Analysts are worried about a knock-on effect on the UK’s shadow banking sector in the event of a sudden rise in interest rates.
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LONDON – After last week’s chaos in British bond markets following the government’s “mini-budget” on September 23, analysts are sounding the alarm about the country’s shadow banking sector.
The Bank of England was forced to intervene in the long-running bond market after a strong sell-off in UK government bonds, known as “gilts”, threatened the country’s financial stability.
The panic was particularly focused on pension funds, which hold substantial amounts of gilts, while a sudden rise in interest rate expectations also caused chaos in the mortgage market.
While the central bank’s intervention offered some fragile stability to the British pound and bond markets, analysts have pointed to lingering stability risks in the country’s shadow banking sector: financial institutions acting as lenders or intermediaries outside the traditional banking sector.
Former British Prime Minister Gordon Brown, whose administration introduced a bailout package for British banks during the 2008 financial crisis, told BBC Radio on Wednesday that UK regulators should strengthen supervision of banks in the shade
“I’m afraid that as inflation rises and interest rates rise, there are going to be a number of businesses, a number of organizations that are going to be in serious trouble, so I don’t think this crisis is over because the pension funds have been bailed out. ‘last week,” Brown said.
“I think there needs to be an eternal vigilance about what has happened with the so-called shadow banking sector, and I fear that there are more crises to come.”
In recent sessions, global markets have been buoyed by weak economic data, which is seen as reducing the likelihood that central banks will be forced to tighten monetary policy more aggressively to curb soaring inflation.
Edmund Harriss, chief investment officer at Guinness Global Investors, told CNBC on Wednesday that while inflation will be moderated by falling demand and the impact of higher interest rates on household incomes and purchasing power, the danger is a “softening and extension of weakened demand.” “
The US Federal Reserve has reiterated that it will continue to raise interest rates until inflation is under control, and Harriss suggested that year-on-year inflation impressions above 0.2% will be viewed negatively by the central bank, which will drive a more aggressive tightening of monetary policy. .
Harriss suggested that sudden and unexpected changes in rates where leverage has built up in the “darkest corners of the market” during the previous period of ultra-low rates could expose areas of “fundamental instability”.
“When you came back to the question of pension funds in the UK, it was the requirement for pension funds to meet long-term liabilities through their gilt holdings, to get cash flows, but very low rates they meant they weren’t. getting the returns and so they applied swaps on top, that’s the leverage to get those returns,” he said.
“Non-bank financial institutions, the problem is likely to be access to finance. If your business is based on short-term financing and a step back, credit institutions have to tighten their belts, tighten their credit conditions, etc. and start to move towards capital preservation, then the people who are going to starve are the ones who need the short-term financing the most.”
Harriss suggested that the UK is not there yet, but there is still plenty of liquidity in the system at the moment.
“Money will become more expensive, but it’s the availability of money when you hit a tipping point,” he added.
The greater the debt of non-bank entities such as hedge funds, insurers and pension funds, the greater the risk of a ripple effect through the financial system. Capital requirements for shadow banks are often set by the counterparties they deal with, rather than regulators, as is the case for traditional banks.
This means that when rates are low and there is a lot of liquidity in the system, these collateral requirements are often set quite low, meaning that non-banks have to post substantial collateral very suddenly when markets are headed towards the south
Pension funds triggered the Bank of England’s action last week, with some starting to receive margin calls as gilt values fell. A margin call is a broker’s demand to increase the capital of an account when its value falls below the broker’s required amount.
Sean Corrigan, principal at Cantillon Consulting, told CNBC on Friday that pension funds themselves were in fairly strong capital positions due to higher interest rates.
“They’re actually ahead of actuarial funding now for the first time in five or six years, I think. They clearly had a margin problem, but who’s short on margin?” he said
“It’s the counterparties that have transmitted it and stirred it up. If there’s a problem, maybe we’re not looking at the right part of the building that’s in danger of falling.”
