More UK finance regulatory failure

In previous blog posts here and here, I criticized UK financial regulators for missing simple leverage and margin requirements in UK pension funds. To be clear, I don't criticize the people. The point is, if after 10 years of intense regulation, a group of really smart and dedicated people can't see plain old leverage, the whole project of regulating risks is broken. And it's not just the UK. The Fed bailed out money market funds in 2020. Again. 

I insinuated the regulators were not paying attention. I was wrong. It turns out they were paying attention. Which makes the failure all the more stark.  

In Friday's Wall Street Journal, Greg Ip writes 

In 2018, the Bank of England investigated whether a big rise in interest rates would trigger a cascade of forced selling by bond investors, destabilizing the financial system. The answer was no, 

That they did think about it, and they missed it anyway is even more damning for the regulate-risks project. 

Part of the explanation: 

even if long-term rates rose a full percentage point in a week, which had never happened in records going back to 1990.

In the days surrounding the British government’s tax-cut announcement on Sept. 23, yields on British government bonds, called gilts, gyrated as much as 1.27 points in a single day 

This is part of the problem of regulation. Regulators test a single number, 1.00000 percent rise. But 1.27%? The world ends. Also it's fairly easy to make a strategy that is safe up to 1.0000 percent but blows up at 1.0001 percent. 

“The speed and scale of the moves in gilt yields was unprecedented,” the bank explained in a letter to Parliament. The refrain sounded familiar: the stock market crash of 1987, the near-failure of hedge fund Long-Term Capital Management in 1998, and the housing and mortgage crisis of 2007-09 were all precipitated by financial prices moving violently, by magnitudes outside historical experience. 

Isn't the point of regulation and stress testing to worry about "unprecedented" events? After all, one might trust markets to think about precedented events. And, as the rest of the paragraph points out, it does seem like we're getting 100 year floods every 2 or 3 years these days. 

The regulators even thought about derivatives and margin. Kudos. They just got the answer wrong. 

In its November, 2018 financial stability report, the Bank of England included a lengthy analysis of leverage at pension funds, hedge funds, insurance companies and other “nonbanks.” It was mostly concerned that margin calls could lead to forced sales of assets that the market couldn’t absorb without big price moves. It concluded any such selling would be small “as a proportion of the total demand on market liquidity,” even if rates rose a full percentage point in a single day or week, which “has never been experienced in 10-year sterling swap rates looking back to 1990. Even over a month, it would be a 1-in-1,000 event,” plenty of time for a relatively smooth adjustment, BOE wrote.

Is it cheeky to point out that climate risk to the financial system has never happened in 1000 years?  

In part thanks to those benign assumptions, the notional value of LDIs soared from £400 billion in 2011 to £1.6 trillion, equivalent to $1.7 trillion, last year, a staggering sum. This indirectly put downward pressure on long-term interest rates, making investors’ expectation of low rates partly self-fulfilling. But as high inflation sent rates higher this year, the opposite happened. LDI positions began to lose money. The jump in yields following the tax-cut announcement triggered widespread margin calls and forced liquidation of positions. A strategy that had once amplified downward pressure on rates is now doing the opposite.

When regulators bless risk taking, that absolves market participants of a lot of due diligence. Like the FDA approving a pill. So regulatory blindness can make matters even worse. 

Again, it's not the people, it's the system. Allowing massive leverage but trusting regulators to regulate risk is broken.  

*** 

A lesson in bond yields vs. bond prices for your MBA class. 

A colleague sends a great trio of graphs: 

This is the UK sovereign yield curve. Reading from the bottom, 28, 6, 2 months ago, and now. Looking at the long end, it rises from 1% to a bit over 3%. 3% long-term yields used to be considered very low. This is a disaster? Aha, at low yields, small rises in yield mean big declines in prices. Here are the prices: 

The price of indexed bonds has gone from 100 to 29!

The price of nominal bonds went from 400 to 100. 

from The Grumpy Economist https://ift.tt/3w9sdq1