Citing the risks posed by the accumulation of leverage at hedge funds, broker-dealers, and other players in the so-called shadow banking sector, the Financial Stability Board (FSB) set out its recommendations for addressing these sorts of potentially systemic threats.
The global policy group has launched a consultation on its proposals that aim to help regulators, standards setters, and industry firms, monitor the vulnerabilities that can arise due to leverage among the shadow banks, to curb leverage that creates stability risks, and to mitigate these risks.
In its report, the FSB noted that leverage played a part in exacerbating several recent episodes of market stress, including the financial market reaction to the onset of the pandemic in 2020; the fallout from the failure of hedge fund Archegos Capital in 2021; and disruptions in the commodities markets and the U.K. Gilt market in 2022.
“Certain factors, which include interconnectedness, concentration and liquidity imbalances can amplify vulnerabilities related to leverage and accelerate and magnify disruptions that leverage can generate within the financial system,” it said. It added that shadow bank leverage “can create financial stability risks, particularly in financial markets that are at the core of the financial system and whose functioning is essential for the real economy.”
The fallout from the build-up of leverage can cascade through financial markets due to two main channels, the report noted — counterparty exposure, and the pressure to rapidly liquidate large trading positions due to margin or collateral calls, which can lead to asset sales that drive downward price spirals.
According to the report, most of the on-balance sheet financial leverage is attributable to broker-dealers, hedge funds, finance companies, and securitization vehicles, while synthetic leverage is generally concentrated in certain hedge funds.
“[Hedge funds] often employ substantial leverage to amplify returns, which can lead to rapid deleveraging during market stress, causing significant price movements and affecting liquidity in the underlying assets,” the FSB said.
Banks and broker-dealers that act as prime brokers have a central role in providing leverage to hedge funds, it noted. And large hedge funds often diversify their leverage across several prime brokers, which makes it difficult to track and manage total leverage positions.
“The failure of a major hedge fund could lead to substantial losses for prime brokers, which in turn could affect other financial institutions and markets,” it warned.
In a report, the FSB sets out nine policy recommendations that “call for authorities to address financial stability risks from [non-bank] leverage in core financial markets; ensure sufficient counterparty credit risk management by leverage providers; and determine whether and how to address any inconsistencies in regulatory treatment.”
The proposals are intended to work alongside other ongoing efforts to address systemic risks. These include the FSB’s recommendations on liquidity for margin and collateral calls during episodes of market-wide stress, the Basel Committee on Banking Supervision’s work on counterparty credit risk management, and the joint work to address margining practices that’s been undertaken by the Basel Committee, the Bank for International Settlements’ Committee on Payments and Market Infrastructures, and the International Organization of Securities Commissions (IOSCO).
The FSB’s proposals are out for comment until Feb. 25, 2025. A final report will be published in mid-2025, the group said.