FSB Calls for Leverage Limits on Shadow Banking Sector

The Financial Stability Board (FSB) has released a series of recommendations aimed at enhancing the safety of the "shadow banking" sector. The FSB suggests that regulatory bodies should consider imposing direct limits on the leverage of non-bank financial institutions in core markets and take measures to control their size.

The FSB, an organization under the G20 composed of global financial regulatory bodies and relevant departments, reported that in 2022, non-bank financial institutions, including hedge funds, private credit providers, and insurance companies, held 21.8 trillion dollars in assets, accounting for nearly half of global financial assets.

The rapid expansion of the "shadow banking" industry has become a growing concern for the FSB and regulatory bodies. They are worried about the lack of transparency in this sector and the potential threat it poses to the resilience of broader financial markets.

In the past, the FSB has identified that highly leveraged non-bank financial institutions played a significant role during the market crash in March 2020, at the onset of the COVID-19 pandemic. During this period, hedge funds rushed to close out their positions in U.S. Treasury cash and futures basis trades, exacerbating market instability.

Other notable events mentioned by the FSB include the collapse of the hedge fund Archegos in 2021 and the market turmoil caused by a hedging tool used by British pension funds in 2022. This turmoil nearly led to the collapse of a significant portion of the industry.

The report released on Wednesday is the culmination of years of work. It provides key recommendations for financial regulatory bodies to improve oversight of the non-bank sector and enhance the safety of the financial system through intervention.

The FSB stated in the report, "Authorities should take measures to address the financial stability risks posed by the leverage of non-bank financial institutions (NBFIs) in core financial markets."

"In the absence of appropriate measures, authorities should select, design, and calibrate activity-based and entity-based measures, as well as measures related to concentration, to ensure that these measures are both effective and commensurate with the identified financial stability risks."

Among the recommendations, the FSB suggests that regulatory bodies should impose direct limits on leverage when necessary, increase margin requirements in the derivatives market, take measures to limit institutional over-concentration, and require market participants to report large holdings.

Other recommendations include strengthening regulatory coordination and preventing "inconsistent regulatory treatment," which could lead to regulatory arbitrage and increase financial stability risks.

The FSB will continue its work to assist authorities in implementing these recommendations. Its members will consider whether further work is needed on specific recommendations later this year.