Published as part of the Financial Stability Review, May 2024.
Recent stress episodes have shown how leverage in the non-bank financial intermediation (NBFI) sector can be a source of systemic risk and amplify stress in the wider financial system. Excessive leverage in the NBFI sector can increase the likelihood of procyclical deleveraging and counterparty losses, with potential spillovers to banks and the broader financial system. Prominent examples of procyclical deleveraging include the role of leveraged hedge funds in the US Treasury market in March 2020 and liability-driven investment (LDI) funds in UK gilt markets in September 2022.[1] Both reveal how NBFI vulnerabilities associated with high leverage can spill over to core government bond markets. The failure of Archegos Capital Management in March 2021 highlights how the build-up of concentrated derivative positions combined with a lack of transparency on these positions can impose significant counterparty losses on systemically important banks.
In response to these events, policymakers around the world have launched a range of policy initiatives to contain risks from leverage in the NBFI sector more broadly (Table A). As the NBFI ecosystem comprises a wide range of entities performing different economic functions, with varying degrees of complexity in their use of leverage, authorities need to carefully choose and calibrate their measures. In doing so, they face certain trade-offs concerning, for example, the effectiveness of measures to target specific risks (e.g. procyclical deleveraging), their feasibility (e.g. complexity in their use) and potential costs (e.g. impact on hedging). This box provides an overview of recent policy initiatives aimed at addressing risks from NBFI leverage, including policy responses to the examples above. In other instances, policymakers have acted pre-emptively after identifying systemic vulnerabilities, as in the case of Irish real estate funds.
Authorities in Ireland, Luxembourg and the United Kingdom have used entity-based measures to address leverage-related risks in government bond and real estate markets. In response to deleveraging by LDI funds in September 2022, authorities in the United Kingdom as well as in Ireland and Luxembourg, where a significant share of GBP-denominated LDI funds are domiciled, introduced entity-based measures to ensure a minimum level of resilience among these funds, which also acts to (indirectly) limit leverage.[2] Moreover, authorities in Ireland have responded to heightened concerns regarding real estate risks by imposing macroprudential measures to mitigate the potential for deleveraging in these markets in times of stress. Irish authorities have introduced a leverage limit on borrowing of 60% for real estate funds, calculated as the ratio of a fund’s total debt to its total assets.[3]
In the United States, new rules mandating the central clearing of US Treasury (UST)-backed repos are part of a broader package to enhance UST market resilience. The U.S. Securities and Exchange Commission (SEC) has recently introduced rules mandating the central clearing of UST securities in repo transactions, which is an important example of an activity-based measure. This followed periods of turbulence in UST markets, which was partially driven by deleveraging of hedge funds engaging in basis trades. Moreover, the use of leverage by these funds was often facilitated via uncleared repo transactions, which were typically contracted with 0% haircuts. Due to the stricter risk management practices for cleared transactions (relative to the terms provided by prime brokers), the new rule will also help to ensure that higher haircuts are applied to such trades.[4] The SEC has also introduced rules to improve the regulatory oversight of NBFI market participants that play a significant liquidity-providing role in overall trading and market activity in UST markets. These rules may also affect some large hedge funds.[5]
The failure of Archegos Capital Management prompted global efforts to review the risk management practices of leverage providers and assess risks from “hidden” leverage. The collapse of Archegos in 2021 and the fallout in the banking sector raised serious questions regarding banks’ counterparty credit risk (CCR) management practices for their NBFI exposures.[6] The ECB recently reviewed the CCR management practices of a sample of banks that are particularly active in providing prime brokerage services to NBFI entities and has issued guidance and outlined sound practices on areas such as governance, risk management and stress testing.[7] In addition, the Basel Committee on Banking Supervision is currently reviewing its guidance on CCR regarding banks’ NBFI exposures.[8] The Financial Stability Board has also examined the issue of “hidden” leverage in the financial system, which may lead to important policies to enhance transparency as part of a broader policy initiative to address NBFI leverage risks.[9] In this light, joint work by the Federal Reserve Board, the Bank of England and the ECB to share information on their banking sectors’ NBFI exposures provides a useful example for how broader international efforts could improve transparency in cross-border and cross-sectoral exposures.[10]
The examples presented in this box suggest that a broad and tailored set of policies is required to address the various risks posed by NBFI leverage. Authorities around the world have engaged in a wide range of policy initiatives to address risks posed by NBFI leverage. In doing so, they have needed to balance various trade-offs, which is reflected in their policy choices. A key takeaway from these recent experiences and policy initiatives is that no single tool can be uniformly applied to address risks stemming from NBFI leverage. An effective policy response requires a broad range of tools to be made available, which should be appropriately tailored to the specific circumstances and can serve as complements to each other. Given the significant cross-border and cross-sector dimension of these risks, close coordination and cooperation between various authorities is essential, ensuring that risks are addressed from a system-wide perspective.
Table A
Authorities around the world are actively engaged in initiatives to contain risks from NBFI leverage
Overview of policy measures
Event/ vulnerability | Risk channel | Policy measures | |||
|---|---|---|---|---|---|
NBFI activities | NBFI entities | Leverage providers | Transparency | ||
COVID-19 market turmoil | Procyclical deleveraging by leveraged (multi-strategy) hedge funds in UST markets | SEC proposals on mandating clearing of repos (part of broader package) | |||
UK gilt market crisis | Procyclical deleveraging by LDI funds in UK gilt markets | Indirect leverage limits for GBP-denominated LDI funds domiciled in IE, LU and UK |
|
| |
Excessive leverage among Irish real estate funds | Potential procyclical deleveraging of funds in Irish property markets | Direct leverage limits for Irish real estate funds (phased-in for existing funds) | |||
Archegos fallout | Counterparty losses due to inadequate risk management and transparency |
| ECB review of banks’ CCR practices BCBS review of its CCR management guidelines | Cross-border information-sharing (BOE-ECB-FRB) International work on transparency and data | |
Source: ECB.
See the box entitled “Non-banks’ liquidity preparedness and leverage: insights and policy implications from recent stress events”, Financial Stability Review, ECB, May 2023.
In the case of Ireland and Luxembourg, this tool is referred to as a “yield buffer”, which is set at between 300 and 400 basis points, thus ensuring that the fund can absorb a corresponding increase in yields before its net asset value falls to zero. It can be seen as a measure to ensure minimum resilience, which indirectly affects leverage at LDI funds but does not impose a leverage limit as such. See “The Central Bank’s macroprudential policy framework for Irish authorised GBP-denominated LDI funds”, Central Bank of Ireland, April 2024, and “CSSF communication on macroprudential measures for GBP denominated Liability Driven Investment funds”, Communiqué, CSSF, April 2024.
All new property funds will need to comply with this limit, while existing funds are granted up to five years to comply. See “The Central Bank’s macroprudential policy framework for Irish property funds”, Central Bank of Ireland, 24 November 2022.
See “Final rule: Standards for Covered Clearing Agencies for U.S. Treasury Securities and Application of the Broker-Dealer Customer Protection Rule with Respect to U.S. Treasury Securities”, U.S. Securities and Exchange Commission, 13 December 2023.
See “Final rule: Further Definition of “As a Part of a Regular Business” in the Definition of Dealer and Government Securities Dealer in Connection with Certain Liquidity Providers”, U.S. Securities and Exchange Commission, 6 February 2024.
In 2021 Archegos defaulted on portfolio losses related to highly leveraged and concentrated positions using total return swaps in equity markets. At the end of March 2021, bank losses linked to the failure totalled over USD 10 billion.
See “Sound practices in counterparty credit risk governance and management”, ECB, October 2023, and “Supervisory expectations for prime brokerage services”, Supervision Newsletter, ECB, 17 August 2022. The ECB also identified counterparty credit risk as a broader supervisory priority in 2022.
See “Basel Committee work programme and strategic priorities for 2023/24”, Basel Committee on Banking Supervision, 16 December 2022.
See “The Financial Stability Implications of Leverage in Non-Bank Financial Intermediation”, Financial Stability Board, 6 September 2023.
See “Supervising counterparty credit risk – a European perspective”, keynote speech by Elizabeth McCaul, Member of the Supervisory Board of the ECB, ECB, 28 February 2024.