BIS Paper Contributes to Debate on Regulating NBFIs and Big Techs

The paper examines the differences between activity- and entity-based regulations and between micro- and macro-prudential regulations, followed by their applications to NBFIs and big tech firms. The paper notes that activity-based regulation is superior when the failure of an activity—as opposed to that of the entities performing it—can create a systemic event and this activity can be effectively regulated directly on a standalone basis. However, when financial stability requires constraining the combination of different activities within entities, authorities need to resort to entity-based measures. This is often the case because of the very nature of financial intermediation, notably in the presence of leverage and liquidity transformation, which are at the root of key financial vulnerabilities. Entity- and activity-based regulations can reinforce each other in a belt-and-braces approach (for example, loan-to-value/debt-to-income maximum ratios alongside capital requirements). The paper also notes that comparing the entity-based versus activity-based classification with the micro-prudential versus macro-prudential one yields important insights. Although activity-based measures target systemic activities, they are not necessarily macro-prudential because they may not account for the importance of individual entities for the given activity. When activity-based regulation does adopt a macro-prudential perspective, it is not necessarily consistent with a level playing field, in contrast to a common view. Notably, such regulation should impose stricter standards on entities that perform a larger share of a systemic activity, thus putting them at a competitive disadvantage, all else equal.

Applying the framework to NBFIs and big tech firms highlights deficiencies of current approaches to achieving financial stability objectives. The key aspects of NBFI regulation are largely entity-based. A notable example is (minimum) liquidity and leverage requirements for mutual funds, which are calibrated at the level of funds’ balance sheets. Seeking to strengthen the resilience of individual funds, these measures are conceptually equivalent to regulatory requirements for banks and structured in a very similar way—and they are, in both cases, micro-prudential. In times of stress, mutual fund liquidity requirements lead to liquidity hoarding or deleveraging that exacerbates market swings, thus undermining financial stability. One reason for the mismatch between NBFI measures and financial stability objectives is that the requirements were designed for narrow investor-protection purposes. Activity-based margining requirements are another example of tools whose design could be improved to better support financial stability; despite concerns about their procyclicality, they are still calibrated largely without regard to systemic risks. By contrast, financial stability would call for a macro-prudential perspective along the time dimension. Overall, the dominance of investor-protection objectives in the investment fund sector and the  consequent focus on entities on a standalone basis result in a policy gap from a financial stability perspective.

With respect to big tech firms, however, although their financial activities (for example, payment services) are a small part of their overall business, big tech firms may already be large players in some systemic activity, or soon could be. Activity-based regulation would be a natural starting point to ensure that big tech firms are subject to the same financial stability measures as other entities performing the same activities. In addition, macro-prudential considerations would call for imposing tighter constraints on big tech firms that dominate a specific activity. This would tilt the playing field against them. That said, an activity-based approach will generally be insufficient. Since big tech firms provide a gamut of services, the systemic repercussions could be substantial if one of these entities were to fail. Entity-based measures with macro-prudential orientation, as in the case of global systemically important banks (G-SIBs), would thus be warranted. For such regulation to be effective and efficient, notably avoiding the imposition of financial stability measures on non-financial activities, big tech firms may need to adopt a holding company structure and engage in financial activities.

Related Links

• Press Release
• FSI Paper (PDF)

Keywords: International, Banking, Financial Stability, Entity Based Regulation, Activity Based Regulation, Bigtech, NBFI, Regtech, Lending, Systemic Risk, FSI