Global finance unknowns are more “who” than “what”

LONDON, Dec 27 (Reuters Breakingviews) – After British pension funds narrowly dodged catastrophe in 2022, regulators are hunting enthusiastically for hidden risks in the non-bank financial industry. Also known as shadow banking, it’s a market that could be over USD 225 trillion in size. The key to stopping a crisis isn’t locating the landmines – it’s working out who’s most likely to stand on them.

When UK pension funds were caught short by a sudden fall in government bond prices in September, the Bank of England had to launch a 65-billion-pound scheme to stabilize the market. Had it not done so, it said, the funds would have had to liquidate investments to meet margin calls on their loans. Panicked sales of bonds could have pushed borrowing costs up in the mortgage market, rippling through the wider economy. As a result, regulators everywhere, including the G20’s financial stability task force, are on high alert looking for hidden leverage.

Emerging market funds are one place to start the search. When interest rates were low, investors sought out riskier assets in markets like Indonesia, Brazil and Mexico. But as US interest rates rise past 4%, there is less need for investors to venture into riskier markets for returns. If a fall in demand for a country’s bonds coincided with a political upset, for example, investors might rush to liquidate holdings in emerging market funds, causing rapid and disorderly price falls.

Leveraged loans are also vulnerable to a similar fire sale. Before the pandemic, banks, hedge funds and other investors were happy to back corporate takeovers with high levels of debt. So-called open-ended funds, which make up 4% of the leveraged loan market, are a particular worry, because these allow investors to demand their money back, even though the fund’s assets might not be easily sellable. In the market ructions of March 2020, open-ended funds sold USD 14 billion of leveraged loans, which accounted for 11% of the transactions in the secondary market and contributed to a 19% drop in prices.

But not all market weaknesses deserve heavy-handed regulation. It might make sense to police investments crowded with pension funds whose activities also influence government bond prices, but not those where losses would be borne by other less interconnected investors. An obvious example is the collapse of cryptocurrency exchange FTX in November; it involved an investor panic, but left critical firms like banks unscathed, because most regulated institutions have given crypto a wide berth.

Regulators around the world are intent on preventing another crisis. It’s good that they’re focused on hidden leverage and potential fire sales. When it comes to stress-testing the system, though, it makes most sense to be clear about who has the potential to cause systemic risk, not just what. Otherwise watchdogs risk trying to regulate everything and achieving little.

(This is a Breakingviews prediction for 2023.)

CONTEXT NEWS

The G20’s Financial Stability Board recommended in a report on Nov. 10 that systemic vulnerabilities in investment funds and other “non-banks” that make up almost half the world’s financial system be addressed by tweaking existing rules, before assessing whether more radical action was needed.

The Bank of England on Sept. 28 unveiled a 65-billion-pound bond-buying scheme to stabilize the bond market, after some funds were forced to sell government bonds to meet margin calls.

(Editing by John Foley and Katrina Hamlin)