Megnaz S.Safavian
Practice Manager – The World Bank

Mehnaz S. Safavian is the Practice Manager for the Digital and AI Global Practice of the World Bank in the Africa East Region based in Kenya. Before moving to Kenya, Mehnaz was Practice Manager for Finance, Competitiveness and Innovation (FCI) Global Practice based in Accra, Ghana and Lead Financial Sector Specialist across multiple regions. Her experience spans Africa, South Asia, East Asia, and global assignments. Mehnaz has more than twenty years of experience in financial and private sector development. She holds a PhD in Agricultural Economics from Ohio State University, Ohio.

Banks’ exposures to nonbanks (the “boomerang” back to banks)

The banking story today is increasingly written beyond banks’ balance sheets—and tested in how shocks travel across the system. The financial conditions remain vulnerable, and banks are asked to perform two tasks simultaneously: reinforce resilience and risk governance while keeping credit flowing to firms, especially SMEs and households that rely on finance to invest and sustain jobs and growth. The share of intermediation is increasingly through nonbanks, diversifying sources of finance but also potentially different dynamics of liquidity and leverage and less consistent transparency. Yet banks are not bystanders in this evolution and continue to be exposed to nonbanks through funding, market-making, and contractual linkages, creating a “boomerang” risk of potential spillovers from nonbanks to banks and the real economy.

By “banks’ exposure to nonbanks,” I mean the ways banks remain financially tied to lenders and investors outside the traditional banking system, even when those activities sit beyond the traditional banking regulatory perimeter such as hedge funds, private equity and private credit funds. In practice, this is visible in committed credit lines and liquidity backstops to funds and finance companies, prime brokerage and margin lending to leveraged investors, and derivatives and collateral relationships that can expand quickly in volatile markets. It matters because these connections can amplify stress across the financial system and, when confidence turns, tighten credit and disrupt market functioning—ultimately affecting firms, households, and jobs.

There are three key factors that have brought bank-nonbank exposures to the forefront. First, nonbank financial intermediation has continued to grow in scale and the relationship between banks and nonbanks in terms of funding and markets has continued to grow. Second, there have been vulnerabilities in the nonbank financial sector. For instance, there have been concerns about leverage and liquidity mismatches. Third, authorities and market participants still face material data and visibility gaps across entities, instruments, and jurisdictions, making risk concentrations harder to identify in real time. These trends are affecting incentives and risk concentrations across banks and markets in ways that will test resiliency when it is needed most.

The core transmission channel is a liquidity-and-collateral shock that spreads through tightly connected balance sheets and markets. It first hits bank balance sheets through higher counterparty risk, rapid valuation changes, and sudden liquidity demands as contingent commitments are drawn and collateral needs rise. Stress then shows up in funding and confidence: haircuts increase, spreads widen, and rollover shortens as margining and collateral requirements become procyclical under volatility. Finally, the feedback reaches the real economy as banks protect liquidity and capital by tightening credit conditions, pulling back market intermediation, and repricing risk. When volatility spikes and market liquidity thins, these dynamics can shift quickly from contained pressures to system-wide stress.

We have already seen how non-banking strains can become bank relevant. In India, stress in the Non-Banking Financial Company (NBFC) sector emerged after the unexpected defaults of Infrastructure Leasing & Financial Services (IL&FS) (September 2018) and Dewan Housing Finance Corporation Limited (DHFL) (June 2019) and quickly tightened funding conditions across the segment. As pressures mounted, the IMF noted that bank exposures to NBFCs had risen significantly, with bank lending to the sector more than doubling—leaving NBFCs accounting for almost 9% of banking system loans, equivalent to more than 60% of Tier 1 capital. This is a classic case of direct transmission effects, with pressures in the NBFC liquidity and asset quality directly impacting bank balance sheets and risk capacity, tightening overall financial conditions rather than insulating the banking system.

When bank–nonbank linkages amplify stress, the first casualty is often the flow of finance to the real economy. Adverse shocks can translate into tighter financial conditions, risk premia increasing, and loan growth slowing down, pressures that are felt most quickly by SMEs and households that depend on bank credit and functioning markets. Disruptions in core markets can amplify this tightening, as these markets are key to overall economic financing conditions.

What is needed now is a targeted resilience agenda across the bank–nonbank boundary. First, there should be enhanced system-wide monitoring to be able to pinpoint concentrated linkages and vulnerabilities, addressing fragmented visibility that limits a consolidated view of risks. Second, policy should reduce procyclicality by improving nonbank market participants’ liquidity preparedness for margin and collateral calls—through stronger liquidity risk management, governance, stress testing, and collateral management practices. Third, leverage-driven fragilities in nonbank intermediation, particularly those that have an impact on core markets, should be identified and met with appropriate, proportionate measures. Finally, there should be risk governance and stress tests conducted by banks that consider plausible scenarios of nonbank stress and market dysfunction.

What is clear is that the system has changed: risk does not respect institutional labels, and shocks rarely stay contained where they begin. As banking and market-based finance become more intertwined, the challenge is to ensure that confidence is maintained even when strain occurs beyond traditional perimeter. This requires coherence across institutions and jurisdictions, ensuring strain is addressed quickly and before it becomes systemic and undermines stability.