The Bank of England (BofE) has announced plans to tackle systemic risks in market-based finance by developing a new facility to allow it to lend to insurance companies and pension funds (ICPFs), including newly-resilient liability driven (LDI) funds.

The tool, which will also require the support of market participants and regulators, will be designed to address dysfunction in core sterling markets in the exceptional circumstances where there is a threat to UK financial stability.

BofE executive director for markets, Andrew Hauser, announced the plans at a Market News International Connect Event, highlighting the move as the first step in a "journey of 1000 miles".

In his speech, Hauser noted that the use of so-called non-bank financial institutions (NBFIs), including ICPFs, has increased in recent decades, in turn increasing competition and innovation, driving cheaper, faster and more diverse financial services.

However, he clarified that “it’s not all one-way”, arguing that as their scale and range has grown, it’s become increasingly clear that NBFIs have the capacity to pose new forms of liquidity risks to financial stability, either directly or through their influence on core financial markets.

Whilst a comprehensive solution to these risks has proved “elusive”, Hauser admitted that the past three years have been a “serious wake-up call”.

"It is impossible to argue that market-based finance cannot threaten stability, after the strains that emerged in US repo markets in 2019, the 2020 ‘dash for cash’, the near-collapse of financial commodity market functioning in spring 2022, and the UK’s LDI fund crisis later that same year," he stated.

He also cited past experience in 2020, and again in 2022, when traditional central bank tools for lending to banks were not enough to stabilise the financial system as a whole, because banks did not (or could not) on-lend to NBFIs in sufficient size.

These experiences, according to Hauser, sparked “renewed urgency” for a Grand Bargain that couples heightened NBFI resilience with a set of more targeted, lower-risk central bank tools.

Given this, Hauser confirmed that the BofE is looking to build a "new generation of lending tools" to help underpin financial stability during periods of exceptional liquidity stress, channelling liquidity directly to resilient NBFIs when capacity constraints prevent banks from lending in sufficient size.

He stated: “Our end destination is clear – to build a new central bank backstop tool capable of lending directly to NBFIs against high quality assets to help tackle future episodes of severe dysfunction in core markets that threaten UK financial stability.

“The impetus for this work is real and pressing: NBFIs have introduced important new sources of systemic risk, and our current toolkit – though effective – is incomplete, with bank lending tools unable always to reach the source of the problem, and asset buy/sell tools posing financial and policy risks.

"But to reach our goal we must solve a series of daunting policy and operational questions. We have much to learn as we embark on this journey."

The first step in this journey, with immediate effect, will be the design of a facility allowing the BofE to lend to ICPFs – including newly-resilient LDI funds.

He continued: “We will need to work closely with ICPFs, and the relevant regulators, as we push forward with this project: to help test alternative answers to the policy questions I have set out; to innovate and lead on designing market solutions to the operational challenges; and to help ensure that what we end up with is in the collective interests of all public and private participants in core markets."

However, Hauser acknowledged that this approach leaves other key NBFIs central to the functioning of UK core markets outside the direct lending net, complicating the task of maintaining financial stability.

He therefore confirmed that, as a "second and parallel step", the bank will be reaching out to a broader set of NBFIs active in core sterling markets to explore how access might be expanded beyond ICPFs over time.

"Foremost amongst the challenges this work will need to confront are: (a) what other types of NBFI need to be included to maximise policy efficacy; (b) whether there may be ways to reach firms not subject to formal liquidity resilience requirements while still meeting the backstop principle, eg by varying the terms of access (including prices and haircuts) according to firms’ resilience levels and/or the efforts being made to reach resilience; and (c) how to address the scaling-up challenge," he added.

However, Hauser emphasised that "none of this can be done in isolation", arguing that whilst it is central banks’ job to protect the system against genuine threats to stability, it is firms’ job to protect themselves against a wide range of less severe shocks.

"We cannot afford to conflate the two," Hauser continued. "To reach our goal, we must undertake this journey together."

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