Bank of England Page 9
In addition, in our financial stability analysis of the mortgage market, we recognise that
reductions in spending by highly indebted mortgage borrowers as they keep up with debt
repayments can create negative spillover effects to the rest of the economy.
And perhaps in the same way, too, might forced asset sales into stressed financial
markets have negative spillovers for all other users of that market. In the case of the core
government bond market that could be significant.
What is being done to address risks from non-bank leverage,
and where is there further progress to be made?
Having set out how leverage in non-bank financial institutions might create risks to
financial stability, I’ll turn now to what needs to be done if we are to ensure those risks are
reduced.
Let me be clear. The onus for building resilience in the non-bank system sits first and
foremost with the firms themselves.
If firms use leverage, they must be able to manage the liquidity consequences of their risk
exposures. As part of this, they need to learn from the decades of experience that show
how leverage and liquidity risk creates rollover risks; volatility; operational challenges in
accessing liquidity; and exposures to amplification mechanisms from the wider system.
Firm stress testing and resilience must be set with reference to the system and to market
dynamics and not just a firm’s own atomistic actions. Indeed this is where associations
such as yourselves, ISDA and AIMA, can be hugely supportive in sharing best practices
and industry standards.
LDI funds have demonstrated the art of the possible here, by building resilience at speed
when severe stress demonstrated the clear need for it.
Regulators worked with LDI funds during the Bank’s operations to ensure greater
resilience for future stresses. And in aggregate, intelligence suggests that LDI funds raised
over £40 billion in funds and made over £30 billion of gilt sales during our operations, both
of which have contributed to significantly lower leverage.
As a result, LDI funds report that their liquidity buffers can withstand very much larger
increases in yields than before, well in excess of the previously unprecedented move in gilt
yields. And so the risk of LDI fund behaviour triggering ‘fire sale’ dynamics in the gilt
market and self-reinforcing falls in gilt prices is – for now at least – significantly reduced. It
is important that it stays that way.
Others need to act too.