The Bank of England promotes moral hazard – again.

In the 20th century, banks were the foundation of the global financial system. No more. If there were any doubts about the changes that have taken place in finance over the past decades, recent events in the UK should dispel them.

The Bank of England has made two significant interventions in the past two weeks to support financial stability; neither directly involved banks. In response to the violent movements in the long-term gilts – following the government’s since-rejected proposal to cut income taxes for the highest earners – the central bank hastily launched a program to buy up to £65 billion ($74 billion) in government bonds. . And, in partnership with the UK Treasury, it announced £40bn of emergency funding for energy companies struggling to meet margin calls.

Together, they reflect the evolution at the heart of the global financial order: the system is no longer bank-based; rather, it is increasingly market-centric. This is an important distinction, with far-reaching implications.

When banks served as gatekeepers, central bankers had a simpler life. To fulfill their obligation to provide financial stability, they acted as lenders of last resort to banks – a role they largely fulfilled during the global financial crisis. By limiting the number of banking licenses, they maintained control of the sector and by extension of the financial system.

But over the years, lenders have ceded market share to a diverse list of financial institutions. Twenty years ago, banks held 46% of global financial assets, according to Financial Stability Board data; it’s now down to 38%. In contrast, non-bank financial institutions – including insurance companies, pension funds and others – account for 48%, up from 41% in 2002. While the trend reversed briefly during the 2008 global financial crisis, she resumed her earlier course at an accelerated pace soon after.

To finance their operations, non-banking institutions rely on the wholesale markets and, in particular, on government bonds, which serve as collateral enabling them to borrow. Many also use the same collateral to support hedging programs.

The system has many advantages, providing institutions with quick access to funding and hedging solutions using the security of a safe and liquid asset. But it has an unfortunate tendency to be pro-cyclical: periods of market turbulence can lead to significantly higher collateral requirements, which can lead to more turbulence if it leads to forced sales – as we have seen. in the UK last week.

In the past, banks may have stepped in to manage the fallout, but largely due to stricter post-crisis trading and capital rules, their balance sheets have remained very small relative to the size of the markets. guarantees. In the UK, for example, UK government bond market maker assets have fallen 25% since 2008, even as UK government bonds outstanding have increased 2.7 times.

So when the gilt market faltered last week, only the Bank of England was left with the firepower to intervene.

Fortunately, the BOE had already laid the groundwork. In January 2021, its Executive Director for Markets, Andrew Hauser, gave a speech in London setting out the case for its role as “market maker of last resort”. Central banks had already broadened their scope from supporting banks to supporting markets. But given the shifting sands of the global system, he warned the pace could pick up: “There is every reason to believe that, absent further action, we will see more frequent periods of market dysfunction. on which households and businesses increasingly depend. .”

When it occurred, this dysfunction was not only evident in the gilt markets, but also in the energy markets, where greater volatility weighed on the financing of participating companies. Here, the bank had a ready-made solution borrowed from its traditional playbook: any “financially sound” energy company could approach the bank as a lender of last resort.

All the characteristics of Walter Bagehot’s famous maxim are evident in the diagram: the bank will lend freely, to sound institutions, against good guarantees, at rates substantially higher than those prevailing under normal conditions. The only difference is that the banks will not be the ultimate recipient of the funding (although they can be used as conduits) – rather they will be companies that “make a material contribution to the liquidity of UK energy markets”.

While central banks have adapted to the new market reality, other players remain obsessed with the old paradigm, where the vulnerability lies with the intermediaries rather than the markets themselves. Credit Suisse Group AG’s widening credit spreads and falling share price aren’t good news for its investors, but they are unlikely to herald a “Lehman moment.” Similarly, the sell-off in UK life insurance stocks when the UK government bond market sold out last week reflected their role as intermediaries. BlackRock Inc., one of the biggest pension fund managers under pressure, issued a press release reminding investors that “we are not a commercial counterparty to these risk mitigation strategies.”

For years we have become accustomed to the concept of moral hazard in banking – the lack of incentive for banks to hedge against financial risk given their protection against potential consequences. Post-crisis reform may have tamed this risk among banks, but it could spread elsewhere. A recent regulatory review of the policy response to market turmoil in March 2020 concluded that clients “varied in their level of preparation for margin calls”.

In this case, even the less prepared have benefited from the actions of the central bank. If that is the lesson others take away, it will have the effect of encouraging risk not just in the UK, but everywhere.

More from Bloomberg Opinion:

• BOE should echo fiscal U-turn by scrapping QT: Marcus Ashworth

• Gilt market carnage prompts risky BOE U-turn: Mark Gilbert

• No surprise: pension funds have fueled the British rout: Allison Schrager

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Marc Rubinstein is a former hedge fund manager. He is the author of the weekly financial newsletter Net Interest.

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