Banking News

Safer banks at the expense of bond market volatility?

(5 December 2018 – United Kingdom) The Bank of England (BoE) and US Federal Reserve have both raised concerns about the potential damaging knock-on effects for corporate debt markets when the world’s largest institutional investors inevitably face demands for liquidity in the coming 12 months.

These demands could roil markets more than what has occurred historically because investors now provide much more corporate funding and are more exposed to collateral calls from derivatives. Bond markets are set for a turbulent start to 2019 as a direct result of the shift to a safer banking system, raising downside risks for investment institutions. US regulators issued a warning in their inaugural Financial Stability Report and British regulators highlighted the risk in its regular brief with both noting a recent increase in leverage by hedge funds.

The US Federal Reserve noted that lending commitments by large banks to non-bank financial firms rose to nearly US$1 trillion over H1 2018, from less than US$600 billion in 2013. Most of the growth was associated with closed-end investment and mutual funds, REITs and special purpose vehicles. US regulators are also concerned about the potential for runs from open-ended mutual funds. A decline in corporate debt prices / increase in yields could prompt a rush to redeem funds, exacerbating liquidity constraints. Non-banks have become much more important providers of credit to companies and individuals since the financial crisis as a result of stiffer regulations and higher capital requirements for banks. The Fed noted that mutual fund holdings of corporate debt had grown to about $US2.3 trillion in September this year, from more than $US500bn at the end of 2009 in 2018 dollars.

The BoE focused on the risk to asset managers, insurers and pension funds from greater demands for liquidity linked to derivatives used to boost returns or hedge exposures. Another debt crisis is less likely to threaten the financial system’s survival because banks are less exposed, but end investors will suffer more losses directly. Banks are less able to cushion price falls. They once were effective at absorbing holdings of temporary inventory but this is no longer possible. As investor holdings of corporate bonds have grown, exit alternatives have dwindled. Institutional investors who are sensitive to market values either because of their leverage or because their clients panic are likely to make market routs worse. Market corrections seem more likely with business borrowing at historically high levels according to the US Fed and valuations of corporate bonds and loans also high. Ultimately banks may now be safer but investors are growing more heavily exposed.