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    BIS Discusses Regulatory Approach for Non-Bank Intermediation

    December 06, 2021

    The Bank for International Settlements (BIS) published the December issue of the Quarterly Review, which analyzes the non-bank financial intermediation mechanisms that could undermine financial stability. BIS notes that a macro-prudential regulatory approach is needed to address the structural vulnerabilities in non-bank financial intermediaries, most notably liquidity mismatches and hidden leverage. The Quarterly Review also contains special features on decentralized finance, achievements and challenges in environmental, social, and governance (ESG) markets, systemic risks and policy implications of open-ended bond funds, non-bank financial intermediation in emerging Asia, and the rise of private capital markets.

    In the Quarterly Review, BIS emphasizes that the non-bank financial intermediaries not only provide a valuable source of alternative financing but also give rise to new channels of financial instability, as also seen in the March 2020 turmoil. Recent developments in sovereign bond markets show that non-bank financial intermediaries can influence the conduct of monetary policy too. BIS notes that addressing these gaps will require a systemic approach to regulating the non-bank financial intermediaries, which is also the key to better addressing their structural vulnerabilities, notably liquidity mismatches and hidden leverage, and building adequate shock-absorbing capacity. Given the increasing role that the non-bank financial intermediation sector plays in the market ecosystem, it is important to apply a macro-prudential approach to regulation. More effective prevention should be the main answer to regulatory gaps in this sector. Reducing the likelihood and intensity of financial stress would also reduce the need for emergency central bank assistance. As always, one element of the multi-pronged policy response should be better information. For authorities, this would come in the form of enhanced reporting as a basis for stronger monitoring; for markets, it would take the shape of enhanced disclosure.

    The importance of reliable information comes to the fore in the context of climate change and green financing. This is emphasized in a special feature in the Quarterly Review, which examines how investors seek to address ESG issues, largely through non-bank financial intermediaries. The analysis finds that investors do respond to data on firm-level carbon emissions and to social bond designations, even if funding costs have seen little effect so far. However, markets are grappling with unreliable taxonomies and inputs into these taxonomies, resulting in "greenwashing" or "ESG-washing," which stand in the way of the desired transition. Another essential element in the policy response is to ensure that non-bank financial intermediaries have sufficient shock-absorbing capacity. This capacity will have to be tailored to the nature of the non-bank financial intermediation's vulnerabilities and, hence, the inherent leverage and liquidity mismatches. Other pre-emptive steps include taking a less fragmented and more consolidated supervisory perspective. 

    The Quarterly Review also notes that regulatory challenges may appear insurmountable in the case of the decentralized finance, which is designed to avoid central oversight and rulemaking. However, in the special feature on decentralized finance, Aramonte, Huang and Schrimpf show that  decentralization is an illusion: pivotal entities (typically, application developers) are ultimately in control. With appropriate adjustments to legal systems, these entities, as well as links of the decentralized finance with the traditional system, could become the natural entry points for the regulation that is needed to address money laundering and other abuses as well as to achieve financial stability goals. Given the characteristics of decentralized finance, these efforts will require international coordination. Any final coherent and inclusive framework may also have to include prohibitions for some decentralized finance activities. Overall, BIS notes that the challenge for the authorities is to manage those risks effectively while allowing the financial system to perform its basic functions in the interest of society. Policymakers cannot afford to fall behind the curve.

     

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    Keywords: International, Banking, Quarterly Review, Sustainable Finance, ESG, COVID-19, Regtech, Decentralized Finance, Blockchain, Greenwashing, Liquidity Risk, Non-Bank Financial Intermediaries, Macro-Prudential Approach, NBFI, BIS

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