Financial Stability Report – December 2022
The resilience of market-based finance
Tightening financing conditions and greater volatility, alongside a number of economic shocks, have caused long-standing vulnerabilities in market-based finance (MBF) to crystallise in a number of areas over the past three years.
These episodes underline the need to develop and adopt policy reforms to increase resilience across the system of MBF. The Financial Stability Board (FSB) has a comprehensive international work programme in train focused on increasing the resilience of money market funds and open-ended funds, improving margin practices and understanding drivers of illiquidity in core funding markets, including non-bank financial institution (NBFI) leverage.
The FPC welcomes the FSB’s recent progress report to G20 leaders and the proposed work plan for 2023, which includes developing policy recommendations that seek to address vulnerabilities. The Bank and FPC continue to support strongly this programme of international work. In 2023 international and domestic regulators urgently need to develop and implement appropriate policy responses to address the risks from MBF. Absent an increase in resilience, the sharp transition to higher interest rates and currently high volatility increases the likelihood that MBF vulnerabilities crystallise and pose risks to financial stability.
Alongside this international work, the Bank will continue to work to reduce vulnerabilities domestically where it is effective and practical. To support this, there is a need to develop stress-testing approaches to understand better the resilience of NBFIs to shocks and their interconnections with banks and core markets. The Bank will run, for the first time, an exploratory scenario exercise focused on NBFI risks, to inform understanding of these risks and future policy approaches. Further details will be set out in the first half of 2023.
The resilience of liability-driven investment funds
In late September, UK financial assets saw severe repricing, particularly affecting long-dated UK government debt. The rapid and unprecedented increase in yields exposed vulnerabilities associated with liability-driven investment (LDI) funds in which many defined benefit pension schemes invest. This led to a vicious spiral of collateral calls and forced gilt sales that risked leading to further market dysfunction, creating a material risk to UK financial stability.
There is a clear need for urgent and robust measures to fill regulatory and supervisory gaps to reduce risks to UK financial stability, and to improve governance and investor understanding.