Indirect impacts
Crucially, both the direct and indirect effects would add up as they would likely occur simultaneously. We see three indirect impacts that would occur in the event of intense stress on the NBFI sector.
1. Financial instability and asset value drop
As mentioned, shocks to NBFIs may lead to fire sales of assets, which could itself lead to turmoil in financial markets. Banks would also be affected via the drop in value of some of their assets.
Given the larger size of the NBFI sector, the effects will be stronger than in the past. This would hurt the value of the assets that banks use as collateral themselves (e.g. in liquidity operations with the central banks), thus hitting the ability of banks to fund themselves. Also, this would hit the collateral that banks require from customers. In the event that the resulting margin calls couldn't be met, this could lead to credit losses for banks and possibly result in doubts about the bank itself.
2. Wealth effects in the population
Shocks to NBFIs would induce a hit to the value of their investments. Most hedge fund investors and other financial intermediaries are considered to be high-income individuals, who would experience a negative wealth effect, leading them to spend less. Nevertheless, this would not have a big impact on the broader economy, as spending among high-wealth individuals actually has a limited relationship to their wealth. However, this is not the case for pension funds. One could expect a shock affecting many pension funds or one fund, in particular, (as we have seen in the UK) to affect the middle-income population. On top of being a huge confidence shock, this could potentially impact the solvency and default probability of a portion of banks’ middle-income customers. With a shock large enough, this could also imply less spending and a potentially significant slowdown of the broader economy.
3. Credit availability and costs, affecting the loan book
NBFIs play an important role in the economy by providing access to credit to those who cannot borrow at a reasonable cost through banks. An important stress could mean a contraction in credit and sudden higher financing costs in the real economy. This would slow the economy down and therefore also impact the banking sector.
Furthermore, the link between a client and an NBFI (such as an investment fund) is less strong than between a bank and its client. When the going gets tough, banks often support their clients. Investment funds may not have this same incentive. This may mean that banks will be looking at a situation where either they see their client defaulting (if the NBFIs do not extend their funding) or they are forced to refinance. These dynamics may pressure bank loan quality.
A financial shock that hits the NBFI sector could lead to financial stress in the banking system both via direct and indirect channels.
