(Bloomberg) – With odd timing, the Bank of England’s quarterly review of the risks facing the banking system landed amid another bout of market panic.
Bloomberg’s Most Read
Wednesday morning’s financial policy summary expressed confidence in the resilience of traditional banks in the face of a downturn. Shadow banking, the industry of lenders, brokers and other intermediaries that fall outside the realm of regulated traditional banks, was of greater concern.
“The vulnerabilities exposed by the malfunctioning gilt market share characteristics with those of the non-banking financial system,” the central bank’s report said. It is crucial to strengthen “the resilience of non-bank financial institutions globally in the face of sharp reductions in asset prices and liquidity”.
Those concerns echoed Governor Andrew Bailey’s call in a speech Tuesday for tougher standards for the nonbank financial sector, which accounted for about half of all global financial assets – some $227 trillion – in 2020. said the Financial Stability Board in a report. in December.
Regulators have worried about this opaque market for years, but those fears have deepened in the past two weeks after the UK government announced a package of unfunded tax cuts. This caused chaos in a little-known corner of the pensions market as funds dumped government and corporate bonds to hedge their derivative positions.
Read more: How ‘liability-focused’ funds sparked the UK bond panic: QuickTake
With the Bank of England appearing determined to end its emergency bond buying program on Friday, the turmoil is unlikely to ease. This could spill over to the broader shadow banking system which is already suffering from rising interest rates.
Former British Prime Minister Gordon Brown told the BBC last week that more problems lie ahead.
“As inflation hits and interest rates go up, there will be a number of businesses, a number of organizations that will be in serious trouble, so I don’t think this crisis is over because the pension funds were saved,” he said. “There must be eternal vigilance over what has happened to the so-called shadow banking sector, and I fear there are more crises to come.”
Shadow banking is a catch-all term that encompasses hedge funds, risky investment products, pawnbroking and loan sharking, and so-called peer-to-peer lending. The common denominator is that these products and practices develop outside the mainstream banking system and often beyond the reach of regulators.
Above all, they raise short-term funds and buy assets with longer-term maturities. The mismatch was a concern long before the mini-budget, drawing the attention of regulators around the world. The Financial Stability Board said in a review last year that the market chaos at the start of the pandemic in March 2020 highlighted vulnerabilities in the sector and exposed the interdependence of shadow banks and traditional lenders.
Read more: Shadow banking is booming outside the grip of regulators: QuickTake
At the heart of the turmoil this time around is a little-watched cornerstone of Britain’s pension funds, which manage more than $1 trillion in assets. These funds have been unloading all sorts of holdings over the past few weeks to meet margin calls on the derivatives they used to ensure they had enough money to pay retirees for decades to come.
The UK pensions industry has weathered years of falling interest rates, but rising rates are now the new normal, said Scott Peng, founder and CEO of Advocate Capital Management LLC. This left the industry blind to the impact of tighter monetary policy. “It’s the first time in over a decade that Britain’s LDI risk management framework has really been stress tested and it’s performed quite badly,” he said. “This should prompt a serious review of pension risk and liquidity management.”
Multi-asset funds are also victims of the cash rush in the pension sector. Funds run by major asset managers including Aviva Plc and Schroders Plc have seen hundreds of millions of pounds in net outflows since September 23, when the UK government announced a package of unfunded tax cuts that will drove down the price of gilts.
Other entities or asset classes that rely on leverage could also find themselves in the limelight, according to Howard Davies, chairman of NatWest Group Plc and former central bank deputy governor. Mutual funds, hedge funds and private equity have all spent years in a world of low interest rates and adjusting to higher rates could trigger turbulence.
The woes of the shadow banking world could spill over to the wider economy, as shadow banking firms now play a big role in markets from real estate to auto finance.
“Just as you’ve seen some fringe players in mortgage markets pull out because their wholesale funding isn’t available, I think you’re going to see it in other parts of shadow banking,” Davies said on Bloomberg. TV Wednesday. He said he would pay particular attention to areas that depend on short-term funding.
That could include home loan providers outside of traditional banks, a blow to an already squeezed housing market that has seen mortgage costs soar, pulled proceeds and caused some home sales to slump.
Yet history suggests that it will be difficult to predict where the crisis will come from.
“It’s been the pattern of every financial crisis for hundreds of years,” said Charlie Parker, managing director of boutique investment manager Albemarle Street Partners. “It’s always the part of the market you focus on the least.”
Bloomberg Businessweek’s Most Read
©2022 Bloomberg LP