tolerant private capital, as opposed to demand deposits. Non-bank financial institutions are also far less consolidated than banking institutions. Previously designed macroprudential policy frameworks have understandably focused on the banking system because of the important role banking institutions play in the real economy. In a systemic risk framework, banking institutions raise concerns because of their funding via demand deposits (provided by risk-averse agents) and reliance on the aforementioned publicly-provided ‘safety net.’ Non-bank financial institutions do not present these concerns. As such, any macroprudential policy that aims to simultaneously manage overall risk and diminish the negative externalities of bank failure should address banks’ exposure to non-bank financial institutions. The reasons for this are two-fold: first, banking institutions contribute more to systemic risk because of their highly consolidated nature. Second, traditional banking institutions take advantage of many ‘socially-provided’ benefits that mitigate their risk (deposit insurance; access to the central bank as a lender of last resort; discounted interbank lending; potential assistance from the U.S. Treasury Department). This establishes an explicit public interest in reducing the ‘social cost’ of these benefits, which can be achieved through supervision. As the current supervisory regime relies on measurement of institutional risk exposure, macroprudential policy measures should be designed to more effectively measure systemic risk exogenous to banking institutions—particularly risk arising from the non-bank financial system. The framework established by Basel III does attempt to achieve this through more effective measurement of counterparty risk, but development of more effective risk measurement methodologies is needed. The improvement of these methodologies requires greater involvement and collaboration between banking institutions, non-bank financial institutions, supervisory authorities and academics.
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