António Guterres, Secretary-General of the United Nations, has previously voiced that the urgency for climate action has reached a zenith. If temperatures continue their relentless ascent, we may witness catastrophic sea-level rise, the decimation of tropical coral reef ecosystems, the ruination of the livelihoods of hundreds of millions, and further perturbation of weather patterns. The international community stands at a crossroads, with immediate action against climate change being the only viable path forward.

In Pakistan, the National Disaster Management Authority’s report dated September 2nd lays bare the stark toll of monsoon-triggered disasters between July 1st and August 31st—claiming the lives of at least 293 individuals and injuring 564 others. Images from the southern Sindh province’s Dadu district show swathes of land besieged by floodwaters, a testament to nature’s unbridled force.

Meanwhile, Tropical Storm Capricorn has cast a shadow over the Philippines since the evening of September 1st, unleashing torrential rains and landslides. The tempest’s wrath has led to the cancellation of numerous domestic flights and the suspension of operations at ports in the eastern and central regions of the country. Photographs from September 2nd depict residents navigating the inundated streets of Rizal province—a visual echo of the storm’s disruptive might.

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.