A decade of effort to prevent a repeat of the GFC means half the world’s financial assets are held outside the banks, posing new and dangerous challenges.
The dramatic capitulation of long-term UK bonds was only halted by an emergency intervention by the Bank of England, the motivation of which was to bail out the nation’s pension funds.
Meanwhile, an overhaul of the bank risk-taking meant that their trading desks were constrained in their capacity to facilitate making markets in over-the-counter securities such as government and corporate bonds and loans. The quasi-crisis that led to the BoE intervention was also created by a sustained period of low-interest rates.As bond rates fell to zero and in some cases beyond, the risk they could not meet their future liabilities increased. So, they were lured into creative solutions such as Liability-Driven Investment products that hedged them against further falls in bond rates.
We’re also finding out how damaging a clogged-up bond market is – which sets the price of borrowing costs in the economy and asset valuations in financial markets, let alone the cost of financing government spending. Violent market moves created by liquidity squeezes create sudden negative feedback loops in a dis-intermediated system.
The vulnerabilities were being created by funds that had “liquidity mismatches , taking on risky derivative positions and “insufficient forward-looking margining practices.”
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