The Role of Banks vs. Non-Bank Financial Institutions in the Financial Ecosystem — The Pension Funds Perspective

The financial ecosystem is composed of both banks and non-bank financial institutions (NBFIs), each playing a crucial role in ensuring financial stability and economic growth. While banks are traditionally the dominant players in financial intermediation, NBFIs—including pension funds, investment funds, and insurance firms—have gained prominence in recent years. The interplay between these institutions influences risk distribution, financial stability, and the overall resilience of the financial system.

Regulatory Developments and Financial Stability

In the wake of the global financial crisis, the European Union has strengthened its regulatory and supervisory frameworks through measures such as Basel III, Solvency II, and macroprudential policies. These reforms have enhanced financial stability, particularly within the banking sector. However, discussions have emerged regarding the need to extend macroprudential tools to the growing NBFI sector, particularly investment funds.

Pension funds, a key component of NBFIs, depend on intermediaries for liquidity management since they cannot hold sufficient cash reserves to handle market shocks. Notably, the European Economic Area (EEA) had pension fund exposure to banks amounting to approximately 6% of total investments by the end of 2023, with variations across Member States.

The European Central Bank (ECB) acknowledges potential vulnerabilities in the NBFI sector and advocates for policy responses to enhance resilience. Key concerns include liquidity preparedness, non-bank leverage, and liquidity mismatches in open-ended funds. However, pension funds are generally well-capitalized, with stress test results indicating resilience even under adverse conditions. For instance, post-shock funding ratios in defined benefit (DB) schemes remained above 100% in most EU states, reflecting strong pre-shock positions.

Regulatory Challenges for Pension Funds

Pension funds primarily operate under the IORP II directive, though some countries, like Denmark, apply Solvency II regulations. These frameworks require risk management functions and own risk assessments (ORA) to ensure adequate risk treatment. However, additional supervisory measures for pension funds are debated, as existing regulations are deemed sufficient.

One pressing challenge is liquidity risk from derivatives trading. Pension funds frequently use derivatives to manage financial solvency risk, particularly interest rate risks. However, sudden spikes in margin calls during market stress can pose significant liquidity issues. The expiration of the EU’s exemption for pension funds from central clearing has further complicated liquidity risk management, forcing pension funds to adapt to new regulatory requirements.

Additionally, pension funds have exposure to the real estate sector, which has recently faced valuation declines due to inflation, interest rate hikes, and shifts in remote work trends. Despite these challenges, stress tests indicate that the impact of real estate shocks on pension funds remains moderate.

Technological Advancements and Their Impact

The rapid evolution of technology, particularly artificial intelligence (AI), is reshaping financial services. While AI presents opportunities for operational efficiency and customer interaction, it also introduces challenges related to data quality, prediction accuracy, and third-party dependencies. Financial stability risks could arise if AI adoption is concentrated among a few dominant players.

In the pensions sector, AI applications are relatively limited, mainly focusing on chatbot interactions, asset management optimization, and employer-related use cases. The regulatory response to AI should be risk-based and principle-driven to ensure effective oversight without stifling innovation.

Cybersecurity is another growing concern, with increasing cyber incidents posing threats to financial stability. The EU’s Digital Operational Resilience Act (DORA), effective from January 2025, establishes a comprehensive cybersecurity framework. However, pension funds argue that the broad regulatory approach may impose disproportionate compliance costs on institutions with lower operational risks than banks and payment service providers.

Crisis Response and Market Liquidity

A key concern for NBFIs during crises is the reliability of repo markets in stressed conditions. Liquidity constraints may arise as banks reduce their risk appetite, limiting access to cash for NBFIs. This could lead to forced asset sales, exacerbating downward market spirals.

Recognizing this challenge, PensionsEurope advocates for central banks to serve as a secondary liquidity provider during financial distress. Countries like the UK, US, and Canada have already implemented liquidity facilities to support repo markets, ensuring financial stability during turbulent times.

Conclusion

The financial ecosystem is evolving, with NBFIs playing an increasingly significant role alongside banks. While regulatory frameworks have strengthened financial resilience, additional considerations are necessary to ensure NBFIs, particularly pension funds, remain robust without unnecessary regulatory burdens. Addressing liquidity risks, adapting to technological advancements, and enhancing crisis response mechanisms will be critical in shaping a resilient and well-balanced financial system for the future.