Global regulators to increase scrutiny of risks outside the banking system

Global regulators are set to step up their scrutiny of hedge funds, clearing houses and pension funds this year after a series of crises shifted regulators’ focus to risks outside the banking system.

The disparate group, loosely defined by regulators as “non-bank financial institutions,” has come under the spotlight after a series of market turbulences over the past two years.

“It’s different now,” Bank of England Governor Andrew Bailey told reporters in mid-December, speaking of the “urgent” need to translate long-standing research and advice from global policymakers on non-bank financial stocks into swift global action.

The first seeds of the NBFI regulators’ awakening were sown in March 2020, as hedge funds were swept away by Covid-panic markets. Two years later, the London Metal Exchange had to temporarily close its nickel market because its clearing house was threatened with a bottleneck.

Before the end of 2022, European governments bailed out energy companies caught off guard by rising energy prices, and the BoE had to step in to stem a collapse in UK government bond markets triggered by misjudged risks in obscure investment strategies by pension funds whose businesses are growing spanned Great Britain, Ireland and Luxembourg.

Overall, the crises have shed light on risks, which have migrated largely in whack-a-mole fashion elsewhere in the financial system after regulators tightened regulations on banks following the collapse of Lehman Brothers in 2008.

“It’s critical for global regulators to look some 15 years down the road and see if that’s what we were trying to achieve?” said Ana Arsov, co-head of global banking at Moody’s, echoing Bailey’s need for globally coordinated action as both argue that the sector is so international that it can only be tamed by global action.

Regulation of NBFIs that are now dropped almost half of global financial assets, is new territory for policymakers in several respects.

Line chart shows non-banks playing a bigger role in the wake of the global financial crisis

Liquidity has been the major stressor in the recent series of disruptions, unlike the 2008 financial crisis, when concerns revolved around whether institutions’ balance sheets, mainly banks, were strong enough to absorb all of their liabilities in a market of falling asset prices and increasing credit to cover defaults.

The BoE last month announced the world’s first stress tests, which will examine underlying risks in key financial markets where NBFIs are key players, an exercise that Arsov said could be “very helpful”.

The Financial Stability Board, which draws guidelines from the world’s largest central banks, finance ministries and regulators, will this year report on how well countries have implemented their 2021 recommendations to improve oversight of money market funds, vehicles that act like bank accounts in the investment industry and are meant to be ultra-secure and push policy in other areas.

“Since the pursuit of cash, we’ve been trying to figure out what happened and then worked to fix the vulnerabilities,” outgoing FSB secretary-general Dietrich Domanski told the Financial Times of the turmoil in the early pandemic era. as companies were forced to call on more than $100 billion in credit lines after market funding dried up.

An early area of ​​focus was money market funds, for which the FSB has proposed a variety of Dimensions including some that would reduce “cliff effects” that trigger herd selling once artificial thresholds are crossed, and other proposals that would narrow the gap between the maturity of the instruments a fund invests in and the liquidity it guarantees to its investors , would limit.

The second area is open-end funds, which the FSB sees as an area likely to contribute to the kind of “sudden spikes in liquidity demand” that trigger bailouts because there’s a fundamental mismatch between the instant repayments they promise their clients , and the challenges of selling assets quickly in a falling market.

One suggestion to address issues related to the first mover advantage in a falling market is “swing pricing” which smoothes the price received by all traders within a window. “It has the potential to be a big step forward in solving problems [of price spirals]’ Domanski said. “But it’s also not a miracle cure.”

The FSB is also trying to better understand things like hidden leverage in different parts of the NBFI market.

“We have to recognize that this is a very diverse part of the financial system, which differs from banks in many ways,” added Domanski of NBFIs. “No one would seriously argue that you should apply the same rules to mutual funds and insurance and pension funds, to name just three.”

Dozens of policy initiatives are underway around the world as regulators scramble to get a handle on a multitude of potential problems. Global securities regulator Iosco has put forward a series of proposals to improve liquidity in key financial markets, particularly during times of stress.

ISDA Chief Executive Scott O’Malia said he expects the role of intermediaries such as clearing houses to be a “key issue” for 2023. In December, the FSB called for “urgent work” to address contingency plans for the collapse of both companies, clearinghouses and insurers.

Meanwhile, the U.S. Securities & Exchange Commission is pursuing the biggest overhaul of stock trading rules in two decades, imposing a series of measures that will primarily lower costs for retail investors, but will also ease the frenetic trading that triggered the meme boom stocks in 2021.

In Europe, Andrea Filtri, an analyst at Mediobanca, said the focus is likely to shift from working around the structure of European markets in 2022 to looking at liquidity issues “in a challenging environment of rising interest rates and quantitative tightening”.

“There are several dozen markets that could face an LDI-style black swan without necessarily having the tools to do so,” he said, citing the LDI funds-of-pension plans that are covering the UK turmoil market in September.

Domanski also said NBFIs are fraught with feedback loops and reinforcements, making it harder to find solutions. “Before 2020, when some people were talking about magic bullets, they would say that the answer was to hold liquidity in government bonds[ . . .]We have seen that under stress in recent years.”

“What is needed as a basis for political action[ . . .]is a clear understanding of how this [NBFI entities interact].” Global regulators to increase scrutiny of risks outside the banking system

Adam Bradshaw

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