SUNANDO ROY – On Banking, Finance and Society

Shifting risk residence in recent years is best understood as a story of transformation rather than simple migration, in which credit risk has increasingly come to reside in NBFIs while liquidity and contingent funding risk concentrate in banks and the official safety net. Post‑crisis regulatory reforms were a central catalyst of this pattern, but they interacted with low rates, investor demand for yield and financial innovation to produce a tightly coupled bank–NBFI intermediation complex.

From migration to transformed intermediation

The traditional narrative of “disintermediation” depicts risky credit leaving bank balance sheets and reappearing in capital markets or shadow banks, with banks rendered safer but less central. Recent work by Acharya, Cetorelli and Tuckman challenges this view, arguing instead that the rapid asset growth of NBFIs relative to banks reflects a re‑allocation of who holds credit risk versus who stands behind liquidity and funding commitments. In their “transformed intermediation” framework, NBFIs increasingly hold the junior, loss‑absorbing claims on households and firms, while large banks pivot towards providing senior secured finance, back‑up credit lines, derivatives intermediation and balance‑sheet capacity to those NBFIs.

This shift changes where shocks are first absorbed and how they propagate. Losses on underlying loans and securities are now more likely to be borne by investment funds, finance companies and securitisation vehicles, but the need to meet margin calls, fund redemptions and roll wholesale funding means that liquidity strains can boomerang back onto bank balance sheets and, ultimately, central banks. The result is a system in which credit risk resides outward in NBFIs while liquidity risk and last‑resort support remain concentrated in the regulated banking core.

Regulatory push: bank reforms as catalysts

Post‑GFC reforms materially increased the cost of holding and funding risky, illiquid assets inside the banking system. Higher risk‑sensitive capital charges for securitisations and trading‑book exposures, together with the introduction of the Liquidity Coverage Ratio and Net Stable Funding Ratio, made it more expensive for banks to warehouse complex credit and fund long‑term assets with short‑term liabilities. Stricter treatment of off‑balance‑sheet vehicles, tighter large‑exposure limits and the rise of macroprudential tools for high‑risk lending further raised the regulatory cost of certain activities for banks relative to lightly regulated NBFIs.

These reforms were successful in their narrow objective: they strengthened bank solvency and liquidity, and reduced the likelihood of outright bank failure from classic maturity transformation and credit concentration. Yet, as the Basel Committee and FSB acknowledge, differences between the prudential regimes for banks and NBFIs created incentives to conduct similar intermediation in less regulated forms, a dynamic often labelled “regulatory arbitrage”.

Demand‑side and structural pull factors

Regulation alone does not explain the scale and composition of NBFI growth. A prolonged period of low interest rates and search‑for‑yield led institutional investors to demand higher‑return products, spurring the growth of bond funds, private credit funds and structured investment vehicles that sit largely outside bank capital and liquidity rules. At the same time, advances in technology and data analytics enabled fintech platforms and nonbank lenders to originate and service loans efficiently, helping them capture market share in segments such as mortgages and SME credit even as banks faced tighter regulatory constraints.

Monetary policy and market structure also mattered. Central banks’ large‑scale asset purchases compressed yields on traditional bank‑eligible collateral and boosted demand for market‑based credit intermediation, while the deepening of derivatives and repo markets increased the role of dealer banks and nonbank intermediaries in transforming risk exposures through collateralised finance. In this environment, NBFIs were natural vehicles to house credit risk, while banks specialised in providing leverage, liquidity and transactional infrastructure.

Intertwined  bank–NBFI balance sheets

Evidence from supervisory and market data underscores how closely banks and NBFIs are now intertwined. The Basel Committee’s study of bank–NBFI interconnections documents multiple channels: banks fund NBFIs through loans, credit lines and securities financing; NBFIs in turn fund banks through wholesale markets and bond holdings; and both are linked via derivatives and collateral chains. Case studies show that banks have shifted from holding the mezzanine and equity tranches of securitisations to financing NBFIs that now take those junior risks, while continuing to provide committed liquidity support and derivatives hedges.

Empirical work finds that shocks originating in NBFIs can transmit rapidly to banks. Episodes of fund outflows, margin spirals or dysfunction in core markets reveal that liquidity stress in investment funds and dealers often leads to demands on bank credit lines, haircuts in securities financing and valuation losses on assets held by both sectors. These dynamics underline that while credit risk may reside in NBFIs, the system’s ultimate liquidity backstop remains the regulated banking sector supported by central banks and, in extremes, the fiscal authority.

Policy implications: regulating risk where it resides

The transformation of risk residence raises challenging questions for prudential and macroprudential policy. If NBFIs hold a growing share of credit risk but rely on banks for leverage and liquidity, limiting risk in one sector alone can simply redirect it along the network of interlinkages. This has led international bodies to call for a more system‑wide approach, combining resilient banks with targeted tools for NBFIs, such as leverage limits, liquidity management rules for open‑ended funds, minimum margining standards and enhanced transparency on leverage and interconnectedness.

A key theme in the emerging literature is that supervision must track not only where assets sit, but also where contingent commitments, guarantees and liquidity backstops reside. Acharya, Cetorelli and Tuckman emphasise that central banks effectively provide a form of “too‑interconnected‑to‑fail” insurance to the joint bank–NBFI ecosystem, whether through direct market interventions or through support to banks that are deeply exposed to NBFIs. Designing coherent regimes for resolution, lender‑of‑last‑resort access and macroprudential constraints that recognise this transformed intermediation structure is central to ensuring that the shift of risk residence does not simply displace, but genuinely reduces, systemic vulnerability.

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