(Bloomberg) -- The Bank of England revealed details of a new facility designed to avoid UK bond market blow-ups like the one two years ago by lending directly to asset managers.
During times of “severe” market dysfunction, the BOE will provide non-bank financial institutions (NBFIs) such as pension funds cash in return for gilts pledged as collateral, the central bank said in a note Wednesday. Lending directly to firms other than banks is a radical proposal as it greatly expands the central bank’s purview, which traditionally has relied on commercial banks to manage the liquidity needs of financial markets.
It reflects the increasing need to stem risks that the sector poses. These firms have not faced the same regulations as banks did following the global financial crisis, and over the years have taken an outsized role in the system.
“As NBFIs continue to grow in significance both in terms of total market footprint and influence over the supply of finance to UK businesses, the impact NBFIs have on financial stability has increased,” the central bank said. “Central bank facilities can support financial stability by providing backstop liquidity by lending to NBFIs, reducing their need to sell assets.”
The central bank has been working on the so-called Contingent NBFI Repo Facility (CNRF) for over a year as it looks to respond to the 2022 gilt market blow-up. The crisis was initially triggered by former Prime Minister Liz Truss’s unfunded tax cuts, but was exacerbated by a leveraged pension fund strategy known as liability-driven investment (LDI) funds.
Facing emergency collateral calls from counterparties, they created a vicious circle of forced selling, with the BOE only stemming the crash by stepping in to purchase long-dated gilts — an extraordinary measure that risked complicating its efforts at the time to tighten monetary conditions.
Officials would prefer that any future crises are resolved by giving these funds access to the BOE’s lending facilities rather than outright purchases of gilts.
“Collateralised lending presents less risk to public funds, lower moral hazard and reduces unintended spillovers to monetary policy from financial stability interventions,” the notice said.
Liquidity Shocks
The CNRF will be open to eligible pension funds, insurance companies and LDI funds. The price to borrow from the facility will be “attractive in times of stress but expensive relative to pricing in normal times,” the BOE said, adding this would ensure market participants continue to self-insure against a range of liquidity shocks.
Higher collateral buffers have already been imposed on such LDI strategies, and the BOE said Wednesday it is “first and foremost for NBFIs to manage the liquidity risks they face.” However, officials acknowledged it is not feasible for such firms to be resilient to the most extreme liquidity stresses, where central support may prove necessary.
The central bank said applications to join the facility are expected to open in the final quarter of 2024, and that it welcomes feedback on the proposed design before then. The BOE said it was separately exploring how to design a facility that would enable access to “a broader set of NBFIs that are relevant to the functioning of UK core markets.”
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