Are financial risks now building?

Financial transactions and risks may be expanding faster than the regulatory perimeter designed to oversee them

Financial crises often occur when the architecture designed to safeguard stability fails to keep pace with the changing financial system. New institutions and transactions expand the perimeter of finance while regulation, supervision and crisis-management arrangements adjust more slowly. Risks accumulate where they are poorly measured or understood — until a shock reveals how interconnected they have become.

 

This was part of the story of earlier crises. The Asian financial crisis exposed vulnerabilities from rapid cross-border flows, foreign-currency borrowing, and weak financial-sector oversight. A decade later, the global financial crisis revealed how securitisation, leverage and shadow banking had developed beyond the reach of an architecture still focused heavily on regulated banks.

 

Could a similar gap be opening again? Banks today are generally more resilient than they were before 2008. But finance has moved on. Non-bank financial institutions (NBFIs) accounted for 51 per cent of global financial assets in 2024 and grew at twice the pace of banks. At the same time, near-record government debt and the growing role of NBFIs have changed sovereign debt markets, with the Bank for International Settlements (BIS) warning that the combination can heighten the risk of market dysfunction.

 

Risk has migrated: Post-2008 reforms strengthened banks, but some risks migrated elsewhere. Hedge funds can carry substantial leverage, investment funds face liquidity mismatches, and private credit has expanded rapidly. Yet banks remain connected through credit lines, repo, and derivatives. The relevant unit of analysis is increasingly not the individual bank but a sovereign-bank-NBFI-market network.

 

Japan provides a striking illustration. Decades of exceptionally low interest rates made the yen a global funding currency. Cross-border yen borrowing reached an estimated ¥360 trillion ($2.3 trillion) by March 2026, an increase of more than two-thirds from its level in late 2021. Yet the true scale of the carry trade remains uncertain because derivatives and off-balance-sheet positions can be difficult for regulators to observe.

 

As the Bank of Japan normalises monetary policy, a rapid yen appreciation could force leveraged investors to unwind positions elsewhere. The partial unwinding of the yen carry trade in 2024 showed how quickly such pressures can spread: The effects reached Japanese, US, European and other Asian equity markets, cryptocurrencies and emerging-market currencies. Japan illustrates the wider problem —  transactions have become global and interconnected while supervision remains predominantly national.

 

Is the protective perimeter weakening? This comes as parts of the regulatory architecture face pressure. US Federal Reserve Governor Michael Barr has warned that recent regulatory changes have reduced capital requirements for large American banks and that divergence from international standards could encourage a regulatory “race to the bottom”. US bank credit commitments to other financial entities exceeded $2.6 trillion in the second half of 2025. Regulatory simplification extends elsewhere. Proposed US changes would substantially reduce the number of listed companies requiring independent auditor attestation of internal financial controls introduced after the Enron accounting scandal. Compliance costs are a legitimate concern. But companies already exempt from the requirement have accounted for 60-80 per cent of annual financial restatements in recent years.

 

Technology is simultaneously extending the perimeter. Financial Stability Board Chair Andrew Bailey has warned that frontier artificial intelligence (AI) could expose financial institutions to simultaneous disruption through cyberattacks and shared technology dependencies. Common AI models, automated trading, and dependence on common technology providers could create correlated behaviour or operational failures across otherwise unrelated institutions.

 

Who can provide the new perimeter? The International Monetary Fund (IMF) and BIS are central to closing these gaps — but neither can itself provide a global regulatory perimeter. The IMF can bring sovereign, macroeconomic and financial risks together through surveillance and financial-sector assessments. The BIS and Basel Committee can develop common prudential standards, identify cross-border risks and encourage consistent supervision. But neither is a supranational regulator. Implementation and enforcement remain national. The answer must, therefore, be a more connected architecture, with national regulators following risks beyond traditional institutional boundaries; international standards limiting regulatory arbitrage; better cross-border information on leverage and liquidity; and IMF surveillance assessing whether the pieces add up to system-wide resilience. The regulatory perimeter increasingly needs to follow the activity and the risk, not simply the institution undertaking it.

 

India provides an instructive counterpoint. Regulation and supervision have strengthened considerably following earlier banking distress, and the IMF’s latest financial-sector assessment finds banks and nonbanks broadly resilient. Yet India’s financial system is also evolving: Nonbanks now provide nearly half of private-sector credit, while connections among banks, non-banking financial companies and markets have grown. The lesson from India is, therefore, encouraging but also relevant more widely — that regulatory authorities need to continually adapt the perimeter as financial activity, institutions and their interconnections change.

 

The emerging-market test: This matters particularly for emerging economies. Financial instability need not originate within them. An advanced-economy shock can arrive through portfolio outflows, currency depreciation, higher sovereign yields and refinancing costs. The yen carry trade demonstrates how leveraged positions created elsewhere can suddenly affect emerging-market assets. None of this means another financial crisis is imminent. It suggests something subtler: Financial transactions and risks may once again be expanding faster than the perimeter designed to oversee them. The next crisis may look nothing like 1997 or 2008. The more important question is whether the financial architecture has evolved sufficiently to see it coming — and to contain it when it does.

 

 

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The writer is distinguished fellow at CSEP, New Delhi, and was a member of the 15th Finance Commission