The architecture of the financial markets is undergoing a seismic shift. Continuous financial innovation, the fragility of bank balance sheets post-financial crisis, shifts in operational paradigms, and intensified banking regulations have collectively pivoted financing away from traditional bank loans towards bond issuance. This pivot has elevated the role of non-bank institutions—such as insurance companies, pension funds, and asset management firms—into prominence. These entities have become pivotal in financial intermediation in the United States and have seen their significance surge in Europe and emerging market economies.
The Diminishing Dominance of Banks
The question arises: Has the ascent of non-bank financing diluted the potency of monetary policy? Some argue that the impact of monetary policy on economic activities has waned due to the diminished importance of bank credit, traditionally a primary transmission channel. Theoretically, non-bank institutions could either dampen or amplify the effects of monetary policy. On one hand, if non-bank institutions are less affected by monetary policy changes than banks, or are not subject to the same regulatory constraints, they could step in and replace banks in lending, potentially muting the transmission of monetary policy. On the other hand, if non-bank institutions are more sensitive to changes in monetary policy due to their risk preferences, they could magnify its transmission.
This chapter delves into this relatively unexplored yet critical area, first framing the discussion conceptually, then employing innovative analytical methods to scrutinize empirical evidence.
A New Era of Monetary Influence
The findings of this chapter are telling. Over the past 15 years, the rising importance of non-bank financial intermediaries has, if anything, strengthened the transmission of monetary policy. The efficacy of monetary policy has been bolstered across multiple nations, with a larger non-bank financial sector correlating to greater monetary influence. Like banks, non-bank institutions reduce their balance sheet size in response to monetary policy tightening, with the scale of reduction often exceeding that of banks. This behavior can be partly explained by the impact of monetary policy on risk-taking activities. The result is a shift in bond yields and risk premiums, thereby affecting borrowing costs and real economic activities. Thus, the composition of the non-bank financial sector is a significant factor in the transmission of monetary policy.
Adapting Monetary Policy in the Face of Change
With the rising role of non-bank institutions, it is clear that monetary policy operations must continually adapt to changes in transmission channels. The scale and timing of monetary policy actions must be adjusted continually, as their magnitude and speed of effect are in flux. For instance, as the relative importance of the risk-taking channel increases, the impact of monetary policy changes on the real economy could be more immediate and pronounced. Although not the focus of this chapter, changes in the regulatory framework could affect the strength of monetary policy transmission, as banks and non-bank institutions respond differently to monetary shocks, reflecting differences in their regulatory regimes.
Monetary Policy and Financial Stability
The impact of monetary policy on financial stability has become increasingly significant. For example, the influence of monetary policy operations on the financial robustness of banks and non-bank financial institutions might have grown, as the risk-taking channel appears to be a more crucial mechanism driving the response of financial intermediaries. This suggests that prudential and regulatory authorities need to maintain heightened vigilance.
Monetary policy must consider the size and composition of the primary financial intermediaries’ balance sheets to better gauge shifts in financial institutions’ risk preferences. Given the growth of the non-bank financial sector, information on non-bank institutions’ balance sheets is at least as informative as traditional measures of the money supply. Metrics such as the leverage of broker-dealers and the total assets managed by bond funds can provide valuable insights for monetary policy. Against this backdrop, bridging the data gap on the non-bank side is of paramount importance.
