Exchanging collateral as security has become the norm between financial market counterparties. That has made the system much safer. But counterparties need to be prepared for the potential liquidity need from sharp margin calls in stress. And enough collateral has to be collected during good times, via initial margin or haircuts, otherwise that can allow the build-up of excessive leverage, which can unravel and destabilize the system in bad times, said
These issues relate directly to the typical systemic vulnerabilities in market-based finance identified by the Bank of England’s Financial Policy Committee (FPC), including liquidity mismatches, excessive leverage, and lack of operational readiness, at the level of individual financial institutions.
This jumps to illiquidity at the system-wide level, which is exacerbated by concentrated or correlated positions, and interconnectedness. During stress, these vulnerabilities can disrupt financial stability by impacting systemic markets, systemic institutions, and the provision of vital services such as funding to the real economy.
The good news? A lot of work is happening – internationally and domestically – to ensure the financial system evolves in a safe and sustainable way. This includes efforts to address low haircuts, particularly in sovereign debt repo markets. And to ensure market participants are prepared for inevitable margin calls and the liquidity need they will generate. Getting this right is particularly important for many vulnerabilities in the financial system.
Excessively high margins can unnecessarily tie up resources that could be used more productively elsewhere, but setting initial margin or haircuts too low can undermine financial stability as counterparty risk is not adequately captured, and it means they have to rise more sharply in stress.
To mitigate this risk, UK CCPs are required to implement anti-procyclicality measures in their initial margin models. Financial institutions must also continue to improve their own risk management frameworks so that they adequately consider the exposures of their clients and counterparties.
On the public sector side, the BoE is also developing a new contingent repo lending facility, enabling the central bank to provide liquidity directly to non-bank financial intermediaries (NBFIs) at times of severe liquidity stress in core UK markets, as a backstop.
“The steps I have mentioned today are key to ensure market participants manage and take responsibility for the risks to which they choose to expose themselves. So that the level of risk in the system is properly priced. And so that market participants play their part in ensuring exposures are adequately covered, and that they act as an effective first line of defense. And so that central banks can be the last resort, not the first resort. The international policy work currently underway is key to address these issues, and harmonized guidance and standards will also prevent risks of regulatory arbitrage or a race to the bottom,” he said.
“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.”