Collateralisation brings ‘significant benefits’, says BoE
19 July 2024 UK
Image: riebevonsehl/stock.adobe.com
As counterparties across the financial ecosystem have become increasingly interconnected, credit relationships have become increasingly collateralised, says Nathanael Benjamin, executive director of financial stability strategy and risk at the Bank of England.
The statement was heard at Linklaters during an event hosted by the International Swaps and Derivatives Association (ISDA).
In 2023, half of the funding for UK businesses came directly from financial markets and non-bank financial institutions (NBFIs), rather than from traditional bank loans. This shift has increased banks’ exposure to the non-bank sector.
According to Benjamin, this move to become increasingly collateralised has brought “significant benefits” such as offsetting counterparty risk, making systemic firms more resilient and supporting market activity in stress.
However, there are also new challenges.
First, the counterparty risk of banks has partially transformed into liquidity risk for their clients. Sharp rises in margin requirements in times of stress can result in increased liquidity demands, and the pressure to find cash or high-quality collateral at short notice may result in fire-sales of assets.
Benjamin says: “Enhancing market participants’ liquidity preparedness to meet their collateral requests would go a long way towards reducing procyclical behaviours in response to large margin calls and preventing the liquidity crises that have amplified past financial shocks.
“This requires a high degree of transparency, effective stress testing, and improvements to operational processes.”
Another challenge is the potential interaction between initial margin requirements and leverage.
If bilateral initial margin requirements in derivatives markets and haircuts in repo markets are insufficient, counterparties can protect the other side by taking self-funded positions, which may facilitate excessive leverage.
If holders of over-leveraged positions cannot source enough collateral to meet margin calls, they may have to de-leverage by selling assets.
Benjamin says: “To mitigate this risk, UK CCPs are required to implement anti-procyclicality measures in their initial margin models. Financial institutions must also continue to improve their own risk management frameworks, so that they adequately consider the exposures of their clients and counterparties.”
He adds that concentrated or correlated positions and interconnectedness exacerbate jumps to illiquidity at the system-wide level.
“During stress, these vulnerabilities can disrupt financial stability by impacting systemic markets, systemic institutions, and the provision of vital services such as funding to the real economy,” Benjamin comments.
On the other hand, there are efforts to address low haircuts, particularly in sovereign debt repo markets, as well as to prepare market participants for inevitable margin calls and the liquidity need they will generate.
The Bank of England aims to enhance margin and haircut practices and improve liquidity preparedness, while also addressing the build-up of excessive NBFI leverage.
The System-Wide Exploratory Scenario (SWES) is working with substantial liquidity needs to test how shocks propagate throughout the financial system and potentially affect core markets.
The statement was heard at Linklaters during an event hosted by the International Swaps and Derivatives Association (ISDA).
In 2023, half of the funding for UK businesses came directly from financial markets and non-bank financial institutions (NBFIs), rather than from traditional bank loans. This shift has increased banks’ exposure to the non-bank sector.
According to Benjamin, this move to become increasingly collateralised has brought “significant benefits” such as offsetting counterparty risk, making systemic firms more resilient and supporting market activity in stress.
However, there are also new challenges.
First, the counterparty risk of banks has partially transformed into liquidity risk for their clients. Sharp rises in margin requirements in times of stress can result in increased liquidity demands, and the pressure to find cash or high-quality collateral at short notice may result in fire-sales of assets.
Benjamin says: “Enhancing market participants’ liquidity preparedness to meet their collateral requests would go a long way towards reducing procyclical behaviours in response to large margin calls and preventing the liquidity crises that have amplified past financial shocks.
“This requires a high degree of transparency, effective stress testing, and improvements to operational processes.”
Another challenge is the potential interaction between initial margin requirements and leverage.
If bilateral initial margin requirements in derivatives markets and haircuts in repo markets are insufficient, counterparties can protect the other side by taking self-funded positions, which may facilitate excessive leverage.
If holders of over-leveraged positions cannot source enough collateral to meet margin calls, they may have to de-leverage by selling assets.
Benjamin says: “To mitigate this risk, UK CCPs are required to implement anti-procyclicality measures in their initial margin models. Financial institutions must also continue to improve their own risk management frameworks, so that they adequately consider the exposures of their clients and counterparties.”
He adds that concentrated or correlated positions and interconnectedness exacerbate jumps to illiquidity at the system-wide level.
“During stress, these vulnerabilities can disrupt financial stability by impacting systemic markets, systemic institutions, and the provision of vital services such as funding to the real economy,” Benjamin comments.
On the other hand, there are efforts to address low haircuts, particularly in sovereign debt repo markets, as well as to prepare market participants for inevitable margin calls and the liquidity need they will generate.
The Bank of England aims to enhance margin and haircut practices and improve liquidity preparedness, while also addressing the build-up of excessive NBFI leverage.
The System-Wide Exploratory Scenario (SWES) is working with substantial liquidity needs to test how shocks propagate throughout the financial system and potentially affect core markets.
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