Why Central Banks Will Soon Lend to Hedge Funds

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Advisor Perspectives
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Hedge funds are in regulators’ sights again. Their risk-taking with borrowed money must be better monitored and will sometimes have to be limited, the head of a global group of supervisors told the Financial Times last week.

But it isn’t just hedge funds. The Financial Stability Board is reviewing the growth of leverage in markets so it can combat the risks posed by all non-bank money managers, according to the comments from Klaas Knot, the Dutch central bank chief who also chairs the FSB. Regulators want more disclosure of how much borrowing and leverage from derivatives exists and even to cap what some players can do.

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This seems a natural reaction to a string of crises, from the 2021 collapse of the hedge fund Archegos, which cost banks billions of dollars, to Britain’s pension-fund-driven government bond market blowup in 2022 and to the chaotic “dash for cash” at the start of the Covid-19 pandemic.

What’s going on here is bigger than a few episodes of market mayhem, however. This FSB review is part of a fundamental shift in central bankers’ view of financial markets. To see why, read the speech given last week by Andrew Hauser, the Bank of England’s executive director for markets, about “filling gaps in the … liquidity toolkit.”

Behind this unpromising subtitle is a radical plan: The BOE will become the permanent lender of last resort to investment funds in the way it has been to banks for hundreds of years. Initially, this support will be available only to insurers and pension funds, but it is exploring how it might bring in hedge funds and other asset managers in the future. There are many details to be ironed out but a necessary quid pro quo is stricter monitoring and regulation.

The UK plan goes further than the Federal Reserve’s Standing Repo facility, which allows it to lend to the shadow banking system, but through dealers. I think other central banks will follow the BOE. Why? Behind all the dry technical talk of systemic risks and liquidity shocks lies a very simple recognition. A run on financial markets causes the same lethal problem as a run on banks: It drastically restricts or cuts lending to the economy.

Hedge funds, dealers, mutual funds and so on collectively supply massive amounts of credit to industry and society. This role has only grown in size, importance and complexity since bank regulation was tightened after the 2008 crisis. The non-bank financial system has doubled in size and now accounts for half of all financial assets globally, according to the FSB. Hauser’s speech delivered a startling statistic: Almost all of the £400 billion ($488 billion) increase in net borrowing by UK businesses since the global financial crisis came from market sources rather than banks.

Read the full article here by Paul Davies of Bloomberg News – Advisor Perspectives

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