- `Detailed response' required to query on risks to gilts
- QE unwinding, higher rates, regulation may all impact market
Mark Carney and his officials must take a close look at the risks posed to the U.K. from a possible drought in bond-market liquidity and report back to Parliament, the chairman of its Treasury committee said.
Andrew Tyrie, a Conservative Party lawmaker, said on Sunday in a letter to the Bank of England governor that he would like a "detailed response" to his query on potential threats posed by a cocktail of future unwinding of stimulus, including quantitative easing, and the effects of rules imposed on banks.
“A combination of QE divestments, rising interest rates, and new regulation may leave the U.K. economy -- in the event of a shock to bond markets, possibly triggered by even a relatively modest rise in interest rates -- vulnerable to a vicious circle of declining liquidity and financial distress,” Tyrie said in a statement. “Regulatory action could inadvertently compromise, not bolster, financial stability.”
The BOE’s Financial Policy Committee has already identified market liquidity as one of the main risks threatening the U.K., highlighting the issue repeatedly in the panel’s most recent policy statement in September, and before that in its Financial Stability Report. In that half-yearly review in July, officials pledged a “regular deep analysis” starting with a look at investment and hedge funds.
Declining liquidity is investors’ number-one concern about Europe’s bond market, according to a study by consultancy firm Greenwich Associates LLC released on Nov. 12, while Bank of America Merrill Lynch analysts said in a report earlier this month that the the situation may get worse next year as more regulation hits the financial industry. Lower liquidity increases the risk of dramatic swings in bond prices as a lack of depth means they’re less capable of smoothly handling shocks.
“There are some reasons for concern that market liquidity may become stretched in the future -- in contrast with the ample liquidity conditions which have prevailed since the mid-1980s -- and that financial stability and the infrastructure of the gilt market might be threatened,” Tyrie said.
A BOE spokeswoman confirmed receipt of the letter and declined to comment further.
Tyrie’s first concern is on the effect of limits and rules imposed on financial institutions in the post-crisis era.
"The ability of banks to act as market-makers is now constrained by new restrictions on their proprietary trading, and by higher risk-weights applied to their trading positions," he wrote to Carney.
Credit Suisse Group AG withdrew from its role as U.K primary-dealer market last month, the first time a gilt primary dealer -- which buys sovereign debt directly from the government -- walked away since December 2011.
The combination of the BOE’s static retention of the gilts acquired through quantitative easing, liquidity rules requiring banks to hold the securities, and pension funds’ obligations to do so too, have also limited liquidity, Tyrie said.
A further concern derives from the threat posed by volatility as growth in the economy pushes down gilt prices.
“Liquidity is likely to decline in a falling market,” Tyrie said. “As a consequence, there may be large and sudden jumps in prices and yields.”
The committee chairman said he wanted to know how the BOE and other agencies, such as the U.K.’s Debt Management Office, are communicating with each other.
“I would also be grateful for a detailed explanation of arrangements for coordination of the Bank’s work on this with the DMO and the Treasury, as well as between the three policy making committees of the bank, given the different statutory objectives and overlapping memberships of each,” Tyrie said. “Among other things, it is important that respective responsibility for liquidity risk has been clearly identified.”