Non-bank Financial Institutions at the Ground Zero of Next Crisis

• Non-bank financial institutions (“shadow banks”) filled the funding gap following banks’ retreat in the wake of the post-crisis regulatory tightening and amid pressure to bolster returns in response to central banks’ low rates policy • “Shadow banks” such as investment managers, insurance companies and pension funds reacted to policy-induced volatility suppression by moving up the risk ladder: longer term bonds, high yield debt, equities, and direct lending • Prolonged volatility dampening induced investors to forgo volatility hedging and fueled the growth of passive funds, and rising concentration of “flighty asset” in passive funds increased probability for a “shadow bank run” • Non-banks are becoming increasingly reliant on monetary authorities to continue volatility suppression, and many “reach for yield” and risk-parity strategies hinge on prolonged policy accommodation to ward against redemption • Looming increase in Fed balance sheet reinvestment cap and ECB QE taper will threaten years of non-bank risk accumulation made viable by low volatility, and a decline in asset prices will likely trigger a systemic VaR shock