The Financial Policy Committee (FPC) of the Bank of England (BoE) has recently published its latest Financial Stability Report (Report). The format of the Report is that the FPC assesses the outlook for financial stability by identifying the risks faced by the financial system and sets these against the resilience of the system.

The FPC has identified the main risks facing the financial system in the United Kingdom as:

• the global environment;
• the reduction in market liquidity in some markets;
• the United Kingdom’s current account deficit;
• the housing market in the United Kingdom;
• consequences of misconduct in the financial system; and
• cyber attack.

It judges that some risks, particularly around Greece and emerging market economies, have increased since its last assessment in December 2014. Some other risks have declined, for example, risks associated with low growth in advanced economies moderated as growth prospects in the euro area improved following actions by the European Central Bank.

Regulators to Scrutinise Shadow Banking

One of the FPC’s responsibilities is to identify, assess, monitor and take action in relation to financial stability risk across the UK financial system, including risks beyond the core banking sector. In its first such assessment, published in June 2014, it focused on five categories of non-bank financial institutions and activities: finance companies, investment funds, money market funds, hedge funds and securities financing transactions.

As part of the Report, the FPC has provided the results of its second annual review of risks beyond the core banking sector by considering the channels through which activities undertaken by the non-bank financial system could affect UK financial stability. The FPC has decided not to recommend a change in how these activities are regulated at this time.

However, the FPC has expressed concerns over market liquidity and it intends to undertake a regular, deep analysis of a range of activities. This will start over the next year with the FPC examining:

• the investment activity of investment funds and hedge funds;
• the investment and non-traditional, non-insurance activities of insurance companies; and
• securities financing and derivatives transactions.

We look at some of these activities in more detail below. In addition to undertaking these detailed assessments, the FPC has an ongoing workplan to assess risks arising in the context of market liquidity.

Investment Activities of Open-Ended Investment Funds

The FPC states that globally, open-ended investment funds account for around US$27 trillion of assets under management, of which around US$1.2 trillion are domiciled in the United Kingdom.

As part of its work on market liquidity, the FPC states that it is assessing the strategies of investment fund managers for managing the liquidity of their funds in normal and stressed conditions. The Financial Stability Board and the European Systemic Risk Board are apparently also considering this issue.

Investment Activities of Hedge Funds

The FPC states that globally, the hedge fund industry manages around US$3.1 trillion of assets, with those funds authorised or marketed in the UK estimated to be managing around US$553 billion of assets.

The FPC observes that hedge funds are also interconnected with banks via repo transactions, margin loans and through derivatives. It identifies a risk that, if a hedge fund becomes distressed, it could withdraw from markets in which it was previously active or sell assets rapidly, which could have a destabilising impact on markets. In the event of a failure of a hedge fund, the FPC states that (unsurprisingly) counterparties with inadequately collateralised exposures to the fund could experience losses. This potential for fire sales of assets, price distortions and counterparty losses could be amplified if the hedge fund employs leverage. The Financial Conduct Authority’s (FCA) Hedge Fund Survey found that hedge funds are on average leveraged 27x on a synthetic basis (that is, through derivatives) and 2.3x on a financial leverage basis (that is, through cash and securities borrowings). It may go without saying, but since funds and other types of non-bank financial institutions engaging in lending activity are not subject to traditional bank regulation, they cannot—unlike banks—borrow in an emergency from the Federal Reserve or Bank of England (or another central bank), which amplifies the risk to their investors and others exposed to them.

The FPC states that BoE and FCA staff continue to gather data on the hedge fund sector.

Non-Traditional, Non-Insurance and Investment Activities of Insurance Companies

Some insurance companies engage in insurance activities other than normal life or general insurance underwriting, such as providing financial guarantee insurance. The FPC observes that insurers may also be involved in non-insurance activities, such as cash collateral reinvestment programmes, associated with securities lending, or writing credit default swaps. Such activities involve maturity transformation (that is, raising shorter-term funds and using those funds to buy assets with longer-term maturities) or leverage, which the FPC believes increases insurers’ fragility and the interconnectedness between insurance companies and the rest of the financial system.

The FPC states that insurers also create interconnectedness where they issue catastrophe bonds. These products contain specific provisions causing interest and/or principal payments to be delayed or lost in the event of a catastrophe, for example, a natural disaster. It is estimated that around £25 billion of catastrophe bonds are outstanding globally, exposing risk to other parts of the financial system.

Insurers are also major investors in various types of financial instrument, for example, corporate bonds and equities, which the FPC believes gives insurers the potential to exacerbate asset price falls.

Moreover, the message from the BoE seems to be that it is keeping a closer eye on the activities of players and developments in the shadow banking market and it is certainly not closing off the possibility of regulating this area differently in future, even if it does not believe more regulation is necessary at this stage.

The Report can be found here.