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Law360 (October 20, 2020, 5:50 PM EDT) -- The Federal Reserve Board's top supervision official on Tuesday hinted that policy changes could be underway after the so-called nonbank sector revealed itself to be "significantly more fragile" than the banking system amid the COVID-19 pandemic.
Speaking at the Securities Industry and Financial Markets Association's annual conference via webcast, Vice Chair for Supervision Randal K. Quarles said "swift and decisive policy action succeeded in calming markets" during the pandemic, but there is still "work to do" in addressing the risks linking the banking and nonbank sectors.
"The COVID event revealed a banking system that withstood this shock quite well with limited official sector support, and a nonbank system that was significantly more fragile," Quarles said, according to a transcript of the speech. "By this measure, the COVID event demonstrates that we have work to do."
Nonbanks are financial institutions that don't fall under the supervision of a national or international banking regulatory agency and lack the legal status as a bank. These includes certain insurance firms, mortgage providers, payday lenders and others who don't provide full banking services, though Quarles did not give any names.
Quarles said a special steering group of the international Financial Stability Board he chairs has spent several months identifying areas of the so-called nonbank financial intermediation, or NBFI, framework that "did not exhibit sufficient resiliency" during the pandemic, noting that the FSB will deliver a report on the findings at the 2020 G20 Summit in November.
The main areas of concern Quarles cited were not specific to nonbanks, but he stressed that financial sector risks today should be addressed in light of the increased "interconnectedness" between the banking and the nonbank sectors, particularly as the latter gains a larger financial footprint than ever before.
The FSB now estimates the sector accounts for almost 50% of total financial intermediation globally, which is "up sharply in the last decade" and has created "greater interconnectedness," Quarles said.
"The interconnectedness of our financial system means that it is not enough to understand the vulnerabilities arising from the banking sector," Quarles said. "We must also understand vulnerabilities in the nonbank sector and how shocks are transmitted to or from the nonbank sector."
Quarles pointed to the difficulties that "traditional sources of cash" had keeping up with liquidity demand during the pandemic, which depleted banks' lending reserves; as well as an "alarming" government bond selloff that led to unanticipated pricing dips among some of those bonds.
In addition, he noted that U.S. money market funds, which are traditionally viewed as "very safe," required government intervention after a run on the funds created a "potential to destabilize the financial system." Quarles noted that the outflows from money market funds in March 2020 exceeded those that occurred during the fall 2008 run-up to the Great Recession.
"Work needs to be done to improve the resiliency of money market funds before the vulnerabilities in these funds amplify another shock," he said.
Quarles said next month's report to the G20 Summit by the FSB, a consortium that addresses the global financial system, will address areas "where policy consideration may be warranted" in light of the shocks to the system that COVID-19 has delivered, noting the necessity to better address the risks linking the banking and nonbanking sectors.
"This exercise will identify nodes and channels of risk transmission in the system, which will also help policymakers identify and understand the pathways for both amplification and absorption of risk in the financial system," he said.
The 2020 G20 Summit, the group's 15th meeting, is scheduled for Nov. 21 through Nov. 22 in Riyadh, the capital of Saudi Arabia.
"The FSB will provide a forum for international experts to understand vulnerabilities in NBFIs, promptly prescribe reasonable policy solutions, and monitor the implementation and effectiveness of any agreed-upon reforms," Quarles said.
--Editing by Bruce Goldman.
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