The importance of non-deposit-taking financial institutions

I'm away from my desk at the moment so posting volume is reduced, but I do want to draw attention to an excellent piece by David Roche in the FT. Firstly he points out the importance of non banks to the liquidity of the US financial system:

The Federal Reserve has belatedly recognised that investment banks, hedge funds and other non-deposit-taking financial institutions are as vital as banks to both the financial and "real" economies. The Fed is lending them massive amounts of capital through newly created facilities. It is right that central banks should be able to do so; NDFI's create more "asset money" than banks but are much riskier institutions.

NDFIs, though, are not regulated as deposit takers, and in particular the broker/dealers benefit from SEC supervision. As David continues:

What is wrong is that the Fed is doing so without having oversight or supervision of the borrowers.

He then looks at both the size and the velocity of NDFI money:

Investment bank, hedge fund and broker balance sheets are about half the size of the commercial banks in the US and about one-quarter the size in Europe. Both assets and liabilities of NDFIs are dominated by repos, meaning that NDFIs lend and borrow based upon collateral of assets that are constantly marked to market. As asset prices fluctuate, leverage must constantly be adjusted.

This is related to the procyclicality of a leveraged fair value player as I discussed here. As David explains:

In a bear market, as asset prices fall, leverage is reduced. This causes lenders to ask for more collateral on existing loans and borrowers to sell assets so as to reduce the need for such loans and for additional collateral.

The opposite happens in a bull market when rising asset prices cause the balance sheets of NDFIs to expand. The liquidity this creates is used to invest in assets, boosting their prices and creating demand and collateral for more borrowing to make more investments.

So the balance sheets of NDFIs are highly geared to asset price cycles. They act in a pro-cyclical manner, reinforcing bull and bear market cycles and through them economic cycles. So the effect on "asset money" is greater than that of deleveraging by banks, which lend for a wider range of purposes than NDFIs.