Analysis | The Bank of England Promotes Moral Hazard — Again.

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

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

Together, they reflect the evolution at the heart of the global financial order: No longer is the system based around banks; rather, it is increasingly centered around markets. It’s an important distinction, with wide-ranging implications.

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

But over the years, lenders ceded market share to a diverse roster of financial institutions. Twenty years ago, banks held 46% of global financial assets, according to data from the Financial Stability Board; that’s now down to 38%. In contrast, non-bank financial institutions – comprising insurance companies, pension funds and others – make up 48%, up from 41% in 2002. While the trend reversed briefly during the global financial crisis of 2008, it resumed its prior course at an accelerated rate shortly afterward.

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

The system has many merits, providing institutions ready access to financing and hedging solutions using the security of a safe, liquid asset. But it does have an unfortunate tendency towards pro-cyclicality: periods of market turbulence can drive sharply higher collateral requirements, which can prompt more turbulence if that leads to forced selling – such as we saw in the UK last week.

In the past, banks may have stepped in to manage the fallout, but due largely to tighter post-crisis rules on trading and capital, their balance sheets have been left very small relative to the size of collateral markets. In the UK, for example, the assets of UK government bond market makers have fallen by 25% since 2008 at the same time as the stock of UK government bonds outstanding has increased by 2.7 times.

So when the gilt market wobbled last week, there was no one left other than the Bank of England with the firepower to intervene.

Fortunately, the BOE had already laid the groundwork. In January 2021, its executive director for markets, Andrew Hauser, made a speech in London outlining a case for its role as “market maker of last resort.” Central banks had already broadened their focus from backstopping banks to backstopping markets. But given the shifting sands under the overall system, he warned that the pace may increase: “There is every reason to believe that, absent further action, we will see more frequent periods of dysfunction in the very markets increasingly relied on by households and firms.”

When it came, that dysfunction didn’t show up only in gilt markets but in energy markets, too, where greater volatility strained funding among participating companies. Here, the bank had a ready-made solution borrowed from its traditional playbook: Any energy company “in sound financial health” would be able to approach the bank as a lender of last resort.

All the features of Walter Bagehot’s famous dictum are evident in the scheme: The bank will lend freely, to sound institutions, against good collateral, at rates materially higher than those prevailing in normal conditions. The only difference is that banks won’t be the ultimate beneficiary of the funding (even though they may be used as conduits) – rather, it’ll be firms that “make a material contribution to the liquidity of UK energy markets.”

While central banks have adapted to the new reality of markets, other participants remain fixated by the old paradigm, where the vulnerability lies with intermediaries rather than markets themselves. The widening of Credit Suisse Group AG credit spreads and the plunge in its stock price aren’t great news for its investors, but they are unlikely to presage a “Lehman moment.” Similarly, the selloff in UK life insurance stocks when the UK government bond market sold off last week reflected their role as intermediaries. BlackRock Inc., one of the largest managers of pension funds under pressure, put out a press release reminding investors that “we are not a trading counterparty to these risk-mitigation strategies.”

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

In the event, even the ill-prepared benefited from central bank actions. If that’s the lesson others take away, it will have the effect of incentivizing risk not just in the UK, but everywhere.