Non-bank financial institutions must be prepared to meet sharp jumps in margin calls to weather periods of severe market stress, the Bank of England has warned, as it outlined measures to address what it sees as some of the main vulnerabilities in the financial system.
Nathanael Benjamin, executive director for financial stability strategy and risk at the BoE, said in a speech on Thursday that the post-2008 shift towards counterparties exchanging collateral as security in financial market trades has made the financial system much safer.
But he also highlighted new risks that have emerged as a result of this shift. They include dash-for-cash scenarios where firms have to liquidate assets in fire sales to meet hefty margin calls – a dynamic that can exacerbate already stressed market conditions. The BoE has direct experience of such events, having had to intervene to calm UK government bond markets in 2022 when pension funds facing eye-watering collateral calls sold Gilts en masse.
"Greater collateralisation has been positive for financial stability," Benjamin told an event in London held by the International Swaps and Derivatives Association. "But getting margin and haircut levels and practices right is crucial for financial stability.
"Getting these things sorted is essential and will go a considerable way towards addressing some of the main current vulnerabilities in the system of market-based finance," he said.
Reducing counterparty risk by setting aside collateral against derivatives exposures was one of the central planks of post-2008 regulatory reforms. But recent examples of margin calls exacerbating market stress have highlighted other risks that arise if firms are unable to move enough collateral to the right place at the right time to keep the broader system running smoothly.
Benjamin listed several recent examples of these liquidity squeezes alongside the UK's pension fund crisis in 2022. Initial margin requirements at derivatives central clearinghouses rose around 40%, or US$300bn, between the end of February and mid-March 2020 following the outbreak of Covid-19. The surge in energy prices in the wake of Russia's invasion of Ukraine in 2022 provided another example, when average daily variation margin calls on natural gas futures contracts increased more than sixteen-fold in the first half of 2022.
Benjamin also drew attention to the growth in market-based finance over the past decade and a half, with half the funding for UK businesses now coming directly from financial markets and non-banks rather than traditional bank loans. This shift has increased banks’ exposures to the non-bank sector, he said. That is because they often intermediate and provide leverage for this funding, meaning "counterparties across the financial ecosystem have become increasingly interconnected".
"Enhancing market participants’ liquidity preparedness to meet their collateral requests would go a long way towards reducing procyclical behaviours in response to large margin calls and preventing the liquidity crises that have amplified past financial shocks,” said Benjamin, who pointed to work from regulators including the BoE on initiatives to address these risks.
“This requires a high degree of transparency, effective stress-testing and improvements to operational processes," he said.
Further steps
Benjamin’s comments echo the Financial Stability Board earlier this year when the international regulatory body called on pension funds, insurance companies and hedge funds to better equip themselves to handle large margin calls from their positions in derivatives and securities markets during times of heightened stress.
Going further, Benjamin called on banks to “take appropriate steps” to better understand their non-bank counterparties’ liquidity profile and to consider how that profile might change during times of stress.
Toks Oyebode, executive director for the office of regulatory affairs at JP Morgan, said that there was only so much oversight banks could exercise over their non-bank counterparties within regulatory provisions.
“[It’s] perhaps not realistic to expect real-time 365 [day] monitoring of the liquidity position of an entire non-bank portfolio. There just aren’t the regulatory disclosures in place for us to do that. We can of course have ad hoc real-time conversations with [non-bank] clients when geopolitical and market events take place, but systematic, consistent, real-time monitoring is very difficult to do with the disclosures that are in place,” said Oyebode, who was also speaking at the ISDA event.
Steven Kennedy, global head of public policy at ISDA, noted that Archegos Capital Management was exempt from any disclosure requirements under Securities and Exchange Commission rules prior to its collapse in 2021 because it was classed as a family office.
“If Archegos happened today, all of their trades would have been publicly reported and firms would have been able to see concentrated exposure to certain names,” Kennedy said.
Benjamin challenged the notion that greater regulation over non-bank liquidity preparedness was needed. Instead, he said it is “infinitely preferable” that market participants solve and manage such issues on their own – with regulators and central banks only stepping in during extreme scenarios.
“The market is the first line of defence and we’re only the back-stop. That’s how it should work,” he said. “If the market doesn’t do its job then someone [else] has to do something about it.”