a strategic partnership with Know Your Customer, focuses on business verification solutions.  The partnership’s data reach spans 140 jurisdictions and activities such as corporate structure verification, access to official company documents and beneficial ownership information.  

In another example reported by PYMNTS, Treasury Prime partnered with fraud, identity and security platform Footprint to give banks and their FinTech clients access to Footprint’s KYB technology.