Regulators are taking on nonbanks — a little bit at a time

Bloomberg News

WASHINGTON — The 2008 financial crisis amply illustrated the potential for nonbank financial firms to pose a risk to the broader financial system. But the increasing growth and interconnectedness of those firms is compelling regulators to rely on the limited tools they have to check that risk.  

Ian Katz of Capital Alpha Partners says regulators are keeping a watchful eye on the expanding connections between banks and the alternative asset management sector.

"I think this has been building gradually for a long time," said Katz. "More financial activity has moved outside the banking sector in recent years, and a lot of that activity isn't under direct federal oversight." 

Evidence from a Financial Stability Board publication in 2023 showed nonbanks' market share has grown since 2008. FSB estimated that nonbanks collectively have more than $200 trillion in total assets and account for about half of the global financing activities — a higher level than during the financial crisis. Katz noted that while bank regulators cannot directly oversee other sectors, they can engineer solutions that protect the banking sector from nonbank exposure.

"[Regulators] believe that non-banks don't operate under the same tough regulations they face, and it's a fair point that banks are regulated more strictly than non-bank financials," Katz wrote. "At the very least, the bank regulators want to keep the riskiest and sketchiest stuff away from the banks they oversee."

Regulators' strongest tool to rein in risks from nonbanks is housed with the Financial Stability Oversight Council, an interagency commission created by Dodd-Frank tasked with identifying and curtailing risks to the broader financial system. 

While its power to designate nonbanks systemically risky — thereby subjecting such firms to enhanced prudential standards similar to those big banks face — was weakened through litigation and by regulation during the Trump administration, FSOC reclaimed its designation power last year. But David Portilla, a lawyer at Davis Polk and former FSOC staffer argues that may not reduce the risks posed by nonbanks overnight. 

"There doesn't seem to be an indication that the FSOC is working on entity designations in regards to the asset management industry," said Portilla. 

While entity-level designations don't appear imminent, Katz notes that regulators still can exercise some limited indirect power to hedge risks from nonbanks.

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"What they can do is have some influence indirectly," Katz wrote in an email, "by increasing scrutiny or tightening rules around who banks can do business with [or] what they can have on their balance sheets."

Indeed, federal regulators have been floating a variety of new policies related to nonbanks over the past year. Federal Reserve Vice Chair for Supervision Michael Barr called for banks to exercise greater diligence toward counterparty risks and said banks should maintain appropriate margins to pad against a hedge fund collapse like that of Archegos in 2021. The agency also incorporated a counterparty risk scenario into this year's stress tests to gauge banks' resilience to the collapse of a major nonbank counterparty. 

Another top regulator, acting Comptroller of the Currency Michael Hsu, recently called for FSOC to establish a "tripwire approach" to consider designating certain systemically important nonbanks — like hedge funds — which meet certain metrics. 

Additionally, Federal Deposit Insurance Corp. Chairman Gruenberg called for FSOC to apply tailored enhanced prudential standards and reporting requirements to particular nonbanks like open-ended mutual funds, hedge funds and other nonbank lenders.

Treasury's Financial Crimes Enforcement Network also recently proposed a rule subjecting investment advisors to AML/CFT reporting requirements.

Harry Stahl, director of business and solutions strategy at FIS — a leading regulatory technology provider to the nonbank industry — notes the nonbank sector has noticed the spotlight shining on their industry and reacted accordingly. 

"There's a lot more sense of thinking about who are the players in the ecosystem and making sure that everybody is well organized, buttoned down and complying with the critical regulatory concerns," said Stahl. "It's not surprising that this would be happening now when we look at what's going on in the market."

Bryan Corbett, president and CEO of the Managed Funds Association — a trade association that represents asset management firms like hedge funds — argued that nonbanks are less systemically risky and already sufficiently regulated. Unlike banks, he said, their funding is not subject to the same kinds of run risk, and the capital such nonbank firms manage comes from institutional investors and is locked away for some time. 

"FSOC's SIFI designation and other attempts to apply banklike regulation to private funds is misguided and will harm U.S. capital markets," Corbett said. "There is already a robust regulatory regime in place for alternative asset managers that grants regulators insight into the activities and health of funds and the tools to ensure the market is well regulated." 

Banks have appeared to seize on uneasiness about growing influence of nonbanks to argue against the Basel endgame capital reforms proposed last fall. They argue if regulators force banks to fund certain activities with greater levels of equity — as is the key thrust of the proposal — that will drive such activities into the hands of the nonbank sector. Katz notes this is one rare instance where the regulators may see eye to eye with the industry. 

"The regulators trying to get their arms around nonbank activity does respond to the criticism that the Basel endgame pushes activity outside the regulated banking sector," he wrote. "I think that's one of the criticisms of Basel that the regulators view as valid."

Dennis Kelleher, CEO of consumer watchdog Better Markets, said he is equally concerned with less-regulated nonbanks increasing financial services intermediation. However, he argues the solution is not to ease up on banks, but regulate banks and nonbanks alike to prevent regulatory arbitrage. 

"If the nonbank sector is not regulated, that's no reason to also not regulate the banking sector," Kelleher said. "That would be doubling down on disaster and guaranteeing a catastrophic financial crash like or worse than 2008. Strengthening the banking sector is only half the battle of preventing financial crashes, contagion and bailouts, as proved in 2008, 2020 and 2023."