More than 300 years ago, John Law became the economic adviser to the French throne. He rapidly rose to fame for establishing paper money and founding the Banque Générale, the first incarnation of France’s central bank. In a time of recession and at the height of public distrust in the throne, he famously sold shares in the Mississippi Trading Company, which managed the country’s commercial interests in North America, and used interest rates to stimulate economic demand.
While the country was suddenly awash with cash, the prices of futures contracts in the Mississippi Trading Company rose to more than 10,000 francs. But when it became clear that the gains from the exploitation of the new continent were not as easily made as promised by Law, the share price of the company collapsed by more than 70%, leaving investors out of pocket.
It is no wonder then that parallels are drawn between this famous economic bubble and today’s rapid expansion of monetary stimulus. While today’s markets and problems are different from 18th century France, the experience that assets are easily traded when markets are awash with cash but that liquidity can evaporate rapidly is familiar to many investors; last year’s liability-driven investment (LDI) crisis in the UK being a case in point.
Into the shadows
While the French regent cranked up the printing press to fund his unsustainable spending habits, in the 21st century central bankers across the globe have injected money into the system through buying government debt in an attempt to dampen the impact of 2008’s financial crisis. This trend was sharply accelerated by Covid. Indeed, since 2008, the balance sheet of the US Federal Reserve has ballooned to $8.5trn (£6.8trn), from less than $1trn (£810bn) prior to the crisis.
In the wake of the banking crash, regulators responded by clamping down on bank regulation, which in turn resulted in traditional banks gradually retreating from credit provision, while the low yields on traditional fixed income assets caused institutional investors to increase their allocations in private markets.
Simultaneously, pension funds and other institutional investors have also employed increased leverage in their portfolios to compensate for the low returns in traditional fixed income assets. The Financial Stability Board (FSB) defines non-bank financial intermediation, the regulatory term for shadow banking, as maturity transformation (the use of short-term funds to invest in longer-term assets), liquidity transformation, (which involves the use of cash-like liabilities to buy illiquid assets such as loans) and the use of leverage to magnify potential investment returns. As such, it could be argued that institutional investors from pension funds to insurance companies, have become a cornerstone of the rapidly growing shadow banking sector.
The FSB estimates that non-bank financial intermediation assets, the regulatory term for shadow banking assets, now account for nearly half of all financial sector assets and stood at $63.2trn (£51.2trn), or 48.3% of total financial assets, in 2020. In doing so, pension funds, insurers and other financial intermediaries play a role in providing liquidity in a world where banks are retreating from liquidity provision.
But unlike banks, which are required to hold capital in reserve, the capital requirements for pension funds, who embark on leveraged
investments, are a lot more ambivalent and are generally regulated by agreements with counterparties. This means that in the event that institutional investors who employ leverage fail to meet margin calls, the risks fall back onto the banks who issued the derivatives in question, as the 2021 collapse of the family office Archegos Capital illustrates.
The collapse of the $36bn (£29.1bn) family office saw billions of dollars written off across global banks, from Credit Suisse to Deutsche Bank, UBS and Nomura. With that in mind, one dreads to think what the impact of write-offs from the LDI crisis would have been, had the Bank of England not intervened.
But the problem goes beyond LDI. As central banks embark on quantitative tightening, there is now growing concern that non-bank financial intermediaries might retreat from this role as liquidity providers globally. Such a trend could have far reaching implications for the nature of credit provision in the global economy and the asset allocations of institutional investors.
First strains
The US Federal Reserve has barely embarked on quantitative tightening but the first strains in market liquidity are already tangible, as the IMF warns in its latest financial stability report. It concludes that market liquidity has deteriorated across all major asset classes. “There is a heightened risk of rapid, disorderly repricing which could interact with — and be amplified by — pre-existing vulnerabilities and poor market liquidity,” the organisation says.
This trend is also highlighted by the Bank for International Settlements, which points out that the implied volatility of US treasury yields increased by more than 20 basis points during 2022. Moreover, liquidity deteriorated even in core bond markets, such as the US, UK, Germany and Japan, to its lowest levels since the global financial crisis.
Another indication is that bid-offer spreads, the difference between the price dealers buy and sell a security for, have widened. This has been a problem with larger institutional transactions, which would have to be broken down into smaller amounts to be executed.
Marginal adjustment
This in turn means that investors will now think more carefully about their exposure to illiquid assets, predicts Mike Eakins, Phoenix’s chief investment officer. “One of the things we are likely to see in the UK is that there will be marginally less demand for private market assets than there was [last year]. If you can invest in government bonds at 3.5%, you don’t need to go out and shoot below zero in private markets,” he says.
But Eakins adds that this will most likely be a marginal adjustment. “It’s easy to say that the boom in private markets is over, but I don’t think that is the case. “A lot of pension funds, insurance companies and asset managers have invested a lot in private markets. You can’t just suddenly stop these investments; you need to keep managing your portfolio. “Second, private market assets are a good fit for our liabilities because we can tailor the cashflows to meet our liabilities,” he says.
But fund flows from the year end suggest that institutional investors are building bigger liquidity cushions. European money market funds reported close to €124bn (£108.8bn) in inflows in October alone, as fund flow data by Efama shows. Meanwhile, bond and equity funds booked €21bn (£18.4bn) and €14bn (£12.2bn) in outflows, respectively.
Insurance challenges
The 2022 liquidity crunch in the gilt market has had a different impact on insurers, who must hold capital in reserve under Solvency II rules. “The LDI crisis didn’t really affect us,” Eakins says. “We use derivatives for cashflow matching, not investment exposure. We saw some significant margin calls but because we are a regulated insurer, we had excess liquidity and did not have to sell any additional assets.”
But these Solvency II rules are due to be reviewed, as chancellor Jeremy Hunt announced in the autumn statement. Hunt pledged to reduce the risk margin whilst easing the matching adjustment rules in an attempt to attract more investment into infrastructure. The move has been broadly welcomed by the insurance industry.
Mick McAteer, co-director at the Financial Inclusion Centre and a former board member of the FCA, warns that this could leave insurance investors exposed to higher risks at the worst possible time. “The Bank of England and the Prudential Regulation Authority (PRA) originally recommended that in return for relaxing the risk margin, the PRA should tighten up the use of the matching adjustment so that it had an offsetting effect.
“What was worrying is that the government has gone ahead with the reduction of the risk margin but they have ignored the PRA and the Bank of England on the matching adjustment so it is even worse,” he adds.
But simply removing these thresholds is no guarantee that insurers will invest in infrastructure. “I don’t know if the government believes this story that insurers will stomp up money for social housing, levelling up and the green transition or if they are being disingenuous,” he says. “There is nothing in the rules that prevents insurers from investing in infrastructure anyway, they simply find higher returns elsewhere.”
McAteer is not alone in his concerns about liquidity risks in insurance portfolios. In its insurance supervision priorities for 2023, the Bank of England and the PRA disclosed that they were keeping a close eye on the matter. “Recent events such as the liability-driven investment shock has highlighted gaps in insurers’ liquidity risk frameworks, further reinforcing the importance of sound risk management practices.
“We expect insurers to test the resilience of liquidity sources to market dysfunction and to re-evaluate potential liquidity demands created by use of derivatives for risk management,” the regulators say.
Sharper awareness
The question of liquidity management is even more pressing for pension funds. In practical terms, one challenge they face in the wake of the LDI crisis is to assess how much liquidity they need and what the probability of another crisis is.
“Liquidity is something pension schemes have always thought about to some degree but what happened in September has sharpened the focus,” says Dan Mikulskis, a partner at consultancy Lane Clark Peacock. “Liquidity risk is by definition a tail risk which is impactful, but a rare kind of risk that doesn’t fit into the standard mean variance modelling.
“If you are going to address this, you have to handle it outside that framework using different risk scenarios,” he adds. “But you can’t eliminate every single tail risk out there, because then you would just be left in cash.”
Mikulskis argues that pension funds should identify the specific areas in their portfolio that could represent a liquidity risk if markets deteriorate, with derivatives a key concern. “Another factor is when you have regular cashflows coming out of your portfolio. So, depending on how much LDI leverage you have, and how cashflow negative your scheme is, there will be quite a lot of variation in how urgent the question of liquidity is.
“The key issue is what will happen to the illiquid assets they are already invested in,” he adds. “Schemes will certainly think twice about putting more money into infrastructure, but they can’t suddenly disinvest. A lot of schemes will look at running those down over time,” he says.
A slow leak
September’s LDI crisis demonstrated that insufficient capital buffers in the context of a liquidity crunch could be a costly mistake. Schemes that held insufficient collateral to meet margin calls turned into forced sellers of assets and had to report billions of losses. With global liquidity provision being fundamentally altered by the impact of quantitative tightening, last year’s LDI crash may only be a canary in a coal mine.
But there are also reasons to believe that these liquidity challenges could play out differently from the hysteria of the Mississippi bubble, where investors stampeded to sell their shares. In contrast, institutional investors seem unlikely to withdraw from private markets entirely. Investors are looking at reducing their exposure to illiquid assets, but this could turn out to be a slow leak, rather than the sudden burst of a bubble.
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