(Editor's Note: Market participants' need for transparency on the full scope of credit risk will expand as the financial system innovates—with increasing interplay and interconnection between public and private markets. Systemic Risk is a new commentary series from S&P Global Ratings, providing perspective on key contagion and stability risks across sectors, asset classes, and the credit spectrum. Read our latest research on private credit's characteristics, the dynamics of U.S. banks' loans to nonbank financial institutions, and the global state of play for this bank-nonbank nexus.)

The growth in size and complexity of the global financial system over the last decade is exemplified by the increasing role of NBFIs—such as alternative investment funds, asset managers, finance companies (fincos), broker-dealers, and structured finance vehicles—in intermediating credit and taking on bank-like risks.

S&P Global Ratings believes that the growth of credit transformation outside the banking system can bring meaningful funding diversification benefits for borrowers. At the same time, the liquidity transformation performed by some nonbank credit providers exposes these players to funding and liquidity risks, which could be amplified and propagated due to the interconnections and interdependencies between banks and NBFIs.

Because banks and nonbanks operate in a nexus (rather than closed silos) and are interdependent for funding and liquidity, NBFI risks could be amplified and spill over into the broader financial system. Nonbanks are exposed to bank-like risks that can take various shapes and materialize in the event of market shocks.

Fincos' rollover risks are key, because of their need to refinance balance sheets regularly with wholesale investors. For investment funds, redemption risks are most prominent—with a growing cohort of open-ended funds which, from a funding situation, most resemble banks' deposits. Hedge funds face significant margin risks due to their directional positions in derivatives markets.

For private credit funds, funding and liquidity risks appear more limited at first glance given their typically closed-end nature. But we see potential innovations (including the possibility for retail investors to invest in private funds and a growing recourse to bank facilities) that could result in higher redemption or rollover risks.

Traditional banks are net recipients of funding from NBFIs. Although direct exposures may appear limited at a global level, representing 1.9% of total bank assets, they are more significant in certain jurisdictions after a recent period of growth (particularly in the U.S.). We believe that transparency on individual firms' exposures remains relatively low, as the failure of the hedge fund Archegos (which resulted in roughly $10 billion of losses through multiple banks) showed in 2021.

In our overall view, major global banks have improved their counterparty credit risk management practices, due in part to increased regulatory probing, and collateral and good diversification by borrower type can further help mitigate their credit risks.

Yet more indirect spillover risks remain. Banks and nonbanks share exposures to end clients or similar portfolios (such as sovereign debt portfolios). As such, a sudden and massive deleveraging or forced-selling by redemption-vulnerable nonbanks could spread losses throughout the banking system—which, for example, occurred at the onset of the pandemic, during the so-called 'dash for cash' period—or create a liquidity crunch for certain borrowers that hurts the real economy.

We believe that broader market confidence could be jeopardized in the event that a nonbank were to fail, potentially igniting contagion. A run on an open-ended investment fund, for instance, could be seen as a sign of broader weakness in nonbanks and potentially banks, leading to bank runs and self-fulfilling expectations.

While current funding conditions are gradually improving as central banks dial back their monetary tightening, bringing policy rates down and continuing quantitative tightening gradually, market fragilities remain and geopolitical risks are mounting. This indicates that we could face further market shocks, which could be amplified and propagated by the interconnections and interdependencies of banks and their nonbank counterparts.

Unlike traditional banks, nonbanks typically cannot access emergency central bank funding in times of stress. We don't expect governments to use taxpayers' funds to recapitalize any failed nonbanks. This means that nonbanks would need to rely on the provision of liquidity from banks in times of stress or on public authorities' interventions in key or systemic risk markets to mitigate contagion risks, should they arise. More so than with banks, governments and regulators may be more willing to allow nonbanks to fail during a stress period. Where banks have systems in place to turn to central banks or public authorities for liquidity, nonbanks do not typically have such emergency liquidity sources in place. Facing a liquidity shortfall, they would need to turn to banks, or other market sources.

Although the state of nonbank credit providers is not a source of rating pressure for global traditional banks right now, the potential financial stability risks that the bank-nonbank nexus creates will continue to be an area of attention for 2025.

NBFIs' Exposure To Funding And Liquidity Risks Enhances Their Vulnerabilities To Market Shocks

Market shocks tend to create a redistribution of liquidity flows across actors, testing the resistance of their funding model and liquidity buffers. Banks are particularly exposed to funding and liquidity risks, relying on short-term funds (like deposits) to finance long term assets (such as loans). In many ways, nonbanks are also exposed to similar funding and liquidity risks through:

• Redemption risk, from the potential that end investors withdraw their funds from investment funds (like money market funds). This redemption risk vulnerability depends on the design of the funds, with open-ended funds most exposed.
• Rollover risk, from the risk that a firm does not manage to refinance its activities in the wholesale markets. Rollover risks will be particularly significant for firms relying on short-term wholesale funding. Among nonbank credit providers, fincos appear more exposed to this risk.
• Margin risk, from the risk that a firm faces margin calls (from a central counterparty or from a bank) due to an adverse price movement affecting the value of its derivatives positions.

At first glance, private credit funds appear less exposed to these funding and liquidity risks given their closed-end nature, meaning that equity investments from investors are locked in for the life of the fund that often significantly exceeds seven years.

We see potential innovations that could result in higher redemption risks, such as the possibility for retail investors to invest in private credit funds with shorter redemption opportunities. In addition, private credit funds could further expand their usage of bank facilities such as net asset value (NAV) facilities—which are bank loans secured on the net asset value of the funds—to return cash to their investors. This could expose them to greater rollover risks over time.

These risks and the prominent role played by NBFI in several jurisdictions have led global financial regulators to increase their scrutiny and formulate policy proposals to mitigate the risks.

Various Bank-Nonbank Linkages Could Amplify And Propagate Financial Market Shocks

Large and unexpected funding and liquidity shocks can result in systemwide stress.

In the past five years, we have seen three major stress episodes: the aforementioned "dash-for-cash" at the start of the COVID-19 pandemic in 2020; the liquidity stress faced by U.K. pension funds following liability-driven investment strategies in September 2022; and the banking turmoil of spring 2023 spurred by the Silicon Valley Bank failure. In the first two situations, the interdependencies between traditional lenders and NBFIs were a key factor in amplifying and propagating stress, with leveraged nonbanks selling assets to face funding pressures stemming from margin calls or redemptions.

Direct Balance-Sheet Linkages, Though Limited, Could Generate Financial Losses For Banks From NBFIs (And Vice Versa)

On a global level, banks are net recipients of funding from nonbank credit providers. Funding from NBFIs accounted for 2.3% of banks' total assets in 2023 (compared to 2% in 2022) while lending to NBFIs accounted for 1.9% of total bank assets in 2023 (from 1.6% in the prior year). Overall, direct balance-sheet linkages appear limited.

We believe that the small year-on-year evolutions likely reflect accounting discrepancies and other statistical effects, rather than meaningful trends. Looking at subsectors of the nonbank credit provider space, we see that credit investment funds are the main provider of funding to banks—while fincos are the main recipient of bank funding.

On a national level, we see a more direct balance sheet connection between NBFIs and traditional banks in a handful of countries.

In Luxembourg, this reliance is mainly due to many investment funds operating in the country and depositing some of their funds with various custodian banks based there. As such, these funds are not a meaningful source of funding for local banks and the real economy. Traditional banks' exposures to nonbank credit providers are more meaningful in countries where these NBFIs play a prominent role in financing the real economy, such as Korea or India.

In the U.S, loans to non-depositary financial institutions have grown quickly over the past decade—reaching 8% of total bank loans in the third quarter of last year, according to data from the Financial Deposit Insurance Corporation (FDIC). In our view, collateral and good diversification by borrower type have helped mitigate risks for banks.

More broadly, we believe that large investment banks have largely improved the quality of their counterparty credit risk management over time, limiting their exposure to risks from nonbanks. Since the failure of Long-Term Capital Management (LTCM) in 1998 and the more recent 2021 failure of Archegos, initiatives have intensified to bring more transparency and effectiveness to the management and mitigation of this risk.

Last year, the Basel Committee on Banking Supervision issued new guidelines emphasizing the need for banks to improve due diligence and the monitoring of their counterparties, and some supervisors like the ECB requested banks to conduct rigorous stress testing of their counterparty credit risk.

Overall, counterparty exposures to the most leveraged nonbanks are concentrated in a handful of large investment banks with significant prime brokerage activities, mainly in the U.S. This concentration, as well as the growth of new market-making companies with potentially less mature risk management practices, remain key sources of weakness for the financial system in case one of these large entities were to have deficient risk management practices.

The requirement to clear the bulk of derivatives trading with central counterparties, and now the touted possibility to also mandate clearing for the trading of U.S. Treasuries, have also largely contributed to limiting counterparty risks between banks and nonbanks. Central counterparties play a major role by acting as intermediaries, ensuring that both sides of a trade meet their obligations, and benefitting from netting effects and other strict risk management features. Although central clearing limits counterparty credit risk, liquidity risks from margin requirements remain.

Exposure To Shared Clients Or A Similar Portfolio Could Amplify Losses Across The Financial System

Some nonbanks have become prominent lenders in segments of the economy (like U.S. private credit funds in the speculative-grade corporate sector), while other nonbanks hold large investment portfolios (such as U.K. pension funds in the gilt market). As such, a funding shock on nonbanks could lead to forced sale of assets, which could depress the price of the underlying assets (or even lead to firesale prices), or to severe cut-back in lending. For banks, these actions would have negative repercussions, as they tend to be exposed to the similar or correlated portfolios and have credit exposure to similar or connected clients.

The impact of a forced sale can be even more pronounced for an illiquid asset. The secondary market liquidity of the underlying assets of the nonbanks can vary widely, and nonbanks holding illiquid assets such as private credit loans could exacerbate the swing in price for a forced-seller.

Further, the market impact of a forced sale from nonbanks would likely be compounded by a series of structural changes which have decreased the liquidity available in key financial markets. For instance, increased regulation on banks have curtailed their market intermediation capacity, lessened the amount of balance sheet available for market-making activities, and could contribute to potential price swings in case of stress.

To avoid such firesale dynamics, the BoE announced the extension of a new contingent funding facility to selected nonbanks (such as insurers or pension funds) against adequate collateral. Activated in a stress scenario, this facility would allow eligible nonbanks to monetize their assets, rather than sell them in the market to meet liquidity needs. Such new tools could prove a precious mitigant against financial stability risks, assuming that nonbanks are operationally ready to draw on them. But the initiative seems to be limited to the U.K. central bank so far.

Loss Of Confidence And Perceived Interconnection Could Lead To Self-Fulfilling Expectations

More broadly, traditional banks remain highly confidence-sensitive, especially those with significant market-making activities or a reliance on market funding. If a country's NBFI sector experiences acute financial stress, it is likely that traditional banks would, at least temporarily, suffer from perceived interconnectedness. As previous financial crises have shown, this form of contagion risk—via perceived proximity or reputational risk—should not be underestimated.

Given the incomplete information available to the financial markets on many nonbank actors and on banks' exposures to them, stress on large NBFIs could be seen as an indicator of broader issues in the financial sector (including in banks)—and lead to the materialization of funding risks via redemptions or deposit runs.

Central banks have more limited tools to address such contagion risks. Their main tool is the credibility of their own announcements, in that they could or would intervene to stabilize the most systemically affected markets. Overall, we believe that this credibility, and central banks' willingness to use it to stave off systemic risks, is relatively high—following years of quantitative easing and now that central banks have regained some balance sheet space and face lower inflation risks.

Geopolitical Shocks Could Trigger Renewed Turbulence

Systemwide funding stress episodes can largely be explained by the vulnerabilities created by the bank-nonbank nexus, but they typically materialize only when funding conditions tighten.

In our view, geopolitical risks pose the biggest risk to otherwise improving global credit conditions. We believe geopolitical shocks could materialize in macro-financial shocks to confidence, via volatility in commodity prices and through physical and cyber attacks. These events would affect both the financial markets and the real economy and generate financial risks to banks and nonbanks.

Although the state of nonbank credit providers is not a source of rating pressure for global traditional banks right now, we will be closely watching the potential financial stability risks that the bank-nonbank nexus creates, in a context of geopolitical uncertainties, this year.

Related Research

• Systemic Risk: Global Bank-Nonbank Nexus Could Amplify And Propagate Market Shocks, Feb. 18, 2025
• Systemic Risk: U.S. Banks' $1 Trillion In Loans To Nonbanks, Like Private Credit, Creates Risks And Rewards, Feb. 18, 2025
• Systemic Risk: Private Credit's Characteristics Can Both Exacerbate And Mitigate Challenges Amid Market Evolution, Feb. 18, 2025
• Systemic Risk: Global Nonbank Financial Institutions Press Ahead, Feb. 18, 2025
• Systemic Risk: Global Banking Regulation At A Crossroads, Feb. 18, 2025
• Regulators Eye Private Debt Boom In Europe, Dec. 5, 2024
• Global Credit Outlook 2025: Promise And Peril, Dec. 4, 2024
• Mandate To Widen Central Clearing Should Strengthen U.S. Treasury Market And Promote Competition, While Raising Trade Costs, Nov. 7, 2024
• Global Credit Conditions Q4 2024: Policy Rates Easing, Conflicts Simmering, Oct. 10, 2024
• Bottleneck In Exits Will Increase Some Alternative Investment Funds' Leverage, Sept. 3, 2024