We are not an island: how have the UK’s external balance sheet risks changed over the past two decades?

Colm Manning and Alice Crundwell

No country is an island – in terms of economics at least, if not geography. Trade and capital link all the economies of the world. Relative to GDP, the UK has more foreign assets and liabilities than any other large economy. These external liabilities – UK assets owned by overseas investors – could result in vulnerabilities that might cause major disruption to the economy and financial system in a stress. The good news for us is that the UK’s private sector external vulnerabilities have shrunk materially since the global financial crisis (GFC) of 2008, although the public sector’s vulnerabilities have grown. This post explores how the UK’s balance sheet has changed since the GFC and what this means for UK financial stability.

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A simple model of the effects of entity and activity constraints on alternative investment funds

Leo Fernandes, Harkeerit Kalsi, Nicholas Vause, Matthew Downer, Sarah Ek and Sebastian Maxted

Hedge funds and other alternative investment funds (AIFs) often take positions in financial markets that significantly exceed their investors’ capital by using debt or derivatives. However, such ‘leverage’ can pose risks to financial stability. Regulators seeking to reduce these risks may consider applying constraints to the fund entities or the activities in which they engage. In this post, we use a simple portfolio choice model to examine the effects of the two approaches on fund investments. Under the entity-based approach, we find that fund managers substitute from lower-risk to higher-risk investments, whereas an activity-based approach can avoid this unintended reallocation by targeting specific investments.

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A summary measure for UK households’ resilience

Vania Esady and Stephen Burgess

A summary measure for UK households’ resilience

High levels of household debt have been shown to amplify recessions. For example, in the global financial crisis (GFC), UK households with more debt tended to cut back their spending disproportionately, amplifying aggregate demand effects and potentially making the recession worse. High levels of household (and corporate) debt can pose risks to the UK financial system through two main channels: lender resilience and borrower resilience. However, monitoring households’ resilience to future shocks is not an easy task. In this post we construct some new summary measures of borrower resilience. We show that increases in debt-servicing costs or in the flow of credit to households could make households less resilient overall.

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Growth-at-Risk for macroprudential policy stance assessment: a survey

Tihana Škrinjarić

How effective is macroprudential policy and how should policymakers measure its stance? My recent paper surveys the literature on the topic of Growth-at-Risk (GaR), which has been developed as a methodology to provide answers to these questions by relating the effects of macroprudential policy tools to real-economy dynamics. While the results are mixed, the consensus finds a positive impact from macroprudential policy tightening during the expansion of the financial cycle. Policy loosening reduces the potential GDP losses during contractions, with the effects being more prominent in the medium term. Several challenges within this framework still exist. Resolving these would lead to a more accurate evaluation of macroprudential policy effectiveness. Finally, I discuss GaR policy applications.

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Central bank balance sheet policies and the market for reserves

Michael Kumhof and Mauricio Salgado-Moreno

While ‘unconventional’ balance-sheet policies like quantitative easing (QE) and quantitative tightening (QT) appear to have been successful, it is difficult to separate their macroeconomic and financial stability implications from those of other polices. Hence, in a recent paper, we develop a theoretical framework, focusing on the central bank’s liabilities, that sheds light on these implications. The key model feature is the inclusion of a detailed financial system with both heterogeneous banks and non-bank financial institutions that allows us to identify the transmission of QE/QT policies. Our framework provides guidance to policymakers interested in using new combinations of balance sheet and interest rate policies by highlighting the relevance of the interbank market and financial frictions in the transmission of balance sheet policies.

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Caring for the ‘future’

David Glanville and Arif Merali

Short term interest rate (STIR) futures are the bedrock of interest rate markets, used to price expectations of central bank policy rates and other UK rate derivative markets such as swaps and options (see Figure 1). They are key for the transmission of monetary policy and provide an avenue for interest rate risk hedging which is important for financial stability. Financial market liquidity usually worsens when volatility rises, however liquidity in the UK’s STIR futures during 2022 was especially poor. Liquidity in some metrics such as open interest and volumes has since improved as volatility has reduced, however our extensive market intelligence conversations suggest that many still believe there is further to go when looking ‘under-the-bonnet’ at another key metric, market depth. Volatility continues to play a role, but a reversion to publishing key data releases within market hours may help to build liquidity further.

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What caused the LDI crisis?

Gabor Pinter, Emil Siriwardane and Danny Walker

In September 2022 the interest rate on UK gilts rose by over 100 basis points in four days. These unprecedent market movements are generally attributed to two key factors: the 23 September announcement of expansionary fiscal policy – the so-called ‘mini-budget’ – which was then amplified by forced sales by liability-driven investment funds (LDI funds). We estimate that LDI selling accounted for half of the decline in gilt prices during this period, with fiscal policy likely accounting for the other half. Balance sheet segmentation and operational issues slowed capital injections into LDI funds by well-capitalised pension schemes, leading LDI funds to instead sell gilts. Our analysis shows that these frictions were most pronounced for pooled LDI funds. There are further details in an associated working paper.

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Futures under stress: how did gilt futures behave in the LDI crisis?

Joel Mundy and Matt Roberts-Sklar

When markets are volatile, liquidity tends to worsen. This makes it harder to intermediate buyers and sellers. We saw this during the 2022 liability-driven investment (LDI) stress, when the UK government bond (gilt) market exhibited extreme volatility. This illiquidity was also evident in gilt futures, derivatives that support functioning in the cash gilt market. Gilt futures are traded on an electronic orderbook, meaning we can examine liquidity metrics at very high frequency. Looking across a range of liquidity metrics for gilt futures, we find that liquidity was broadly unchanged following the Monetary Policy Committee’s (MPC’s) decision of 22 September 2022. But market functioning deteriorated heavily following the UK Government’s fiscal statement of 23 September and took a long time to recover.

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‘No one length fits all’ – haircuts in the repo market

Miruna-Daniela Ivan, Joshua Lillis, Eduardo Maqui and Carlos Cañon Salazar

Funding markets are crucial for healthy and active financial institutions, and consequently for everyone in the economy. The repurchase agreement (repo) market plays a key role in bank and non-bank financial institutions’ (NBFIs’) daily activities by facilitating short-term financing and risk hedging. In this post, we use novel Securities Financing Transaction Regulation (SFTR) data to highlight new, and corroborate previous, stylised repo haircut facts.

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The link between mortgage debt servicing burdens and arrears: is there a critical threshold?

Nuri Khayal and Jonathan Loke

Many households in the UK have seen their mortgage payments go up since mortgage rates started to increase in 2022. In the current environment of higher rates, the question of how much a household can comfortably spend on their mortgage payments before getting into financial distress is particularly relevant. This blog shows that households which spend a larger share of their income on mortgage payments are at a higher risk of being in arrears. But in contrast to pre-existing work on the subject, we do not find evidence of a critical threshold after which the risk increases much more sharply. These findings imply that changes in the indebtedness across the whole mortgagor population, not just the tail, matter for financial stability.

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