Banks are only part of the story. Where is risk in the financial system?

Modern finance is increasingly typified by transactions between financial institutions. These actors, like pension funds, money market funds, asset managers and banks, are linked together by a constant flow of money, assets, and short- and long-term promises to pay. Cash is raised and repaid at speed, through a complex stream of deals. 

In normal times, this machinery can look efficient. But it depends on constant movement and trust. If borrowers do not repay, and lenders stop lending, the links between financial institutions transmit stress rather than funding, and the whole system begins to creak. 

To see how this works in practice, it helps to follow a single asset through the system, like a government bond.

A government needs to fund public services such as education or healthcare. It does not have the money upfront, so it borrows from investors by issuing a bond. Markets welcome this safe, predictable asset, and on day one, a pension fund buys the bond.

But in today’s financial system, a safe asset like government debt rarely stays still. The pension fund may need cash to meet short-term payments, without wanting to sell the bond outright. So it temporarily gives the bond to a bank in exchange for cash, agreeing to reverse the transaction a few days later. This is called a repurchase agreement, or repo. The arrangement is considered safe because the bank lends less cash than the bond is worth, and earns a small return when the transaction is reversed.

Short-term funding is attractive because it allows institutions to reallocate funding quickly when priorities change, so when the bank spots an opportunity to enter into another profitable transaction for which it needs cash, or simply place the bond on more favourable terms, it gets cash by doing the same thing as the pension fund. So the bond continues its journey and is posted as collateral in another repo deal, for instance, with a Money Market Fund (MMF). The bank can then redeploy the money it temporarily receives from the bond to fund a new transaction.

These types of short-term deals have become central to how the financial system operates. The European Central Bank (ECB) recently found that repo funding from non-bank financial institutions (NBFIs), like MMFs, pension funds or private equity, to euro area significant banks doubled between 2021 and 2025, reaching around €800 billion by the third quarter of 2025. Around two-thirds of that funding lasts no more than 7 days. 

As assets cycle through the financial system, providing short-term funding, links between institutions are created over and over again. The specific contracts differ, but the underlying mechanism is the same.

The “dash for cash” episode in March 2020 demonstrated how these dense interconnections can transmit stress just as well as funding.

In March 2020, as the pandemic spread and markets panicked, investors wanted one thing above all. The safety of cash. Money Market Funds (MMFs) became a fairly predictable choke point. These funds take investors’ money and put it in safe assets, and are often treated as a way to place money for short periods and redeem it quickly when needed. 

The problem was that when COVID hit, everyone wanted cash at the same time. 

In the week of 13 to 20 March 2020, investors asked MMFs for cash equal to nearly 8% of the funds’ total size in a single week. But MMFs do not have huge piles of cash ready to hand back immediately. They are central nodes in the funding deals typical of today’s financial system, and most of the money was tied up in repos or other short-term funding instruments. So when investors rushed to redeem, it was not so easy to raise the cash quickly.

First, they paid out using whatever cash and very liquid assets they already held. Then they started the more difficult task of disentangling themselves from short-term funding. They stopped renewing loans, sold assets, and in some cases, sought early repayment from borrowers.

These borrowers were not ordinary savers. They were banks, corporations, and NBFIs. As MMFs pulled back, banks lost a supply of funding they normally depended on. Simultaneously, demand for bank credit increased as companies found that the credit they could usually access on markets had dried up. Put simply, investors redeeming cash from one corner of the system quickly meant funding withdrawn from the system as a whole.

Banks, NBFIs and even corporations are not just a collection of separate entities; they are cogs in a machine lubricated by the constant circulation of funding. In calm conditions, loans are renewed, repos are rolled over, and cash is available somewhere for the next transaction. But when confidence begins to diminish, and investors spook, that circulation slows. Funding tightens, frictions rise, and parts of the system that depend on constant movement begin to seize up.

In March 2020, the ECB stepped in to get the machinery moving again. It pumped liquidity into banks and started buying assets through the €750 billion Pandemic Emergency Purchase Programme (PEPP). In effect, it replaced both the cash and the buyers that the market had suddenly lost. But the “dash for cash” episode reveals a weakness. When one cog in the system stiffens, the effects spill over. 

The machine is not only fragile. It is also becoming increasingly complex, with more cogs and more connections. 

NBFIs now manage over 51% of global financial assets and fund around 15% of bank balance sheets. The channels that transmit stress are increasing, so what starts in the non-bank sector does not stay there. It can quickly reach banks, and from there, credit to firms, funding for households and the wider economy.

The fundamental problem is that NBFIs have become systemically important, but the regulatory framework has not kept up. The rules introduced after 2008 mostly focus on improving the resilience of banks, but more activity has shifted to NBFIs since. The assumption was that risk could be redistributed to the non-bank sector and absorbed. But that assumption is flawed. 

In 2026, financial stability cannot be protected by regulating banks alone. 

Even if the next crisis does not begin inside a bank, it will reach the banking system. Stress may build in one corner of the non-bank finance, but it does not stay there. Through leverage, short-term funding and interconnected exposures, it can spread rapidly across the system until the whole machinery of modern finance comes under strain. 

It is time that regulation and supervision adopted a system-wide perspective, one that focuses not only on individual entities but on the funding flows and interconnections through which risk is created and transmitted. That also means treating major non-bank actors as systemically important, testing how stress spreads across sectors, and giving supervisors stronger tools to understand and limit connections between vulnerable and vital institutions.

Max Kretschmer, Finance Watch

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