The path to NBFI rules in the US will likely be long

June 10, 2024

Key Takeaways

  • Getting FINRA 4210 through approval process was arduous
  • Global approach to regulating NBFIs has been piecemeal
  • Jurisdictions will differ, but key to success is quality data

It has been a long seven years, but as the month of May neared its close, financial services firms were putting the finishing touches to the implementation of Financial Industry Regulatory Authority (FINRA) Rule 4210 relating to Covered Agency Transactions. However, now the focus has turned to other regulations stuck in limbo such as those covering the nonbanking financial intermediary (NBFI) sector.

In March, the US Securities Exchange and Commission gave the green light to FINRA 4210, but the origins can be traced back to 2016 as a response to the havoc created in 2008. The rule, which was designed to address concerns about excessive leverage and potential systemic risks, encompasses various aspects of margin requirements, from initial and maintenance margins to conditions under which additional margins might be needed. In addition, it categorizes securities, accounts, and strategies, providing a comprehensive framework for margin calculations and requirements.

The rule captures Covered Agency Transactions, such as To Be Announced (TBA) deals, inclusive of adjustable-rate mortgages (ARM), Specified Pool deals and collateralized mortgage obligations (CMOs), issued in conformity with a program of an agency or government-sponsored enterprise (GSE), with forward settlement dates.

Size is everything

As with many new rules, the larger firms were able to dig deep into their resources and pockets to comply, but their smaller peers were expected to have difficulties. In fact, the multi-year delays were attributed to continuing dialogue with industry and market participants, including the staff of the SEC and the Federal Reserve System, about the impact these new margin requirements would have on smaller and midsized firms

This is because of the long checklist, which includes eligibility for different margin accounts, financing arrangements, equity levels, and day-to-day management of margin calls. This translated into new legal agreements, collateral calculations, and market data to include securities prices. Moreover, risk management systems had to be bolstered, while relevant trades had to be tagged and in scope.

The magnitude of the tasks led the Bond Dealers of America and Brean Capital LLC to file a petition with the SEC in 2022, calling for an extended compliance deadline with 22 May 2024 being the agreed date.

NBFI in the limelight

Given that FINRA 4210 took so long to finally pass, there are questions as to how many hoops less defined regulation will have to jump through. This is particularly the case with NBFIs, frequently referred to as shadow banking. This sector came firmly onto the regulatory agenda in 2020 in the wake of COVID-19 and the ensuing liquidity crunch as investors rushed to redeem funds.

The noise has grown louder as NBFIs’ total assets have increased to USD 239 trillion at end-2021 from about USD 100 trillion in 2008, according to a new report from S&P – Global Shadow Banks Face Scrutiny as Risks Rise.

This represents roughly 49% of the total financial assets in countries reporting to the Financial Stability Board (FSB) and around 80% of global GDP. Pension funds and insurance companies are the two largest subsectors, each representing 15%-20% of all NBFI assets, while hedge funds, private equity, money market funds and real estate investment comprise the remainder.

Filling the banking gap

Their growth is not surprising given that they have been increasingly filling the gaps left by banks who are much more constrained due to tighter capital requirements.

While there is recognition that this more diverse group of players spreads the risk, there is growing concern over the leverage that is being accumulated in the form of short-term debt. In fact, a sizeable chunk is emanating from traditional banks, effectively tapping into the government backstops designed to protect the regulated sector.

As of December 2022, banks in the US had lent more than USD 300 billion to nonbanks and committed another USD 1.5 trillion in credit lines, according to a recent academic paper, “Where Do Banks End and NBFIs Begin?“. Taken together, that is nearly triple the level of a decade earlier.

Tackling the issues piecemeal

Although global regulators have pledged to tackle the threats within NBFI, it seems to be in a piecemeal fashion, although liquidity is a common theme. For example, the FSB has been assessing the vulnerabilities associated with liquidity mismatches and leverage which are sensitive to tightening financial conditions and slowing economic activity.

Last December, the FSB and IOSCO, a global group of securities markets regulators, issued tougher liquidity management guidance for asset managers of open-ended investment funds, adding to existing guidance for money market funds, which come into effect in early October 2024, imposing a mandatory fee on large redemptions.

There are also different initiatives and views on a regional level. US policymakers seem to be more focused than in Europe. This is reflected in the European Fund and Asset Management Association (EFAMA) white paper – Open-ended funds and resilient capital markets.

The trade group argues that the European investment fund landscape is not systematically important and that while certain subgroups of funds may contribute to pockets of risk, effective micro- and macro-supervision remains key to identifying and supervising these subgroups.

It is still early to determine how the regulation of NBFIs will unfold, but it is certain that the emphasis should continue to be on obtaining the right information. This is difficult to do in a mostly unregulated sector, but without quality data, it is much harder to identify and quantify the main risks, such as financial leverage, liquidity, and interconnectedness between NBFIs and the banking sector.

In global, interconnected markets, it’s imperative that regulators lay out a shared roadmap and understand the reach of NBFIs. Let’s see if a New York Fed-ECB joint workshop on 21 June sheds light on the matter.

ION Markets

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