Bailing out nonbanks
- Macroprudential Policy
- Aug 9
- 6 min read
Updated: 6 days ago
Nonbank bailouts reward reckless risk-taking and worsen financial instability. Without reform, crises will keep privatizing gains and socializing losses.
Nonbanks (hedge funds, private equity, money market funds, etc.) now dominate global finance, holding over half of financial assets. They provide credit like banks but avoid strict banking regulations, creating systemic risks.
The Rise of Nonbanks—And Their Systemic Role
Nonbanks now control over half of global financial assets, including:
Shadow banks ($240+ trillion, per Financial Stability Board FSB, 2023) – Money market funds, repo markets, and securitization vehicles now provide more short-term funding than traditional banks (Pozsar, 2016).
Asset managers (e.g., BlackRock, Vanguard) – With $20+ trillion in assets, their ETF and bond-market dominance means fire sales can trigger systemic crashes (FSB, 2021).
Private equity & hedge funds – Leveraged buyouts and arbitrage strategies now exceed pre-2008 investment bank risk levels (IMF, 2021).
Key problem: These entities don’t take deposits, so they avoid banking rules—but still create bank-like risks (Gorton & Metrick, 2012).
Nonbanks' functions
Nonbank financial institutions (NBFIs) play critical roles in modern economies, often complementing or competing with traditional banks. While they don’t take deposits like banks, they provide essential services that drive liquidity, credit, and investment. Here’s a breakdown of their key functions:
1. Credit Intermediation (Shadow Banking)
Nonbanks facilitate lending outside traditional banking channels:
Market-Based Lending: Hedge funds, private credit funds, and peer-to-peer platforms lend directly to businesses/consumers.
Securitization: Packaging loans (e.g., mortgages, auto loans) into tradable securities (e.g., MBS, ABS) to redistribute risk.
Example: Private equity firms provide leveraged loans to corporations, bypassing bank balance sheets.
2. Liquidity Provision
Nonbanks stabilize markets by offering short-term funding:
Repo Markets: Hedge funds and money market funds lend cash against collateral (e.g., Treasury bonds).
Commercial Paper: Corporations borrow from NBFIs (e.g., mutual funds) for working capital.
Example: Money market funds hold $4.5 trillion in short-term debt, acting as a cash reservoir for institutions.
3. Asset Management & Investment
They pool and invest capital for higher returns:
Institutional Investors: Pension funds, insurers, and sovereign wealth funds allocate trillions to stocks, bonds, and alternatives.
Risk-Taking: Hedge funds use leverage/derivatives to amplify returns (e.g., arbitrage, short-selling).
Example: BlackRock manages $10 trillion in assets, influencing global capital flows.
4. Risk Transfer & Insurance
Nonbanks absorb risks that banks avoid:
Derivatives Trading: Hedge funds and SPVs trade credit default swaps (CDS) to hedge or speculate.
Reinsurance: Insurers (e.g., AIG, Berkshire Hathaway) cover catastrophic risks.
Example: AIG’s CDS bets triggered its 2008 collapse, showing systemic risk.
5. Payment & Settlement Systems
Fintech firms disrupt traditional payment networks:
Digital Wallets: PayPal, Square enable nonbank transactions.
Blockchain: Crypto exchanges (e.g., Coinbase) facilitate asset transfers without banks.
Bailing out Nonbanks: Moral hazard
Bailing out nonbanks creates moral hazard by shielding financial institutions from the consequences of excessive risk-taking. When firms like shadow banks, insurers, or investment funds expect government intervention in times of crisis, they have little incentive to act prudently, often engaging in reckless behavior—such as overleveraging or speculative investments—knowing they will be rescued if their bets fail. This not only distorts market discipline but also encourages systemic risk, as other institutions may adopt similar strategies, expecting equal treatment. Over time, repeated bailouts socialize losses while privatizing gains, fostering a dangerous cycle where firms grow 'too big to fail' at the taxpayer’s expense. Without credible threats of failure, moral hazard undermines long-term financial stability and fairness in the economy.
Case 1: Money Market Funds (2008 & 2020)
2008: The Reserve Primary Fund "broke the buck" (fell below $1 NAV), triggering a run on $3.6 trillion in money markets. The Fed stepped in with the Asset-Backed Commercial Paper Money Market Fund Liquidity Facility (AMLF) (McCabe, 2010).
2020: COVID panic caused another run. The Fed reopened the MMLF, buying $76 billion in fund assets (Federal Reserve, 2020).
Result: Funds still avoid capital rules, knowing the Fed will backstop them (Sunderam, 2021).
Case 2: Corporate Bond ETFs (2020)
When COVID hit, junk bond markets froze. The Fed bought $13 billion in corporate bond ETFs, disproportionately benefiting BlackRock (which managed the program) (Haddad et al., 2021).
Moral hazard: Private funds now take riskier bets, assuming the Fed will backstop liquidity (Fleming et al., 2022).
Case 3: AIG (2008) – The Shadow Bank That Wasn’t a Bank
AIG’s derivatives unit blew up from credit default swaps (CDS). Since it wasn’t a bank, it faced no capital rules (FCIC, 2011).
The Fed and Treasury gave AIG $182 billion, saving counterparties like Goldman Sachs (Sorkin, 2009).
Aftermath: AIG’s executives kept bonuses, and private equity firms later carved up its assets (McLean & Nocera, 2010).
Case 4: ECB’s LTROs for Hedge Funds (2020s)
The ECB allowed hedge funds to borrow cheaply via LTROs, despite their lack of banking oversight (Darvas & Wolff, 2021).
Result: Funds loaded up on sovereign debt, knowing the ECB would backstop markets (Brunnermeier & Schnabel, 2020).
How Bailouts Make Future Regulation Impossible
Every nonbank rescue reinforces regulatory arbitrage:
2008 taught funds they could rely on the Fed – Post-crisis, shadow banking grew faster than traditional banking (FSB, 2020).
2020 proved even junk bonds get backstops – The Fed’s intervention removed market discipline (Haddad et al., 2021).
Post-crisis reforms exempted NBFIs – Banks now complain they’re at a competitive disadvantage (Tarullo, 2017).
Example: Private equity exploits this gap by loading companies with debt, knowing:
If bets pay off, they keep the profits.
If they fail, bankruptcy or bailouts socialize losses (e.g., Hertz, Toys "R" Us) (Appelbaum & Batt, 2021).
The Rich Capture Returns, the Public Pays Costs
Wealthy investors park money in hedge funds/PE for higher yields, avoiding bank deposit limits (Zucman, 2019).
When crises hit, the Fed/Treasury bail out their holdings (corporate bonds, money markets, ETFs) (Tooze, 2021).
Post-bailout, regulators fail to impose rules, fearing market backlash (e.g., SEC’s 2022 failed money market reform) (Coffee, 2022).
This creates a perverse wealth transfer:
Top 1% gains from risky strategies (Saez & Zucman, 2020).
Mainstreet pays via inflation, financial repression, and future debt burdens (Stiglitz, 2022).
Solution: A New Bagehot Rule for Nonbanks
To stop this cycle:
If it’s systemic, regulate it – Apply capital/liquidity rules to shadow banks (FSB, 2023).
No bailouts without conditions – Any NBFI accessing Fed facilities must submit to oversight (Acharya & Richardson, 2021).
Windfall taxes on bailout profits – Recoup public costs from rescued institutions (Saez & Zucman, 2022).
Close the offshore loopholes – Much of this risk-taking is hidden in Cayman/SPV structures (Zucman, 2021).
Otherwise, we’re just subsidizing the next crisis—and the rich will cash out again.
References
Books & Reports
Acharya, V., et al. (2021). Guaranteed to Fail: Fannie Mae, Freddie Mac, and the Debacle of Mortgage Finance. Princeton University Press.
Financial Crisis Inquiry Commission (FCIC, 2011). The Financial Crisis Inquiry Report. U.S. Government Printing Office.
McLean, B., & Nocera, J. (2010). All the Devils Are Here: The Hidden History of the Financial Crisis. Penguin.
Sorkin, A.R. (2009). Too Big to Fail: The Inside Story of How Wall Street and Washington Fought to Save the Financial System—and Themselves. Viking.
Tooze, A. (2021). Shutdown: How Covid Shook the World’s Economy. Viking.
Zucman, G. (2019). The Hidden Wealth of Nations: The Scourge of Tax Havens. University of Chicago Press.
Academic Papers & Working Papers
Brunnermeier, M., & Schnabel, I. (2020). "Bubbles and Central Banks." ECB Working Paper No. 2428.
Gorton, G., & Metrick, A. (2012). "Securitized Banking and the Run on Repo." Journal of Financial Economics, 104(3), 425–451.
Haddad, V., et al. (2021). "The Fed’s Corporate Bond Purchases: Market Effects and Policy Options." NBER Working Paper No. 28556.
Pozsar, Z. (2016). "Shadow Banking: The Money View." Office of Financial Research Working Paper 16-07.
Sunderam, A. (2021). "Money Market Funds and the Fed’s Rescue Facility." Journal of Finance, 76(4), 1969–2002.
Institutional Reports
Darvas, Z., & Wolff, G.B. (2021). "The ECB’s Monetary Policy During the Pandemic." Bruegel Policy Brief.
Financial Stability Board (FSB, 2020). Global Monitoring Report on Non-Bank Financial Intermediation.
Federal Reserve (2020). Annual Report: Credit and Liquidity Programs.
International Monetary Fund (IMF, 2021). Global Financial Stability Report: Hedge Funds and Systemic Risk.
McCabe, P.E. (2010). "The Cross Section of Money Market Fund Risks and Financial Crises." Federal Reserve Board Finance and Economics Discussion Series.
Media & Policy Analysis
Appelbaum, E., & Batt, R. (2021). Private Equity at Work: When Wall Street Manages Main Street. Russell Sage Foundation.
Coffee, J.C. (2022). "The Failure of Money Market Fund Reform." Columbia Law School Blue Sky Blog.
Tarullo, D.K. (2017). Banking on Basel: The Future of International Financial Regulation. Peterson Institute.
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