We haven’t reduced financial risk, just transformed it

When Citigroup chief executive Jane Fraser was asked earlier this week what risks she was most concerned about, market liquidity topped her list.

The Bank for International Settlements is worried about “fragility” in the market for mortgage-backed securities. And volatility has soared in US Treasury markets this autumn due to poor liquidity.

With the world poised to plunge into recession, stresses are to be expected. But there is growing evidence that the post-crisis reforms, while aimed at shoring up financial stability may have, in important areas, simply traded counterparty risk for liquidity risk.

Back in the 2008 crisis, much of the contagion stemmed from trades between failing institutions and stronger ones. When insurer AIG sold more credit default swaps than it could make good on, its failure threatened to topple a whole slew of banks that were on the other side of those trades. Similarly, the collapse of Lehman Brothers inflicted destabilising losses on money market funds that held its debt.

Since then regulators have concentrated on making sure individual banks are stronger and less vulnerable to troubles brewing in less regulated parts of the financial sector, known collectively as shadow banks. More transactions now run through central clearing houses or require more collateral. The idea is that if one side gets into trouble, the other side is not left holding the bag.

To a large extent they succeeded. Global banks are much better capitalised than they once were. Many transactions, including those involving complex derivatives, have shifted from what was essentially unsecured lending to margin-based arrangements backed by cash or safe, easy-to-sell assets.

But that has not always translated into the broad financial stability policymakers had hoped for. Mass selling in the early days of the Covid-19 pandemic forced the US Federal Reserve to backstop both money market funds and the market for commercial paper.

More recently, the London Metal Exchange in March shut trading and cancelled billions of dollars in deals because surging nickel prices had inflicted a $2.6bn loss on the clearing house it had set up to try to stop contagion. Then in September, the Bank of England was forced to intervene when forced selling to meet margin calls destabilised the UK gilt market.

“We are seeing liquidity strains in places that my generation of central bankers wouldn’t have expected, and hoped to prevent by constraining shadow banking,” says Paul Tucker, the former BoE deputy governor who helped lead the UK response to the 2008 financial crisis.

The displacement of counterparty risk into liquidity risk comes from several sources. In Treasury markets, Wall Street banks used to play a critical warehousing role, particularly in the short-term lending “repo” market. But tougher capital rules have led them to prioritise other, higher-margin business lines, and other market participants have shown no signs of stepping into their shoes. Instead, when volatility rises, hedge funds and high-frequency traders step away from their keyboards.

“Dealer banks are now driven by profit per unit of balance sheet and repo is not at the top of the list,” says the IMF’s Manmohan Singh. “They are judged on share price not on whether they help with the US treasury markets.”

The emphasis on collateral has also contributed to instability in ways that policymakers did not anticipate, most notably by amplifying selling pressure. The UK gilt market meltdown is a prime example: UK pension funds had bought derivatives as part of a strategy known as liability-driven investing. When gilt prices fell sharply, they received margin calls requiring them to post more collateral, so they sold gilts, further driving down the price, leading to more margin calls.

A third kind of illiquidity has emerged in recent years as investors moved beyond bank accounts, stocks and bonds in search of higher returns. In times of market turmoil, funds focused on real estate, private credit and the like have been hit by more redemption requests than they can easily handle. Blackstone recently limited withdrawals from its $69bn Breit private real estate fund after breaching monthly and quarterly limits on redemptions.

Bankers argue that one way to help would be to treat government bond holdings more leniently in capital calculations but that could encourage lenders to game the rules and reawaken counterparty risk. Some regulators want to tighten the scrutiny and collateral rules for nonbanks, but that could exacerbate forced selling during market downturns.

With economic stress growing, policymakers are running out of time to find the right trade-off between sources of risk.

brooke.masters@ft.com

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