• The FPC and Bank of England are aware of huge information gaps in financial markets but have done little to close them.

• Regulators should take a ‘Legal Highs’ approach towards defining financial institutions by following the classification framework of the 2016 Psychoactive Substances Act.

• NBFIs are shown to propagate unsustainable risk through synthetic leverage and liquidity mismatches.

• Subjecting NBFIs to more stringent and carefully designed stress tests will ensure high-risk NBFI positions are identified before a crisis occurs.

Inability of Financial Regulators to implement sufficient reporting standards and stress testing for proven high-risk financial intermediaries is cause for concern.

New research from Leeds Policy Institute (LPI) finds these concerns to be well grounded. LPI’s new paper finds that Financial Regulators are aware of an information gap when regulating Non-Bank Financial Intermediaries (NBFIs). In addition, the paper shows the high risks associated with NBFIs and proposes a new framework to improve data collection.

“There are many tools policymakers and regulators can use to tackle financial instability, specifically that caused by leverage. However, for any of these tools to be effective, the problem of data gaps and mismatches must be solved first. Archegos and LDI were good examples of where data was patchy at best, as was risk management within firms”

The paper provides a novel framework to improve financial regulation by taking the ‘Legal Highs’ legislative success as a framework for the classification of NBFIs in financial markets.

“[Our] report proposes several regulatory responses to combat these issues. First, subjecting NBFIs to more carefully designed stress testing procedures aims to ensure that high-risk NBFI positions are identified and altered before a crisis can occur (NBFIs maintain balance sheets more resilient to shocks). Subsequently, we propose a framework for more extensive and uniform data collection from NBFIs to allow regulators to work with complete information, or at least a fuller picture than they currently have,”  the report states. 

LPI’s Financial Regulation Policy Head and paper author, Adrian Kubiak, said:

“In a landscape where financial stability is paramount, our report offers a critical examination of the Non-Bank Financial Institution sector, dissecting its complexities and proposing a novel regulatory framework. We navigate through the shadow banking system, highlighting maturity and liquidity transformation as pivotal processes that can precipitate first-mover advantages.

“This analysis is particularly relevant in light of recent events such as the European Central Bank’s emphasis on the importance of a strong non-bank financial sector, and the Financial Stability Board’s report on global trends and risks in non-bank financial intermediation. Our report provides valuable insights and actionable recommendations to navigate these evolving dynamics.”

LPI’s Head of Research and paper author, Hubert Kucharski, said:

“When applied to the financial sector, the Legal Highs framework provides clear-cut reporting standards while giving flexibility such that the financial sector may innovate.

“Currently, the FCA handbook suffers from broad, vague, and subjective reporting standards that confuse market participants with unclear reporting standards. By classifying firms into different economic categories based on their systemic importance - similar to how current drug legislation classifies substances - regulators can cover all firms under the regulatory umbrella while creating objective, clearcut reporting standards.”

---

Notes to Editors

• ‘Fixing Information Gaps: A Legal Highs Approach to NBFIs’ is the first paper to be published by Leeds Policy Institute’s Financial Regulation division.

• We write our paper at a time when solving for financial stability remains a wild west of different solutions and approaches, where lucid solutions for better data collection and interpretations of financial markets are key to responsible policy.

• With the ECB stressing the importance of a strong non-bank financial sector on global markets, the importance of effective regulation in this area is paramount, while real current efforts lag behind.

CONTACT: thinktank@luu.group / 07895 958710

A full copy of Fixing Information Gaps: A Legal Highs Approach to NBFIs, can be read here.

---

About Leeds Policy Institute

Leeds Policy Institute (LPI) is a UK-based and student-led Think Tank affiliated with Leeds University Union (a registered UK charity). It is dedicated to undertaking empirically driven and non-partisan policy research that centres on both local and national issues. 

Our 6 Policy Areas for 2024 are: 

• Macro Policy 

• Energy and Environment

• Urban Planning and Transport 

• Social Policy 

• Market Interventions 

• Financial Regulation 

Established in April 2023, the Leeds Policy Institute (LPI) endeavours to facilitate the engagement of young individuals in ongoing policy dialogues. Through initiatives encompassing funding for informative speaker engagements, publication of student-authored articles, and collaborative delivery of skill-enhancing workshops in conjunction with the university, LPI seeks to empower its student members and contribute to the betterment of society.