Archegos and gilts crisis motivates tighter FCA scrutiny of non-bank financial intermediaries
22 May 2023 UK
Image: AdobeStock/mehaniq41
The Financial Conduct Authority has called for better data coverage to monitor risk concentrations in the non-bank financial intermediary sector.
In a recent presentation to the Managed Funds Association Global Summit, FCA chair Ashley Alder notes that prompt action is necessary to enhance reporting from non-bank financial intermediaries (NBFIs) and to establish better frameworks for monitoring levels of leverage, including hidden and synthetic, in this sector.
The FCA believes that NBFI entities need to disclose their exposures more fully to prime brokers, banks and other firms that provide finance or serve as derivatives counterparties, thereby enabling these intermediaries to evaluate levels of leverage and concentration risks more effectively across their clients.
It points to the collapse of Archegos as an example, as a private fund receiving finance and other services from regulated prime brokers and trading using total return swaps and a range of other instruments.
It also looks to learn lessons from the UK gilts crisis, where liability-driven investment funds experienced difficulties in meeting margin calls as gilts yields spiked, triggering dysfunction in government bond markets as LDI funds made forced sales to meet collateral calls.
For the FCA, the growing importance of financial intermediation by non-bank financial intermediaries cannot be underestimated. As public and private debt has mushroomed during the recent period of central bank quantitative easing and low interest rates, NBFI has grown to account for about 50 per cent of global financial assets.
This is explained, in part, because government debt and corporate debt markets have grown too quickly for banks to deal with themselves, particularly in the face of balance sheet constraints imposed by stronger post-2008 capital adequacy requirements. With this, investment funds and private markets have stepped in to partially fill the gap.
Alternative investment fund managers are already regulated in this area to a degree, being required under the Alternative Investment Fund Manager Directive (AIFMD) to demonstrate that their leverage limits are reasonable and that they are operating within those limits.
But investment funds perform a substantially different structural function in these markets to organisations that hold bank licences. The risks are commonly distributed across end investors’ balance sheets, rather than being carried by NBFI entities themselves.
NBFI entities typically act as agents or fiduciaries without assuming balance sheet risk and without offering deposit insurance or any form of indemnification to the investor.
With this, the FCA advises that there should be three main pillars to evaluating NBFI risk in private markets. This requires a solid understanding of off-balance sheet leverage. It demands a better appreciation of liquidity risk. And it calls for better information about exposure levels across traditional banks and private markets.
There is currently little data disclosure or reporting from private markets, the FCA suggests, and international cooperation across financial supervisors is required to address this shortcoming.
Among other initiatives, the Financial Stability Board (FSB) is conducting research on NBFI leverage, with a primary focus on prime brokers, hedge funds and family offices.
The FSB and IOSCO are conducting combined research on equity swaps — although the FCA’s Alder points out that derivatives trade repository data provided little earning warning of risk concentrations prior to the collapse of Archegos for example.
In response, the FCA indicates that it has signed memorandum of understanding (MoUs) with European authorities that illustrate their commitment to cooperating on NBFI supervision and to sharing data and information to enable better oversight of this sector.
In a recent presentation to the Managed Funds Association Global Summit, FCA chair Ashley Alder notes that prompt action is necessary to enhance reporting from non-bank financial intermediaries (NBFIs) and to establish better frameworks for monitoring levels of leverage, including hidden and synthetic, in this sector.
The FCA believes that NBFI entities need to disclose their exposures more fully to prime brokers, banks and other firms that provide finance or serve as derivatives counterparties, thereby enabling these intermediaries to evaluate levels of leverage and concentration risks more effectively across their clients.
It points to the collapse of Archegos as an example, as a private fund receiving finance and other services from regulated prime brokers and trading using total return swaps and a range of other instruments.
It also looks to learn lessons from the UK gilts crisis, where liability-driven investment funds experienced difficulties in meeting margin calls as gilts yields spiked, triggering dysfunction in government bond markets as LDI funds made forced sales to meet collateral calls.
For the FCA, the growing importance of financial intermediation by non-bank financial intermediaries cannot be underestimated. As public and private debt has mushroomed during the recent period of central bank quantitative easing and low interest rates, NBFI has grown to account for about 50 per cent of global financial assets.
This is explained, in part, because government debt and corporate debt markets have grown too quickly for banks to deal with themselves, particularly in the face of balance sheet constraints imposed by stronger post-2008 capital adequacy requirements. With this, investment funds and private markets have stepped in to partially fill the gap.
Alternative investment fund managers are already regulated in this area to a degree, being required under the Alternative Investment Fund Manager Directive (AIFMD) to demonstrate that their leverage limits are reasonable and that they are operating within those limits.
But investment funds perform a substantially different structural function in these markets to organisations that hold bank licences. The risks are commonly distributed across end investors’ balance sheets, rather than being carried by NBFI entities themselves.
NBFI entities typically act as agents or fiduciaries without assuming balance sheet risk and without offering deposit insurance or any form of indemnification to the investor.
With this, the FCA advises that there should be three main pillars to evaluating NBFI risk in private markets. This requires a solid understanding of off-balance sheet leverage. It demands a better appreciation of liquidity risk. And it calls for better information about exposure levels across traditional banks and private markets.
There is currently little data disclosure or reporting from private markets, the FCA suggests, and international cooperation across financial supervisors is required to address this shortcoming.
Among other initiatives, the Financial Stability Board (FSB) is conducting research on NBFI leverage, with a primary focus on prime brokers, hedge funds and family offices.
The FSB and IOSCO are conducting combined research on equity swaps — although the FCA’s Alder points out that derivatives trade repository data provided little earning warning of risk concentrations prior to the collapse of Archegos for example.
In response, the FCA indicates that it has signed memorandum of understanding (MoUs) with European authorities that illustrate their commitment to cooperating on NBFI supervision and to sharing data and information to enable better oversight of this sector.
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