Lessons 'must be learned' from liquidity issues, says BofE

The Bank of England (BofE) has emphasised the need for non-banks, as well as their counterparties such as regulators, to learn lessons from the recent gilt market volatility and subsequent liquidity issues.

In a recent speech, BofE executive director, financial stability strategy and risk, Sarah Breeden, reflected on the Bank's recent gilt market interventions, which were introduced in an effort to prevent a "self-reinforcing spiral".

Breeden noted that the 13 day and £19.3bn intervention was the first example of the BofE acting to deliver on its financial stability objective through a temporary, targeted intervention in the gilt market.

She also explained that these asset purchases were "a means to an end", and were designed to create the right conditions in the right part of the gilt market for long enough so that the liability driven investment (LDI) funds could build resilience.

"It’s clear that leverage is a key function provided by the financial system in support of a thriving and productive economy," she stated. "But it comes with inherent risks that need to be managed."

Breeden therefore stressed the need to take into account the potential amplifying effect of poorly managed leverage, and to pay attention to non-banks’ behaviours which, particularly when aggregated, could lead to the emergence of systemic risk.

Despite this, she clarified that "the onus for building resilience in the non-bank system sits first and foremost with the firms themselves", stressing that if firms use leverage, "they must be able to manage the liquidity consequences of their risk exposures".

"As part of this, they need to learn from the decades of experience that show how leverage and liquidity risk creates rollover risks; volatility; operational challenges in accessing liquidity; and exposures to amplification mechanisms from the wider system," Breeden continued.

However, Breeden said that while "LDI funds have demonstrated the art of the possible here, by building resilience at speed when severe stress demonstrated the clear need for it", others will need to act too.

For instance, Breeden suggested that banks have an important role to play in reducing risks both to themselves and to the wider system from non-bank leverage.

"That starts with information," she stated. "So a first step is for lenders to require greater transparency of hidden leverage taken by their counterparties.

"Banks, like their non-bank clients, need also to improve their stress testing to include better understanding of market dynamics and structural shifts that might change correlations and norms."

Breeden argued that stress testing is also needed across sectors to understand how correlations in risk exposure can lead to correlated behaviours in stress.

"And stress tests need to account for institutional structures, governance and processes for liquidity management, to capture examples like the LDI event above, where defined benefit (DB) schemes had assets available but were simply unable to get them to where they needed to be quickly enough," she added.

Regulatory changes may also be needed, as Breeden suggested that the international nature of leveraged investors requires a "firm response by the global regulatory community to assess those risks and develop policy solutions".

In particular, Breeden highlighted the importance of transparency, arguing that it is "vital" that that regulatory authorities have sight of leverage building up in the system, and what that means for resilience.

She stated: "Given the global nature of non-bank business models, it is essential that transparency and data availability are enhanced through international efforts, and that authorities have the right metrics to assess the risks of leverage.

"Beyond improving transparency, regulators will need to consider how best to ensure leverage is well managed.

"These could, for example, include broad market-wide measures such as market regulations to ensure excessive leverage is better controlled by market pricing and margins."

More broadly, Breeden also suggested that there are "important questions about the role of central bank balance sheets", emphasising that "central banks cannot be a substitute for the primary obligation of market participants to manage their own risk, or for internationally co-ordinated reforms that enhance the resilience of the non-bank financial sector".

"All too often excessive risk taking alongside improper liquidity risk management has threatened conditions in the real economy - an issue that feels especially pertinent in the current environment of high volatility and tightening financial conditions," she concluded.

"Lessons must be learned from these episodes, most importantly by non-banks themselves, but also by: their counterparties; market infrastructure; their regulators; bank supervisors; central banks; and the global regulatory community as we continue our global efforts to ensure the resilience of the system of market-based finance."

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