Britain’s shadow banking system is raising serious concerns after bond market storm

Analysts fear a ripple effect on the UK’s shadow banking sector if interest rates suddenly rise.

Photo by Richard Baker | In pictures | Getty Images

LONDON — After last week’s chaos in Britain’s bond markets following the government’s September 23 “mini-budget”, analysts are sounding the alarm over the country’s shadow banking sector.

The bank of england has been forced to intervene in the long-term bond market after a massive sell-off of UK government bonds – known as “gilts” – threatened the country’s financial stability.

The panic was concentrated in particular in pension funds, which hold large amounts of gilts, while a sudden rise in interest rate expectations also caused mortgage market chaos.

While central bank intervention provided fragile stability to the Pound sterling 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 of the traditional banking sector.

Former UK Prime Minister Gordon Brown, whose administration introduced a bailout for UK banks during the 2008 financial crisis, told BBC Radio on Wednesday that UK regulators should step up their oversight of shadow banks.

“I fear that as inflation hits and interest rates rise there will be a number of companies, a number of organizations that will be in serious trouble, so I don’t think this crisis is over because the pension funds were saved in the last week,” Brown said.

“I think there needs to be eternal vigilance over what has happened to what is called shadow banking, and I fear there are more crises to come.”

In recent sessions, global markets have been encouraged by weakening economic data, which is seen as reducing the likelihood that central banks will be forced to tighten monetary policy more aggressively in order to contain sky-high inflation.

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Edmund Harriss, chief investment officer at Guinness Global Investors, told CNBC on Wednesday that while inflation will be tempered by lower demand and the impact of higher interest rates on incomes and purchasing power households, the danger is “a crushing and extension of the weakening of demand”. “

The US Federal Reserve reiterated that it will continue to raise interest rates until inflation is brought under control, and Harriss suggested that monthly inflation prints of more than 0.2% will be viewed negatively by the central bank, leading to 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 “instability.” fundamental”.

“Going back to the issue of pension funds in the UK, it was the requirement for pension funds to meet long-term liabilities through their gilt holdings, to pass cash flow, but the ultra-low rates 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 probably access to finance. If your business relies on short-term finance and a step backwards, lending institutions have to tighten their belts, tighten credit terms, etc. , and start moving towards capital preservation, then the people who are going to starve are the ones who need the short-term funding the most.”

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Harriss suggested that the UK is not there yet, as there is still enough liquidity in the system for now.

“Money will get more expensive, but it’s the availability of money that’s where you find some kind of tipping point,” he added.

The higher the debt held by non-bank institutions, such as hedge funds, insurers and pension funds, the greater the risk of a ripple effect on the financial system. Capital requirements for shadow banks are often set by the counterparties they deal with, rather than by regulators, as is the case for traditional banks.

This means that when rates are low and there is an abundance 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 the markets are heading down.

Pension funds triggered action from the Bank of England last week, with some starting to receive margin calls as gilts fell in value. A margin call is a request from brokers to increase the equity of an account when its value falls below the amount required by the broker.

Sean Corrigan, director of Cantillon Consulting, told CNBC on Friday that pension funds themselves are in pretty strong capital positions due to higher interest rates.

“They’re actually now ahead of funding on an actuarial basis for the first time in five or six years, I think. They clearly had a margin problem, but who’s the one that’s slightly marginalized?” he said.

“It’s the counterparties that passed it on and shuffled it around. If there’s a problem, maybe we’re not looking at the right part of the building that’s in danger of collapsing.”

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