The Bank of England (BoE) will develop a new lending tool for non-bank financial institutions, starting with UK insurance companies and pension funds, which will be backed by market participants and regulators, to tackle threats to UK financial stability.
Following the LDI crisis last year, in which leveraged pension funds became forced sellers of UK government bonds as they fell in value, the BoE is seeking to firstly address dysfunction in core sterling markets in the exceptional circumstances when systemic risk is created. Firms’ ability and level of access to the facility will depend on their level of resilience. Andrew Hauser cited three reason for its development, in a speech at a Market News International Connect Event on 28 September.
“First, it is impossible to argue that market-based finance cannot threaten stability, after the strains that emerged in US repo markets in 2019, the 2020 ‘dash for cash’, the near-collapse of financial commodity market functioning in Spring 2022, and the UK’s Liability Driven Investment (LDI) fund crisis later that same year,” he said. “Second, in 2020, and again in 2022, traditional central bank tools for lending to banks were not enough to stabilise the financial system as a whole, because banks did not, or could not, on-lend to non-bank financial institutions (NBFIs) in sufficient size, requiring central banks to reach for unconventional asset purchase and sale tools; but third, although those operations were highly effective in restoring stability, they also posed material risks – to market incentives, to public sector balance sheets, and to perceptions of the monetary stance,” he continued.
“Careful tool design can mitigate these risks – but may not always be able to eliminate them.” While he was clear that the primary responsibility for ensuring appropriate resilience liquidity risks lies with NBFIs themselves, with serious remedial work being required still, “it is unrealistic for the private sector to self-insure against the most severe system-wide liquidity shocks: in such cases, safeguarding financial stability requires an effective public backstop.”
Supporting commercial banks to lend is the first preference, backed by the BoE’s Sterling Monetary Framework (SMF). but when banks will not lend in sufficient size or speed to counter a systemic risk, as in 2020 when the dealer banks hit internal limits, it is preferable to backstop market functioning he said, by lending directly to NBFIs against high quality collateral.
“Our end destination is clear – to build a new central bank backstop tool capable of lending directly to NBFIs against high quality assets to help tackle future episodes of severe dysfunction in core markets that threaten UK financial stability,” he confirmed. “The impetus for this work is real and pressing: NBFIs have introduced important new sources of systemic risk, and our current toolkit – though effective – is incomplete, with bank lending tools unable always to reach the source of the problem, and asset buy/sell tools posing financial and policy risks.”
The first step will be to the design a facility allowing it to lend to insurance company and pension funds (ICPFs) – including newly-resilient LDI funds. “ICPFs are major holders of gilts. They accounted for a material share of gilt sales in the dash for cash and LDI episodes,” he said. “Large parts of the sector have taken steps to improve their resilience in response to the dash for cash and the LDI episode. And we expect a range of ICPFs to score reasonably well against practical considerations.”
“A risk with this approach is that it leaves other key NBFIs central to the functioning of UK core markets outside the direct lending net, complicating the task of maintaining financial stability,” he continued. “So while resilience reforms are ongoing, we will also – as a second and parallel step – reach out to a broader set of NBFIs active in core sterling markets to explore how access might be expanded beyond ICPFs over time. Foremost amongst the challenges this work will need to confront are:
(a) what other types of NBFI need to be included to maximise policy efficacy;
(b) whether there may be ways to reach firms not subject to formal liquidity resilience requirements while still meeting the backstop principle, e.g. by varying the terms of access (including prices and haircuts) according to firms’ resilience levels and/or the efforts being made to reach resilience; and
(c) how to address the scaling-up challenge.”
©Markets Media Europe 2023
