FSB warns financial system remains ‘vulnerable’ thanks to high leverage and data gaps

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The Financial Stability Board has warned the financial system remains vulnerable to further liquidity strains in its latest annual report to the G20 on enhancing the resilience of non-bank financial intermediation (NBFI).

The report identifies pockets of high leverage in the NBFI sector and outlines policy recommendations in light of events such as the March 2020 market turmoil, the fall of Archegos and strains in commodities and bond markets, all of which underscore the need for a more resilient NBFI sector.

Joseph Cordahi, investment management strategy director at NeoXam, told Best Execution: “This FSB report identifies several gaps that make it extremely difficult to fully assess the vulnerabilities associated with non-bank leverage. When it comes to liquidity risk, these institutions have never been held to the same standards as the banks, in spite of their increasingly integral role in the effective functioning of global markets. The upcoming one-year anniversary of the Liz Truss fiscal policy fiasco that led to the pension fund gilt crisis in the UK is testament to this.

“Pension funds, asset managers, hedge funds, insurers, and other non-banking financial institutions need to ensure they capture positions, valuations and exposures based upon all of their investment information. Only then can they harbour any hope of complying with any new rules coming their way off the back of this report.”

Joe Midmore, chief commercial officer at derivatives analytics firm OpenGamma, told BEST EXECUTION: “The FSB recommends that rule makers work towards containing excessive leverage behaviour, by carrying out further margin work for derivatives traded by Non-Bank Financial Institutions (NBFIs).

“Stress events over the last few years have got regulators asking how they can limit excessive risk taking to protect stability in financial markets, as well as exposing the need for improved liquidity risk management frameworks for the industry as a whole. For NBFIs, it’s all very well having a levered investment strategy, but the need to manage the inherent risks more dynamically is now a non-negotiable requirement.”

The report sets out policies being developed by the watchdog and standard-setting bodies (SSBs) to reduce excessive and potentially destabilising spikes in liquidity demand, focusing on structural liquidity mismatch in open ended funds and on margining practices.

The report outlines how there are pockets of high leverage in the NBFI sector, such as in hedge funds, and identifies a number of data gaps that make it difficult to fully assess the vulnerabilities associated with NBFI leverage. Some of the ways policy can address these vulnerabilities include addressing the most salient data gaps; the use of trade repository data; enhancing reporting requirements for non-banks with high levels of leverage; and expanding disclosure requirements.

Other recommendations include: containing excessive behaviour by carrying out further work on haircuts and margins for derivatives and securities transactions; and mitigating the financial stability consequences of high NBFI leverage, including by considering measures to enhance prime brokers’ risk management and improve the liquidity preparedness of non-bank investors. 

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