The UK’s shadow banking system is a serious concern following the bond market storm

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Analysts fear a domino effect on the British shadow banking sector in the event of a sudden rise in interest rates.

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LONDON — Analysts are sounding the alarm in the country’s shadow banking sector following last week’s chaos in Britain’s bond markets following the government’s Sept. 23 “mini-budget”.

The Bank of England was forced to intervene in the long-dated bond market after a sharp sell-off in UK government bonds – known as “gilts” – threatened the country’s financial stability.

The panic was particularly focused on pension funds, which hold significant amounts of gilts, while a sudden increase in interest rate expectations also caused havoc in the mortgage market.

While central bank intervention brought some fragile stability to sterling and bond markets, analysts have pointed to lingering risks to stability in the country’s shadow banking sector – financial institutions that act as lenders or intermediaries outside of the traditional banking sector.

Former British Prime Minister Gordon Brown, whose government introduced a bailout for Britain’s banks during the 2008 financial crisis, told BBC radio on Wednesday that Britain’s regulators needed to tighten their oversight of shadow banking.

“I’m concerned that as inflation rises and interest rates rise, a number of companies and organizations will find themselves in serious trouble, so I don’t think this crisis is over because pension funds were bailed out last week,” Braun said.

“I think there needs to be constant vigilance over what has happened to the so-called shadow banking sector and I fear more crises could come.”

Global markets have been heartened in recent sessions by weaker economic data, which is viewed as reducing the likelihood that central banks will be forced to tighten monetary policy more aggressively to curb sky-high inflation.

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Edmund Harriss, chief investment officer at Guinness Global Investors, told CNBC on Wednesday that while inflation is being mitigated by falling demand and the impact of higher interest rates on household incomes and purchasing power, the risk is in a “looping and widening of demand weakness”. exist. “

The US Federal Reserve has reiterated that it will keep raising interest rates until inflation is brought under control, and Harriss indicated that monthly inflation data of more than 0.2% will be negatively viewed by the central bank, prompting more aggressive monetary tightening monetary policy would lead .

Harriss suggested that sudden, unexpected changes in interest rates, where leverage had built up in “darker corners of the market” during the previous period of extremely low interest rates, could reveal areas of “fundamental instability”.

“Coming back to the question of pension funds in the UK, pension funds’ requirement was to meet long-term liabilities through their gilt holdings in order to preserve cash flows, but extremely low interest rates meant that the returns were not and so they overdid swaps — that’s the leverage to get those returns,” he said.

“Non-bank financial institutions, the problem there is probably access to financing. If your business is built on short-term financing and a step backwards, the lenders have to tighten their belts, tighten credit conditions and so on, and start moving towards capital preservation move, then the people who are being starved will be the ones most in need of short-term funding.”

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However, Harriss hinted that the UK is not ready yet as there is still plenty of liquidity in the system for now.

“Money gets more expensive, but it’s the availability of money where you find a kind of sticking point,” he added.

The higher the leverage of non-bank entities such as hedge funds, insurance companies and pension funds, the greater the risk of a domino effect from the financial system. Shadow banks’ capital requirements are often set by counterparties they work with, rather than regulators as is the case with traditional banks.

This means that when interest rates are low and liquidity is plentiful in the system, these collateral requirements are often set quite low, meaning non-banks have to post significant collateral very suddenly when markets go down.

Pension funds sparked the Bank of England’s action last week, with some beginning to see margin calls as Gilt values ​​plummeted. A margin call is a request by brokers to increase an account’s equity if its value falls below the broker’s required amount.

Sean Corrigan, director of Cantillon Consulting, told CNBC on Friday that pension funds are in a fairly strong capital position even because of higher interest rates.

“They are actually now facing funding on an actuarial basis for the first time in five or six years. They clearly had a margin issue, but who’s the one with low margins?” he said.

“It’s the counterparties that passed it on and shuffled it around. If there’s a problem, we might not be looking at the right part of the building that’s at risk of collapsing.”

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