This Financial Stability in Focus (FSIF) sets out the Financial Policy Committee’s (FPC’s) approach to assessing risks in market-based finance (MBF) and ways it intends to develop this approach. It supports the FPC’s medium-term priority to further improve risk identification in, and the functioning and resilience of, MBF.
MBF has grown significantly since the global financial crisis, and non-bank financial institutions (NBFIs) currently account for around half of UK and global financial sector assets. This has reduced the reliance of many UK businesses on banks and diversified their sources of finance and other financial services. But for the benefits of such diversification to be sustainable it is vital that MBF is resilient enough to absorb, and not amplify, shocks.
The FPC seeks to ensure the UK financial system is prepared for, and resilient to, the wide range of risks it could face so that it is able to continue to serve UK households and businesses.
To support this objective, the FPC has an established approach to identifying, assessing, monitoring, and responding to financial stability risks associated with MBF. Through this approach, the FPC has identified a number of vulnerabilities in MBF that could give rise to risks to financial stability. These risks have crystallised several times in recent years, and the FPC has recommended actions to enhance the resilience of MBF in a number of areas.
The FPC’s approach to risk identification, assessment, monitoring, and mitigation in market-based finance
The FPC’s risk assessment framework
Under its risk assessment framework, the FPC considers a range of vulnerabilities in MBF sectors (such as liquidity and maturity mismatch, and leverage) and market features (such as interconnectedness and concentration) that make these sectors and markets susceptible to shocks. Specific plausible risk scenarios are also used to identify how these vulnerabilities and features might interact and propagate through the system to threaten financial stability; for example, through disruptions to systemically important markets and institutions that have consequences for businesses and households.
Building resilience and responding in stress
The system of MBF is global in nature, complex, and different parts of the system are highly interconnected, which creates a range of practical challenges for macroprudential authorities globally. There are also material gaps in the data available to assess financial stability risks in the system. As such, it is not realistic to expect that all risks can be identified in advance.
Where the FPC identifies material vulnerabilities, it considers how resilient sectors and markets are to shocks given these vulnerabilities. Absent sufficient resilience, the FPC seeks to take action, where possible, to remove or reduce risks to financial stability by building resilience in the system.
It is first and foremost market participants’ responsibility to manage the risks they face, overseen by relevant sectoral regulators. But the collective actions of participants in response to shocks can weaken other firms, create and transmit stress to markets, and lead to the disruption of financial services provided to the real economy, even when individual actions seem rational when considered in isolation.
Resilience standards, and macroprudential policy more generally, aim to prevent such systemic risks that lead to disruption to the provision of financial services. Effective resilience for market-based finance therefore needs to cover both idiosyncratic and systemic risk, and be calibrated to appropriate levels such as for a severe but plausible stress.
The FPC has a responsibility to drive policy development and implementation, internationally and domestically, to support the stability of the UK financial system. The FPC considers domestic action alongside or independently from international action where this is expected to improve UK financial stability, may inform or accelerate international policy development, and would not have a negative impact on global financial stability. As one of the largest international financial centres in the world, this is important not only to the UK economy but also to the global economy. As the International Monetary Fund (IMF) has determined, the stability of the UK financial system is a global public good.
At the same time, it is important to recognise that it would be neither feasible nor credible to build resilience to insure against every possible eventuality. There is therefore a role for central banks globally to ensure that their toolkits are sufficiently developed, such that they can respond effectively in exceptional stresses. The Bank of England (‘the Bank’) recently set out its plans to develop a new lending tool for NBFIs to help tackle future episodes of severe dysfunction in core markets that threaten UK financial stability.
Resilience standards for MBF must be developed in co-ordination with work to enhance central bank tools to respond in stress. That is to ensure that public backstops do not end up substituting for a failure to achieve the appropriate level of private insurance.
Developing the FPC’s approach
The FPC continuously seeks to extend its approach, and this FSIF sets out some of the ways it is doing so. These include:
- Enhancing and reviewing how it prioritises risk assessment and policy development. Given the breadth of issues in MBF, the FPC will review its approach to prioritising issues for detailed analysis and policy development.
- Improving its capability for system-wide analysis. The system-wide exploratory scenario (SWES) exercise is an important step in building this capability.
- Considering the potential role for macroprudential tools, including where additional resilience standards may be needed for NBFIs. Effective MBF resilience should: (1) be specific and targeted; (2) cover idiosyncratic and systemic risk; and (3) be calibrated to an appropriate resilience standard such as to cover a severe but plausible stress.
- Setting out how and when it will act domestically or internationally. International policy is crucial to reducing vulnerabilities in MBF, but the FPC will also act domestically, where effective and practical.
- Working with the Bank to ensure it has the tools to address dysfunction in MBF. Such tools should act as a backstop, be designed in a way to minimise any increase in moral hazard and come with appropriate levels of private sector liquidity self-insurance. Indeed, it is vital that firms make progress on building their resilience to vulnerabilities as a counterpart to central banks developing new tools to support markets during periods of severe dysfunction
This FSIF aims to advance the domestic and international debates on financial stability risks associated with MBF. The FPC welcomes feedback from interested parties on its approach to assessing and mitigating financial stability risks associated with MBF, and how it might be refined. Bank staff will seek to engage with interested parties over the coming months on the contents of this FSIF.
1: Background and context: ensuring the resilience of market-based finance
1.1: The importance of market-based finance (MBF)
MBF is an interconnected system of markets, non-bank financial institutions (NBFIs), and infrastructure.
MBF is made up of markets (eg, equity, debt, and derivatives markets) and different kinds of investment funds, insurers, intermediaries like broker-dealers, and market infrastructure like central counterparties (CCPs). These NBFIs are connected to each other and other parts of the financial system, including banks which often play key roles in MBF (eg, as broker-dealers). Crucially, they also affect the real economy through the various markets they operate in and through the services they provide. Collectively, these NBFIs, markets, and infrastructure form the system of MBF.
MBF provides financial services to support the wider economy.
These services include providing credit, intermediating between those seeking to invest their savings and borrowers, insuring against and transferring risk, and offering payment and settlement services.
MBF helps savers by offering a range of vehicles with different risk profiles through which to invest their cash. These vehicles include open-ended funds (OEFs) for investing in equity or bond portfolios, and Money Market Funds (MMFs) for placing cash in short-term, lower-risk instruments. In addition, MMFs are used for liquidity management by pension funds, investment funds, and corporates. In total, investors hold around £1.8 trillion in UK domiciled OEFs and £260 billion in sterling denominated MMFs.
MBF also helps facilitate risk management in the economy via the provision of insurance and derivatives contracts. Derivatives enable non-financial businesses, as well as financial institutions, to transfer the risks they are exposed to in the course of their activities (such as changes in interest rates, exchange rates, equity and commodity prices) to other institutions with different risk profiles and appetites. The ability of firms to take and manage risks in this way supports economic growth. As of December 2022, the gross notional value of outstanding global over-the-counter (OTC) derivatives stood at around US$630 trillion.
Figure 1 illustrates some of the major direct and indirect roles of MBF in the financial system and economy.
Figure 1: Market-based finance provides important services
Key roles played by market-based finance in the financial system and real economy
- Source: Bank of England.
And some financial markets are critical to the functioning of the UK financial system.
NBFIs are an important source of liquidity in critical markets, such as that for UK government bonds (or ‘gilts’), which provide finance to the UK Government. In addition, gilt yields are the benchmark for other borrowing rates for households and businesses, and the gilt market is vital to the functioning of financial markets and the transmission of monetary policy. Repurchase agreement (repo) markets – in which gilts are commonly used as collateral – facilitate the essential flow of cash and securities around the financial system. They enable the low-risk investment of cash, as well as the efficient management of liquidity and collateral by market participants. Furthermore, they provide the foundation for arbitrage activity in sterling financial markets, which supports price discovery and the efficient pricing of risk.
MBF has grown significantly, and NBFI assets account for around half of UK and global financial sector assets.
MBF had been growing rapidly since before the global financial crisis in 2008 and its importance has been further recognised since then. Between the start of the global financial crisis and end-2020, NBFIs more than doubled in size, compared to banking sector growth of around 60%. As a result of this growth, the sector now accounts for around half of the total assets making up both the UK and global financial systems (Chart 1).
Chart 1: Non-banks make up a significant part of global financial system assets
Total assets of major financial sectors globally, as of end-2021 (US$ trillions)
- Source: Financial Stability Board (2022), Global Monitoring Report on Non-Bank Financial Intermediation.
In the UK, MBF is particularly important in the supply of finance to businesses. As of early 2023, it accounted for approximately £740 billion (around 55%) of all lending to UK businesses (Chart 2). And it accounted for nearly all of the almost £425 billion net increase in lending to UK businesses between end-2007 and early 2023. While there is currently limited direct lending to UK households and smaller companies, MBF still plays an important role by freeing up financing capacity in the banking system. For example, around 9% of buy-to-let mortgage loans are securitised and can be financed by investors. In addition, it provides other important services directly to both households and businesses. For example, private pensions are an important vehicle for household savings, making up the largest component of UK household wealth, and insurance companies provide vital risk management services to households and companies.
Chart 2: MBF is an important source of funding for UK businesses
Composition of the current stock of UK private non-financial corporate debt (a)
- Sources: Bank of England, Bayes CRE Lending Report (Bayes Business School (formerly Cass)), Deloitte, Eikon from Refinitiv, Financing and Leasing Association, firm public disclosures, LCD a part of PitchBook, ONS, Peer-to-Peer Finance Association and Bank calculations.
- (a) One square represents approximately £14 billion. There are 100 squares, each representing 1% of the total current stock of UK corporate debt, rounded to the nearest 1%. Debt securities include bonds, private placements, and commercial paper. Non-bank loans to large corporates include lending by securities dealers and insurers, non-monetary financial institution syndicated loans, asset finance provided by the non-bank sector, and direct lending funds. These data are for private non-financial corporates using ONS consistent national accounts definitions, and excludes public, financial, and unincorporated businesses.
Because it provides vital services, disruption to MBF can lead to economic costs and have implications for growth.
Through the activities and services it provides, MBF plays a key role in supporting the UK and global economies, which means that disruption can have a significant impact on financial stability and the real economy. These impacts can span across borders, with events in global financial markets having the potential to affect UK financial stability.
The rapid growth in MBF has also meant that counterparty exposures have grown in size and importance. These exposures have the potential to amplify price movements following a shock and so disrupt the provision of services, resulting in material impacts on UK financial stability and tighter financial conditions for UK businesses and households.
In the past few years, a number of stress episodes have highlighted the potential impact of vulnerabilities in the system of MBF. In particular, they have shown that material market dysfunction has the potential to lead to a tightening of financial conditions and a reduction in the provision of finance to households and to businesses. For example:
- In March 2020, the actions of some NBFIs amplified the initial market reaction to the Covid-19 pandemic to create a severe liquidity shock globally (the ‘dash for cash’). This severely disrupted market functioning, including in the UK, and threatened to harm the wider economy by tightening financial conditions for UK households and businesses through very sharp adjustments in asset prices and corporate and bank funding costs. The disruption only abated following significant policy action from global central banks.
- In March 2021, high levels of hidden leverage associated with equity derivative positions were a key factor in the default of Archegos. This episode led to sizeable losses for some global banks with inadequate risk management, which had the potential to impact the provision of finance to the real economy.
- Following Russia’s invasion of Ukraine in February 2022, the stable functioning of some commodity markets, which play a vital role in the economy (including meeting demand for food and energy – refer to July 2022 Financial Stability Report (FSR)), was tested by extreme price volatility.
- And in late September 2022, the rapid repricing of long-dated UK government bonds generated stress and forced selling by leveraged liability-driven investment (LDI) funds. Had the Bank not intervened, this could have led to a further tightening of financing conditions and a reduction in the flow of credit to households and businesses (refer to December 2022 FSR).
1.2: The need for resilience in MBF
As the episodes described above have demonstrated, if improperly managed or managed without accounting for system-wide dynamics, vulnerabilities in MBF can create spillovers that can negatively impact the real economy.
Many elements of MBF exhibit vulnerabilities, which are features that make sectors or markets more likely to amplify shocks, such as leverage and liquidity mismatch (Section 2.1.1). These vulnerabilities have the potential to lead to financial stability issues because of interconnections within the financial system; indeed, recent stress episodes have highlighted that, if not properly managed, MBF vulnerabilities have the potential to generate spillovers across the financial system. These vulnerabilities and spillovers can in turn combine to create feedback loops that can compromise the resilience of the broader system and lead to disruptions to the vital services provided to the real economy and within the financial system. Policy action, including macroprudential tools and resilience standards, aims to reduce the likelihood of such disruptions happening, and their costs if they were to occur.
Existing regulation of NBFIs is mainly focused on ensuring fair outcomes for investors, suitable consumer protection, and market integrity, which can support, but not fully address, risks to financial stability. Past episodes of stress have shown that this might not be enough given the potential consequences of collective defensive actions that may seem rational individually but effectively amplify the impact of shocks.
1.3: The role of the Financial Policy Committee (FPC)
The FPC is responsible for protecting and enhancing the stability of the UK financial system, including MBF.
It does this by identifying, monitoring, and taking action to remove or reduce risks to financial stability so that the financial system is able to absorb rather than amplify shocks and continue to provide vital services to businesses and households. As such, the FPC adopts a forward-looking approach that aims to take action to address vulnerabilities in advance of shocks occurring in order to reduce their impact should they crystallise, in addition to responding to vulnerabilities if and when they crystallise in response to shocks.
As part of its medium-term priorities, the FPC has set out its intention to further improve MBF risk identification, as well as the functioning and resilience of the system.
To that end, the FPC takes an active role in the development of MBF policy responses domestically and through its contribution to the international policy agenda via the Financial Stability Board (FSB). It is also guiding the development of the Bank’s stress-testing approach including the system-wide exploratory scenario (SWES), as well as efforts to address the quality and coverage of data on MBF.
The FPC has powers to act to mitigate risks to financial stability.
If the FPC identifies a potential risk to financial stability, it can use its power of direction or its power of recommendation to seek to remove or reduce that risk. Its directions are binding instructions that it can give to the Prudential Regulation Authority (PRA) and Financial Conduct Authority (FCA) requiring them to take certain macroprudential measures. The FPC can also make recommendations, including on a ‘comply or explain’ basis, to the PRA and to the FCA. In addition, it can make recommendations to persons other than the PRA and the FCA on a ‘non-comply or explain’ basis. For example, the FPC’s resilience standard for LDI funds is set out as a recommendation to the Pensions Regulator (TPR) (Box B).
The FPC is also responsible for assessing the suitability of the regulatory perimeter, in line with its remit.
The FPC has a statutory power to make recommendations to HM Treasury in relation to the regulation of the UK financial system, to support financial stability. This includes recommending that activities move across the boundary between regulated and non-regulated activities – known as the ‘regulatory perimeter’ – and recommending changes in regulation for activities already within the perimeter where it identifies financial stability risks that cannot otherwise be addressed.
1.4: Challenges in assessing risks associated with MBF
MBF is a complex system, which makes assessing risks associated with it challenging.
Figure 2 provides a stylised illustration of how different elements of MBF interact with each other and the rest of the system. The complexity and interconnectedness of sectors, activities, markets, and participants make it difficult to identify all risks, or predict how these risks might transmit through the system.
Figure 2: Market-based finance is a complex system
Stylised illustration of MBF sectors and interconnections (a)
- Source: FSB (2021), Enhancing the Resilience of Non-Bank Financial Intermediation: Progress report.
- (a) Figure 2 illustrates how funds flow through the system between savers on one side and borrowers on the other side; savers and borrowers are thought to be government, households, and non-financial corporates.
- Between these savers and borrowers, funds go through a complex system of market-based finance represented by three main groups: institutional investors, non-bank lenders, and market intermediaries who sit between the other two groups and facilitate their transactions. Institutional investors comprise pension funds, insurers, money market funds, open-ended funds, real estate investment trusts, as well as hedge funds. Non-bank lenders include private lenders, securitisations, and private equity. Market intermediaries are financial market infrastructure, principal trading firms, broker-dealers, and banks. At the top of these three groups are central banks, sovereign wealth funds, and public pension funds.
- The figure then draws the direction of funds between all these components of the system, and shows the complexity of the flow of funds, which circulate in different directions between and across all components of the system.
- In summary, the system is made up of a diverse set of financial activities, entities, and infrastructures, and these are interconnected among themselves, to the banking sector, and to the broader economy.
A number of factors contribute to the complexity of the system of MBF:
- It is international in nature, with many entities domiciled in one jurisdiction, managed from another, and operating cross-border. This makes risk identification and assessment more difficult.
- It is growing and evolving rapidly in many areas, requiring the FPC and other authorities to stay agile in their monitoring of the system.
- There is a high degree of interconnectedness among markets and participants across MBF, both domestically and internationally, which means that issues experienced in one part of the system can easily cascade to others.
- Systemically important activities can often be carried out by a large number of small entities. This means the FPC needs to consider markets as a whole and the collective behavioural responses of firms in stress.
- Limited transparency and data gaps combined with regulation traditionally focused on market integrity and conduct, rather than prudential issues, are other important barriers to identifying, monitoring, and addressing risks effectively.
- Fragmented regulation of MBF, and the absence of international agreements and standards, mean that assessing risks and developing policy require co-operation across a wide range of authorities.
These factors highlight the importance of taking an holistic approach to assessing and building the resilience of the system, and continuously seeking to strengthen this approach.
1.5: The role of this Financial Stability in Focus (FSIF)
This FSIF is part of the FPC’s commitment through its medium-term priorities to set out its approach to assessing risks associated with MBF in 2023.
This FSIF sets out the FPC’s approach to identifying and assessing risks associated with MBF, building resilience, and responding when disruption to market functioning occurs. It provides more detail on the FPC’s approach than previous publications, and sets out how the FPC intends to continue to extend its approach further.footnote  Given the importance of MBF to the UK financial system, and the importance of the UK financial system globally, the FPC’s work in this area is central to its primary objective for UK financial stability – which the International Monetary Fund (IMF) has determined is a global public good. footnote 
2: The FPC’s approach to risk identification, assessment, monitoring, and mitigation in MBF
In approaching risks associated with MBF, the FPC focuses on issues that have the potential to amplify shocks and create risks to UK financial stability and the real economy.
It is a necessary feature of any financial system that investors can make losses, including large ones, as well as gains. Shocks to the system can lead to sharp price movements in certain financial markets as well as a general increase in volatility. But this does not necessarily constitute a financial stability risk if important financial services to businesses and households are not significantly disrupted. The FPC is, however, concerned with helping to ensure that shocks are absorbed by the system rather than amplified by it.
Shocks can be amplified by the actions of market participants, which can interact with underlying vulnerabilities in the system.
Given the breadth and complexity of sectors, activities, markets, and participants in MBF, actions and behaviours in response to a shock can interact with existing vulnerabilities. This can cause disruptions in different parts of the system and lead to adverse effects on financial stability. For example, this can happen when, as a consequence of an initial shock, market participants take actions which result in an increased demand for liquidity that the system is not able to fully absorb.
An amplified shock can become a risk to UK financial stability if it results in the crystallisation of underlying vulnerabilities that threaten the stable provision of financial services to UK businesses and households. As illustrated in Figure 3 below, this can happen directly through losses or the impairment of services provided, or indirectly via institutions and markets, given the high degree of interconnectedness that characterises the system of MBF.
To illustrate this, if MMFs had suspended redemptions following outflows in the initial market reaction to Covid-19 in March 2020 and not benefited from the interventions of public authorities (refer to the 2020 FSB Holistic Review of the March Market Turmoil), there would have been a significant threat to financial stability in the UK and other jurisdictions. This is because MMFs are interconnected with, and could potentially spread risks to, other institutions, including other OEFs, pension funds, and insurance companies, which rely on MMFs to manage short-term liquidity and to meet margin calls. In addition, MMF suspensions can have a direct adverse impact on the economy; for example, if corporates and local authorities are unable to access their cash to pay creditors, taxes, or wages.
Figure 3: How vulnerabilities in market-based finance can affect financial stability
Vulnerabilities and transmission channels to financial stability
- Source: Bank of England.
Therefore, in order to focus on the most important risks to financial stability, the FPC considers how vulnerabilities in MBF can amplify shocks across the broader financial system, and the extent to which this might impair the ability of the system to support households and businesses. This might happen through systemically important institutions or markets being disrupted, or through a disruption to the provision of vital services.
The FPC has an established approach to identifying, assessing, monitoring, and responding to financial stability risks associated with MBF.
The FPC’s assessments of financial stability risks associated with MBF are underpinned by a framework that considers vulnerabilities within the system of MBF, and the transmission channels through which these vulnerabilities can have an impact on financial stability and subsequently on the real economy. This assessment aims to prioritise monitoring, analysis, and policy work.
The FPC aims to take action to address vulnerabilities before they have crystallised, where possible, by building resilience. And to prepare for severe shocks, the FPC and Bank consider which tools they have to respond as necessary to support financial stability.
Figure 4 summarises the FPC’s overall approach to assessing and responding to risks associated with MBF, which is discussed in more detail in Section 2.1.
Figure 4: The FPC has an established approach to assessing risks from MBF
Overview of the FPC’s approach to financial stability risks associated with MBF
- Source: Bank of England.
2.1: Risk identification, assessment, and monitoring
2.1.1: Assessment of vulnerabilities across the system of MBF
The FPC examines a range of factors that can make individual sectors, markets, and institutions vulnerable.
The FPC considers two types of vulnerabilities:
- ‘Microfinancial’ vulnerabilities. These are inherent to particular business models and make individual NBFIs, sectors, and infrastructure vulnerable to shocks. The FPC primarily focuses on:
- Maturity and liquidity mismatch, which can arise when assets are less liquid or longer dated than liabilities. This is the case, for instance, for many investment funds and commodity trading houses. These mismatches can expose weaknesses in liquidity risk management for funds leading to self-reinforcing ‘run’ dynamics. In turn, this can cause funds to liquidate assets, engaging in fire sales, and putting pressure on asset prices.
- Leverage, which involves a firm increasing its exposure to a risk factor (such as asset prices or interest rates) beyond what would be possible through a direct investment of its own funds, typically using borrowing or derivatives. Leverage can amplify losses and so can lead to forced trading to deleverage and rebalance exposures. It can also lead to liquidity demands, if, for example, significant volatility triggers rapid increases in margin calls, as was the case in commodity markets following the Russian invasion of Ukraine. This would increase firms’ demand for liquidity, which could lead to asset sales, putting downward pressure on asset prices (refer to With leverage comes responsibility – speech by Jonathan Hall).
- Contingent risk, which can occur when changes in external factors lead to sudden shifts in the nature of a firm’s exposures. This could include a counterparty downgrade or default, actions by authorities to suspend markets (eg, due to extreme weather or other physical disruption), or new legal judgements or sanctions that impact the value of a firm’s assets. Events like these may lead to sharp ‘cliff-edge’ changes in asset valuations which may be difficult to hedge, or they might expose underlying correlations between counterparty risk and collateral valuations (‘wrong-way risk’).
- Weaknesses in operational processes and risk management, which can be characterised by: a lack of preparedness or resilience to severe but plausible shocks; inadequate or failed internal processes, people, and systems; and a poor understanding of credit and market risk in products, such as weaker underwriting terms in leveraged lending contracts. These can: increase exposure to shocks; result in material losses that may threaten a firm’s safety and soundness; and lead to disruptions to vital services or the functioning of systemically important markets and institutions. These types of weaknesses were observed in LDI funds, for example.
- ‘Macrofinancial’ vulnerabilities. These are inherent to market structure and the collective behaviour of individual institutions within those markets. A key consideration in MBF is how the different microfinancial vulnerabilities – described above – can interact, and how firms trying to protect themselves can lead to spillovers and feedback loops that propagate risks, such that individually rational actions lead to disruption to markets as a whole. Features of markets that tend to mean microfinancial vulnerabilities interact in an adverse way include, for example:
- High market concentration, which can amplify price moves and increase the risk of interruption to vital services, especially where firms’ liquidity demand is great compared to the system’s overall supply. For example, LDI funds are significant holders of long-dated and index-linked gilts. This meant that, in September 2022, when these funds faced a correlated stress, there were few buyers of the gilts they needed to sell, which amplified market stress.
- Correlation or herding by market participants, which can arise where correlated positions of market participants amplify fluctuations in market prices such as when falls in asset prices force participants with similar trading strategies to sell assets, leading to further price falls. For example, in 1994, and again in 2003, correlated hedging of the negative convexity of US mortgage-backed securities (MBS) amplified the rise in dollar bond yields, as holders of MBS tend to sell fixed income securities as yields rise. Sharp and disorderly market moves, in turn, can cause direct and indirect losses to other institutions, including systemically important banks, potentially leading to tighter financial conditions for households and businesses.
- Jumps to illiquidity, which are instances where sharp and rapid increases in demand for liquidity overwhelm the capacity of markets to absorb it, resulting in sharp and amplified moves in prices and market dysfunction. This can be further amplified by the unwillingness or inability of securities dealers and other intermediaries, such as principal trading firms, to expand their intermediation activity by temporarily warehousing additional assets on their balance sheets. This was evidenced by the volatility in US overnight repo rates in September 2019, when the Federal Reserve had to take action to restore market stability. It was also at the centre of both the March 2020 ‘dash for cash’, during which severe illiquidity crystallised in advanced economy government bond, corporate bond, and repo markets, and the 2022 LDI stress, which caused dysfunction in the long-dated gilts market.
- Interconnectedness and opacity across markets and participants can result in losses being transmitted to counterparties in a sudden way, driven in part by the lack of certainty on overall positions held in the market. For example, during the global financial crisis, the interconnectedness and lack of transparency in derivative markets amplified shocks in the financial system (refer to November 2017 FSR). An opaque and poorly collateralised web of derivatives trades transmitted stress between market participants as they collectively rushed to manage counterparty credit risk. In response, G20 leaders agreed a number of improvements to OTC derivatives markets to increase transparency, prevent market abuse, and reduce financial stability risks. And in March 2020 during the ‘dash for cash’, MMFs, particularly those that invest in non-government assets, saw large outflows as investors redeemed MMF shares to obtain liquidity to make necessary payments elsewhere – in many cases to meet margin calls on derivatives.
The LDI stress in September 2022 is a good example of how microfinancial vulnerabilities can interact with macrofinancial vulnerabilities to amplify shocks with spillovers to the real economy, as is described in Box B.
No part or sector of the system of MBF can be assessed fully in isolation, so the FPC uses a combination of perspectives to identify and prioritise vulnerabilities
The system of MBF relies on the behaviour of a range of intermediaries and investors that, in combination, determine how well markets function and therefore whether, in the face of shocks, the system can continue to support the real economy and the rest of the financial system. To that effect, the FPC aims to consider a number of perspectives or ‘lenses’ to try to identify and prioritise vulnerabilities ahead of stress, as follows:
- A business model lens, through which the FPC assesses microfinancial vulnerabilities stemming from NBFI business models and sector characteristics.
- A markets lens, through which the FPC considers macrofinancial vulnerabilities by analysing and understanding the structure and dynamics across individual markets and how they interact as a whole.
- A scenario lens, through which the FPC uses scenario analysis to evaluate how micro and macrofinancial vulnerabilities may amplify stress. This approach looks at specific plausible system-wide risks or scenarios identified through regular horizon scanning. These scenarios are informed by data, market intelligence, and information exchange with internal and external stakeholders.
Using this combination of perspectives can help identify and prioritise the most material risks more comprehensively, particularly as looking through different perspectives can shine a different light on the same risks and allow the FPC to better gauge their potential impact on financial stability and, consequently, address them more effectively. Additionally, the FPC’s use of these perspectives varies through time, adapting in an agile way to the prevailing risk environment and the FPC’s judgements on priority issues (Section 2.1.3). For instance, in stress, the FPC will make more use of specific plausible scenarios relevant to the stress to identify and assess risks.
That being said, while considering risks through different perspectives improves the FPC and global authorities’ ability to spot risks, the inherent challenges of assessing risks associated with MBF described in Section 1.4 mean that it is not possible that every risk can or will be identified.
MBF vulnerabilities previously identified by the FPC have primarily originated from weaknesses in specific business models.
Disruption in MBF has been driven by problems and poor risk management originating within institutions or sectors, as borne out by recent stress episodes. As a result, the FPC identified and prioritised policy work on a number of microfinancial vulnerabilities, such as liquidity mismatch in OEFs and MMFs, and non-bank leverage, among others, which will be discussed further in Section 2.2.2.
But when assessing the extent to which specific microfinancial vulnerabilities might spill over to the rest of the system, the FPC must also consider the dynamics of the markets that businesses and sectors operate in. It considers their footprint in these markets too, and seeks to assess the impact of spillovers arising from vulnerabilities originating in specific business models to broader liquidity demand in markets and their potential impact on financial stability. For example, the FPC recognises that vulnerabilities in MMFs are particularly important for financial markets given both their use by market participants to manage short-term liquidity as well as their important role in repo markets. Vulnerabilities in MMFs can also have knock-on effects on the price and availability of cash in stress for market participants looking to borrow on a very short-term basis.
More broadly, the FPC has also assessed macrofinancial vulnerabilities that exist in financial markets. One such example is the ongoing work to assess the procyclicality of margin calls in stress, and whether market participants are adequately prepared to meet them. In a similar vein, the FPC has considered how variability in market liquidity in core markets acts as an important source of stress and has focused on market structure as a core potential vulnerability. This includes, for example, analysis of whether dealers in intermediated markets are capable of and willing to engage in intermediation in stress, whether market participants display ‘preferred habitat’ behaviour, and how certain markets are connected to other markets and the rest of the financial system.
Finally, The FPC’s July 2023 FSIF on interest rate risk in the economy and financial system is an example of how the FPC conducts scenario-type analysis and considers impacts across the whole financial system and economy. Among other things, the July 2023 FSIF highlighted that liquidity risk from the use of derivatives – or leveraged products more generally – could arise if the users of such products lack sufficient liquidity to meet higher margin and collateral calls. The pressure of liquidity calls can lead to the fire sale of assets and a tightening in financial conditions for households and businesses.
2.1.2: Transmission channels to financial stability
Having identified vulnerabilities, the FPC then considers the impact that these vulnerabilities could have on UK financial stability.
Identifying vulnerabilities enables the FPC to focus on the risks associated with MBF that could pose the most serious threats to UK financial stability.
Vulnerabilities can build up over time and create imbalances in the system. These imbalances can in turn amplify shocks and disrupt the stable provision of financial services to the rest of the system and the economy, resulting in a material impact on UK financial stability and tighter financial conditions for UK households and businesses.
To fully assess the impact that such imbalances may have on financial stability, the FPC considers three key transmission channels through which shocks can propagate:
- Disruption to systemically important financial markets, ie, financial markets that provide financing or other important services to the real economy, and which cannot be easily substituted. Markets are disrupted when their functioning is seriously impaired leading to unwarranted tightening of financial conditions for UK households and businesses. Nonetheless, financial markets may – and should be able to – exhibit significant volatility but still function without impacting financial stability. As highlighted during the LDI stress, problems in NBFIs can transmit distress to markets that are systemically important, such as the government bond market, which in turn can have implications for the pricing of household and business credit linked to these markets if they fail to function effectively.
- Disruption that could pose risks to systemically important institutions. Problems in MBF can impact providers of vital financial services, such as banks, insurers, and infrastructure providers, which often have significant exposure to NBFIs. For example, banks conduct repo and derivative transactions with hedge funds through their broker-dealer operations. If, for example, asset values fall suddenly, banks’ exposures to hedge funds could become insufficiently collateralised, meaning that disruption in the hedge fund sector could lead to losses for banks, particularly where these banks do not have adequate risk management practices in place, and consequently spill over to the real economy through a reduction in the provision of credit.
- Disruption to the provision of vital services, such as providing payment and settlement services, intermediating between savers and borrowers and channelling savings into investment, and insuring against and dispersing risk. Risks arise when the provision of one or more of these services from a sector is susceptible to rapid withdrawal, which can lead to an interruption of vital economic activity. For example, disruption to CCPs and the clearing and netting services they provide could have a significant impact on financial stability.
2.1.3: Output of the FPC’s risk assessment and how the framework works in practice
The FPC uses this framework to prioritise further analysis and policy development towards the most material risks to UK financial stability.
Taken together, this framework enables the FPC to focus on vulnerabilities in MBF that could pose material threats to UK financial stability (refer to Figure 5). In doing so, the FPC considers the materiality of the risks to the real economy that these vulnerabilities give rise to, as well as interlinkages across financial markets and institutions. The FPC’s assessment relies on regular monitoring and horizon scanning at sector and market level by Bank staff, using available data, as well as domestic and international intelligence (Section 2.1.4). This allows the FPC to identify early on if new or previously identified vulnerabilities or interlinkages are increasing or crystallising in the areas which pose the greatest threats to financial stability.
Given the global nature, complexity, and interconnectedness of MBF, the FPC takes a judgement-led approach, informed by the FPC’s views on the current conjuncture, risk environment, and outlook for the economy and financial markets.
Based on its identification of the most material risks to UK financial stability, the FPC decides whether to commence or continue close monitoring of certain activities or sectors, or to launch in-depth assessments. Following these assessments, the FPC judges, where relevant, whether identified vulnerabilities will be addressed by domestic or international workstreams, or whether further action may be needed (Section 2.2). It may recommend changes to regulation, either by activities moving into the regulatory perimeter, or a change in regulation for activities already within the perimeter, as described in Section 1.3. In doing so, it will also consider whether it is necessary for action to be taken internationally given the global nature of MBF (Section 2.2.3).
In other cases, after identifying vulnerabilities, the FPC can judge that no further action is warranted on financial stability grounds. For instance, the FPC considered risks related to synthetic exchange-traded funds (ETFs) a number of times, and in 2019 judged that the majority of ETFs do not appear to present a material risk to financial stability. This is because the ETFs that could pose risks to financial stability if they grew further – those with less liquid underlying assets, those that use leverage or other procyclical strategies, and synthetic ETFs – accounted for only around one third of the ETF market. And the entire ETF market remained small relative to OEFs. However, this does not imply that vulnerabilities that were once deemed less material will remain so indefinitely, and the FPC regularly reviews its assessment of vulnerabilities and updates its judgements where needed. This is largely supported by effective horizon scanning and risk monitoring.
Figure 5: The FPC’s approach focuses on vulnerabilities, transmission channels and resilience
Factors considered in the FPC’s approach to assessing risks from MBF