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Some observers of the banking industry have argued that the presence of non-banks reduced the impact of countries' monetary policy on the economy. But a report by the International Monetary Fund (IMF) shows that the presence of non-banks has strengthened (not dampened) the effect of monetary policies over the past 15 years.

The analysis in the IMF's Global Financial Stability Report is being released ahead of the IMF's annual meetings on Oct. 7-9.

The new IMF report debunks the underlying belief that non-banks have complicated the functioning of an effective monetary policy, a decision that central banks take partly through an interest rate change.

The report based its analysis on data collected from 12 countries after 2000. It found that compared to the 20-years ending in 1999, the economic impact was slightly stronger in countries with larger nonbank sectors. The affect of monetary policy on GDP was stronger in countries like Korea, South Africa, Spain, Sweden and the United States. 

The report offered three key findings regarding the rise of non-banks on monetary policy:

  • Risk taking has increased through non-banks, which could mean "shorter transmission lags for monetary policy."
  • Regulatory framework changes for non-banks (like closing the regulatory gap with banks) are likely to have an impact on the strength of monetary policy transmission.
  • Since non-banks react strongly to monetary policy changes, the monetary policy dosage will need to be constantly adjusted "as the sector gains in importance."
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The study found that a shift in monetary policy, including interest rate changes, can impact the risk-taking channels, that have become important since the 2008 financial crisis. The IMF report showed that when monetary policy is tightened, non-bank financial intermediaries tend to contract their balance sheet more than the banks and vice-versa. This is partly because the risk bearing capacity of financial institutions is affected by changes in short-term interest rates.

Lower/higher interest rates can encourage/discourage risk taking by financial institutions through greater leverage. Thus, any changes in short-term policy rates largely affect the long-term rates by "reducing term premiums and thereby boosting economic activity, even if expectations about future short-term rates are unchanged", the report shows.

The supply of credits of banks and non-banks respond differently to monetary policy changes due to bank regulatory requirements. Non-banks, also known as "shadow banks" include insurance companies, pension funds and asset managers, and are not regulated like traditional commercial banks. In the U.S., they act as financial intermediaries.

The evolution of non-banks post 2008 stemmed from weakened bank balance sheets, modified business models, and increased bank regulation. In addition, with financial innovations, there was a shift from bank lending services to bond issuance. The "remarkable" growth of asset-management firms has strengthened monetary policy transmission. Fund managers remain sensitive to short-term interest rate changes due to the competitive compensation structure (rewarded based on the performance in comparison to their peers). Hence, this sensitivity can significantly move the asset prices as the size of the asset management industry grows, which forms a big part of the nonbanking sector.

Monetary policies need to consider "the size and composition of balance sheets of key financial intermediaries to better gauge changes in financial institutions' risk appetite", according to the report.

It further suggested that the timing and degree of monetary policy change should be adjusted regularly as the role of non-banks increases and changes occur. Emerging markets and other countries should improve data collection on non-banks' balance sheets to ensure an effective monetary policy impact.

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.