Britain to go it alone for now on reining in 'shadow banking'

Britain, rattled by the recent near meltdown of some pension funds, is pressing ahead to tighten oversight of the so-called shadow banking sector, taking the lead ahead of possible co-ordinated international action.

UK regulators could preempt recommendations by the G20's Financial Stability Board (FSB) to require permanently higher liquidity buffers for Liability Driven Investment (LDI) funds - used by UK defined benefit pension schemes - backed by regular stress tests, two sources said.

The Bank of England in September had to buy UK government bonds after the 1.6 trillion pound ($1.85 trillion) LDI sector struggled to come up with extra collateral to cover crashing bond prices.

It once again shone a spotlight on patchily regulated non-bank financial intermediaries such as investment funds, insurers and pension schemes, now totalling over $200 trillion globally.

The BoE last month called for "effective policy outcomes" from the FSB to improve resilience and remediate "structural vulnerabilities" in non-banks.

Britain hopes the LDI crisis creates momentum for comprehensive global reform to improve data and liquidity in the sector.

Mindful that higher buffers erode returns, regulators could, for example, allow more modest cash cushions for LDI funds with guaranteed access to extra cash within 48 hours, the sources added.

The FSB is due to publish a report on vulnerabilities in non-banks along with policy proposals on Nov. 10, but implementing them will take time given it would be up to each member country how to do this.

"I expect the FSB to come up with a summary of its analysis to date and a workplan to focus on less liquid funds," said Eric Pan, chief executive of the Investment Company Institute, a global funds industry body.

"The FSB has spent a disproportionate amount of time looking at money market and regulated open-end funds. Other types of non-bank financial intermediation activities have been overlooked," Pan said.

The BoE has studied non-banks closely since property funds were suspended following Britain's vote in favour of leaving the European Union in June 2016.

In March 2020 the global $7 trillion money market funds sector also struggled when economies went into COVID-19 lockdowns, forcing central banks to inject liquidity.

"There needs to be more attention to financial stability and macroprudential issues between authorities like the Bank of England, and the securities regulators who are responsible for those markets," BoE Deputy Governor Jon Cunliffe told lawmakers last month.

Sarah Breeden, BoE executive director for financial stability, will set out more of the Bank's thinking on Nov. 7.

In Britain the Financial Conduct Authority (FCA) regulates UK-based managers of LDI funds, and The Pensions Regulator (TPR) regulates pension schemes.

There are no liquidity rules for LDI funds in Britain, and the BoE said last month it would work with both regulators to ensure "strengthened standards are put in place".

Nikhil Rathi, chief executive of the FCA, said last week he also saw a need for "better regulator and risk reporting and oversight".

UK regulators could set formal "expectations" for asset managers and pension funds to maintain sufficient liquidity, while a panel of UK lawmakers investigates whether new rules are needed for LDI funds.

ONCE BITTEN?

The FSB is likely to be cautious about sweeping new rules after being bruised by its previous big attempt in 2015 to push through reforms for systemically-important funds - securities regulators scuppered the attempt to shoe-horn funds into banking-style norms.

ICI's Pan said central bank thinking has since evolved but they still have a tendency to ignore that banks play a role in the sector as well.

UK regulators face pushing ahead alone, for now, hoping global reforms eventually pressure others to follow suit.

Most LDI funds are listed in European Union states like Luxembourg and Ireland, meaning structural changes would rely on the bloc.

Luxembourg regulator CSSF said it was "actively engaged" with LDI managers. The Central Bank of Ireland said it has stepped up data collection, analysis and engagement with LDI funds.

"In practice, we are not at the point of international convergence on how to approach non-banks," said Nicolas Veron, senior fellow at the Peterson Institute for International Economics in Washington.

"What happened in the UK has rightly received attention, but it's not obvious there is a need for follow action at the international level," said Veron, also senior fellow at Bruegel think tank in Brussels.

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