Tag: counterparty risk

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Stress testing shadow banking: new channels but the same old risks

On the 29 November, the Bank of England published the results of its latest stress test of the UK financial system. Annual stress testing was introduced in the wake of the 2008 financial crisis. It models the ability of the financial system to withstand severe macroeconomic and financial market conditions. Typically, the focus has been on testing the resilience of the banking system.

This year’s was the first system-wide exploratory scenario (SWES). This recognises the growing significance of ‘shadow banking’. Shadow banking involves borrowing and lending involving non-bank financial institutions (NBFIs). Such institutions sit outside the regulatory cordons around banking but have become significant actors in the financial system.

However, this obscure part of the financial system poses systemic risks which are not clearly understood and from time to time require costly interventions. Examples include: problems in liability-driven investments (LDIs) for pension funds in September 2022; the money market liquidity crisis involving hedge funds in March 2020; the collapse of Long-term Capital Management (LTCM) in 1998 following the Russian Federation’s default (LTCM had significant holdings of Russian government bonds – see linked article on LTCM below).

The growing significance of shadow banking means that regulators have become increasingly concerned about the vulnerabilities in the financial system which arise from outside the traditional banking system.

In this blog we will explain stress-testing of the financial system and trace the rise in shadow banking which motivated the recent system-wide exploratory scenario (SWES). We will discuss the findings of the stress test, highlighting the systemic risks of shadow banking. Finally, we will discuss the implications for the regulation and supervision of the financial system.

What is stress testing?

Stress testing was introduced by the Bank of England after the financial crisis to assess the ability of the financial system to withstand severe economic and market scenarios.

In the run-up to the 2008 financial crisis, the liquidity and capital buffers of many banks had been extremely thin. These were only able to withstand moderate economic shocks and moderate conditions and buckled under the stresses of the crisis.

Regulators argued that the buffers needed to become much more robust and be able to withstand rare but severe economic and market conditions. The stress testing analogy was derived from engineering, where parts are expected to work not just in benign conditions but also in extreme, hostile environments.

Since 2014, the Bank of England has conducted annual stress testing. Stress testing models the impact of adverse economic conditions on banks’ liquidity, profitability and capital. The results are used to set policy for individual banks (microprudential) and for the system as a whole (macroprudential). Stress test results have allowed the Bank to adjust the loss-absorbing capital that banks must hold to reduce their likelihood of failure.

The scope of the testing has expanded over time to incorporate insurers, central counterparties (financial institutions that provide clearing and settlement services between financial traders) and cyber security. The most recent scenario recognised the increasing significance of non-deposit taking financial institutions in channelling credit. Fifty City of London institutions modelled how a period of intense stress would ripple through the shadow banking sector.

The arcane world of shadow banking

Shadow banking refers to borrowing and lending which occurs outside the banking sector. Traditionally banking involves taking deposits and using these to finance lending.

Shadow banking involves non-deposit taking financial institutions (NBFIs) such as hedge funds, insurance companies, pension funds, private equity funds, as well as some activities of investment banks. These institutions channel funds in different ways from lenders to borrowers. Typically, they use funds from investors to buy securities through financial markets. The emergence and growth of shadow banking has been explained by changing regulation and innovation.

Its first significant period of expansion in the late 1980s was driven by financial innovation. Increased use of ‘disintermediation’ – the replacement of credit channels through banks with ones through markets – meant an increase in the assets invested through NBFIs.

Despite this process playing a major role in the expansion of housing credit in the run-up to the 2008 financial crisis, it was the significant bailouts that banks received that drew the attention of regulators, not the role of shadow banking. This led to more stringent liquidity and capital requirements for banks under the BASEL III international regulations.

This regulatory tightening limited banks’ ability to offer credit, which meant that much of this activity migrated to the shadow banking sector.

Data from the Bank of England show that the percentage of total assets held by NBFIs rose from 41% in 2007 to 49% in 2020. The chart illustrates the total financial assets held by non-bank financial institutions in the UK between 2019 Q4 and 2023 Q3 (click here for a PowerPoint). The amount held has growth by approximately a third in that time, from £4321bn to £6069bn, peaking at £6670bn in 2022 Q3.

The lack of regulatory oversight stems from the nature of the activities in the shadow banking sector. While NBFIs conduct maturity transformation, provide liquidity and help manage risk, unlike banks, they do not accept deposits and are not part of the payments system involving the general public.

Consequently, the consensus among regulators has been that their activities do not pose the same systemic risks as banking of the breakdown of the payments mechanism and associated collapse in business and consumer confidence. Therefore, NBFIs are not subject to conventional regulation and supervision involving liquidity and capital requirements.

However, as the scale of borrowing and lending running through the sector has grown, this argument has become less difficult to justify. There is a concern that ‘regulatory arbitrage’ is happening and that the systemic risks associated with shadow banking are being underestimated.

The familiar risks of shadow banking

The systemic consequences of liquidity and solvency problems in the shadow banking sector may not seem obvious. Much of their activities are arcane and technical. However, there are plenty of examples of instances where the problems of hedge funds or pension funds have caused systemic issues.

While the consequences are not the same as those involving banks, in that the payments mechanism is not directly affected, the risks are. Just like banks, these institutions are exposed to liquidity risks, credit default risks and counterparty risks. The concern is that they do not have the same levels of liquidity or capital buffers as banks to insulate them from the consequences of such risks. Therefore, it might not take much economic stress for one or more of these institutions to fail and, given the increasing significance and interconnectedness of these activities, impose significant costs on the rest of the financial system.

It was for this reason that the Bank of England conducted its first system-wide exploratory scenario to analyse the impact of economic and market stress on these institutions and assess the nature and extent of systemic risks which resulted. Fifty City of London institutions modelled how a period of intense stress would ripple through the non-bank sector.

The scenario involved rising geopolitical tensions which caused a sharp rise in risk aversion and a demand for higher expected rates of return as compensation. This produced sharp rises in both sovereign and corporate bond yields and matching sharp declines in asset prices (remember bond yield and prices have a negative relationship).

The scenario found that the position and behaviour of NBFIs amplified the shock. These institutions invest significantly in marketable financial securities and their liquidity and solvency are susceptible to such falling prices.

The sharp decline in asset prices triggered margin calls – payments to cover open loss positions in financial securities. In response to these demands, while some NBFIs’ internal risk and leverage measures were breached, others illustrated greater risk-aversion and took precautionary action. These institutions acted to deleverage, derisk and recapitalise. Given the interconnectedness of financial markets, the individual actions of institutions rippled across financial markets, causing problems in other segments.

The significant decline in asset prices led insurance companies and pension funds to seek to improve their liquidity and solvency position by liquidating positions in money market funds and hedge funds. This, in turn, required these funds to seek liquidity. Such institutions tend to rely a lot on the repo market (involving short-term sale and repurchase credit agreements) to provide liquidity to investors. This avoids them having to sell assets. This practice has echoes of the banking sectors use of the short-term wholesale markets in the run-up to the 2008 financial crisis.

However, the SWES found that while banks were willing to take on some of the risk, their own concerns about liquidity and counterparty credit risk meant they did not offer sufficient short-term liquidity through the repo markets. If such funding dried up because of a higher risk perception, it could compromise the hedge funds’ ability to raise funds, requiring asset sales. This would amplify the shock to financial markets, driving prices of financial securities even lower.

The scenario concluded that the resulting heavy selling could seize up financial markets, particularly the UK sovereign and corporate bond markets, reducing the ability of companies to finance investment. This is a different type of credit crunch from 2008, which was restricted to banks – but a credit crunch, nonetheless.

At the same time, funds may make capital losses as they sell securities in the downturn. This creates solvency problems and the potential for failure.

In the SWES the institutions were often not able to anticipate how their counterparties, investors, or markets they operate in would behave in the stressed scenario, which echoes the experience of banks in 2007 and 2008 – a significant reason for the ‘crunch’ in banking credit was uncertainty about the creditworthiness of counterparties, meaning that banks were not prepared to lend to anybody.

Conclusion

Since the 2008 financial crisis, there has been a tightening of the regulation and supervision of banks which has limited their ability to channel credit. This has produced an expansion in the shadow banking sector.

However, while the shadow banking sector has not been subject to the same regulation and supervision as banks, there are still potential systemic risks associated with its operations. There have been several examples of such risks in the shadow banking sector which have led regulators to pay more attention. These underpinned the 2024 system-wide exploratory scenario (SWES) conducted by the Bank of England.

The scenario showed the possible transmission mechanism through which problems for NBFIs can have broader consequences. The report nevertheless concluded that:

…the UK financial system was well-capitalised, maintained high levels of liquidity and that asset quality remained strong.

Therefore, the UK financial system was resilient enough to withstand problems in shadow banking.

Although the results of the exercise provide a ‘framework of future system-wide analysis which can be embedded in future market-wide surveillance,’ history indicates that risks tend to exist in obscure and arcane parts of the financial system and that these never tend to be fully appreciated until a crisis occurs. This then tends to involve significant costs for taxpayers.

Articles

Bank of England documents and reports

Data

Questions

  1. Explain stress testing.
  2. What is shadow banking? Explain the factors driving the growth of credit in this part of the financial system.
  3. Compare and contrast the liquidity problems of banks with those of non-bank financial institutions (NBFIs).
  4. Analyse how financial crises can heighten problems of asymmetric information in financial markets.
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Bank failures and the importance of balance sheets

March 2023 saw the failure of Silicon Valley Bank (SVB), a regional US bank based in California that focused on financial services for the technology sector. It also saw the forced purchase of global-banking giant, Credit Suisse, by rival Swiss bank, UBS. These events fuelled concerns over the banking sector’s financial well-being, with fears for other financial institutions and the wider economy.

Yet it is not the only sector where concerns abound over financial well-being. The cost-of-living crisis, the hike in interest rates and the economic slowdown continue to have an adverse impact on the finances of households and businesses. Furthermore, many governments face difficult fiscal choices in light of the effects of recent economic shocks, such as COVID and the Russian invasion of Ukraine, on the public finances.

Balance sheets and flow accounts

When thinking about the financial well-being of people, business and governments it is now commonplace for economists to reference balance sheets. This may seem strange to some since it is easy to think of balance sheets as the domain of accountants or those working in finance. Yet balance sheets, and the various accounts that lie behind them, are essential in analysing financial well-being and, therefore, in helping to understand economic behaviour and outcomes. Hence, it is important for economists to embrace them too.

A balance sheet is a record of stocks of assets and liabilities of individuals or organisations. Behind these stocks are accounts capturing flows, including income, expenditure, saving and borrowing. There are three types of flow accounts: income, financial and capital. Together, the balance sheets and flow accounts provide important insights into the overall financial position of individuals or organisations as well as the factors contributing to changes in their financial well-being.

The stock value of a sector’s or country’s non-financial assets and its net financial worth (i.e. the balance of financial assets over liabilities) is referred to as its net worth. Non-financial assets include produced assets, such as dwellings and other buildings, machinery and computer software, and non-produced assets, largely land.

An increase in the net worth of the sectors or the whole country implies greater financial well-being, while a decrease implies greater financial stress. Yet a deeper understanding of financial well-being also requires an analysis of the composition of the balance sheets as well as their potential vulnerabilities from shocks, such as interest rate rises, falling asset prices or borrowing constraints.

UK net worth

The chart shows the UK’s stock of net worth since 1995, alongside its value relative to annual national income (GDP) (click here for a PowerPoint). In 2021, the net worth of the UK was £11.8 trillion, equivalent to 5.2 times the country’s annual GDP. This marked an increase of £1.0 trillion or 9 per cent over 2020. This was driven largely by an increase in land values (non-produced non-financial assets).

In contrast, the stock of net worth fell in both 2008 and 2009 at the height of the financial crisis and the ensuing economic slowdown, which contributed to the country’s net worth falling by over 8 per cent.

The chart shows that net financial assets continue to make a negative contribution to the country’s net worth. In 2021 financial liabilities exceeded financial assets by the equivalent of 19 per cent of annual national income.

Non-financial corporations and the public sector together had financial liabilities in excess of financial assets of £3.4 trillion and £2.5 trillion respectively. However, once non-financial assets are accounted for, non-financial corporations had a positive net worth of £607 billion, although their value was not sufficient to prevent the public sector having a negative net worth of £1.2 trillion. Meanwhile, households had a positive net worth of £11.4 trillion and financial corporations a negative net worth of £4.9 billion.

Vulnerabilities and the balance sheets

The collapse of Silicon Valley Bank (SVB) resulted from balance sheet distress. Some argue that this distress can be attributed to a mismanagement of the bank’s liquidity position, which saw the bank use the surge in funds, on the back of buoyant activity among technology companies, to purchase long-dated bonds while, at the same time, reducing the share of assets held in cash. However, as the growth of the technology sector slowed as pandemic restrictions eased and, crucially, as central banks, including the Federal Reserve, began raising rates, the value of these long-dated bonds fell. This is because there is a negative relationship between interest rates and bond prices. Bonds pay a fixed rate of interest and so as other interest rates rise, bonds become less attractive to savers, pushing down their price. As depositors withdrew funds, Silicon Valley Bank found itself increasingly trying to generate liquidity from assets whose value was falling.

A major problem with balance sheet distress is contagion. This can occur, in part, because of what is known as ‘counterparty risk’. This simply refers to the idea that one party’s well-being is tied directly to that of another. However, the effects on economies from counterparty risks can be amplified by their impact on general credit conditions, confidence and uncertainty. This helps to explain why the US government stepped in quickly to guarantee SVB deposits.

There is, however, a ‘moral hazard’ problem here: if central banks are always prepared to step in, it can signal to banks that they are too big to fail and disincentivise them for adopting appropriate risk management strategies in the first place.

Subsequently, First Citizens Bank acquired the commercial banking business of SVB, while its UK subsidiary was acquired by HSBC for £1.

Interest rates and financial well-being

In light of the failures of SVB and Credit Suisse, the raising of interest rates by inflation-targeting central banks has raised concerns about the liquidity and liabilities positions of banks and non-bank financial institutions, such as hedge funds, insurers and pension funds. As we have seen, higher interest rates push down the value of bonds, which form a major part of banks’ balance sheets. The problem for central banks is that, if this forced them to make large-scale injections of liquidity by buying bonds (quantitative easing), it would make the fight against inflation more difficult. Quantitative easing is the opposite of tightening monetary policy and thus credit conditions, which are seen as necessary to control inflation.

Yet the raising of interest rates has implications for the financial well-being of other sectors too since they also are affected by the effects on asset values and debt-servicing costs. For example, raising interest rates has a severe impact on the cashflow of UK homeowners with large variable-rate mortgages. This can substantially affect their spending. The UK has a high proportion of homeowners on variable-rate mortgages or fairly short-term fixed-rate mortgages. Also for a large number of households their mortgages are high relative to their incomes.

In short, falling asset values and increasing debt-servicing costs from rising interest rates in response to rising inflation tends to dampen spending in the economy. The effects will be larger the more burdened with debt people and businesses are, and the less liquidity they have to access. This has the potential to lead to a financial consolidation in order to restore the well-being of balance sheets. This involves cutting borrowing and spending.

Such a consolidation could be exacerbated if financial institutions become distressed and if it were to result in even larger numbers of people and businesses facing greater restrictions in accessing credit. These balance sheet pressures will continue to weigh on the policy responses of central banks as they attempt to navigate economies out of the current inflationary pressures.

Articles

Questions

  1. What is recorded on a balance sheet? Explain with reference to the household sector.
  2. What is meant by net worth? Does an increase in net worth mean that an individual’s or sector’s financial well-being has increased?
  3. What is meant by ‘liquidity-constrained’ individuals or businesses? What factors might explain how liquidity constraints arise?
  4. It is sometimes argued that there is a predator-prey relationship between income and debt. How could such a relationship arise and what is its importance for the economy?
  5. Why might a deterioration of a country’s balance sheets have both national and international consequences?
  6. Explain the possible trade-offs facing central banks when responding to inflationary pressures.