Britain’s next financial crash is coming. This time it won’t be the banks. (2024)

The Bank of England can already see the next financial crisis on the horizon. It doesn't have the power to stop it alone.

Bank chiefs fear Britain is badly exposed to another Liz Truss-style meltdown on the financial markets, triggered by uncertainty within a key sector which has grown increasingly important — and risk-exposed — over recent years.

Fears are focused upon the "nonbank financial intermediation" industry — a lengthy term covering any type of major investor which isn't a bank, such as hedge funds, pension funds, insurers or private equity.

Standard-setters globally have been battling to bring this poorly-understood sector under control — but with four dangerous "nonbank" events in as many years having come close to imploding the U.K. economy, plenty of policymakers believe Britain needs a more urgent approach.

The market turmoil that a major collapse within this sector could trigger is hardly an issue that respects borders, and warnings have already been issued by watchdogs in the EU, U.S. and further afield. But for Threadneedle Street, it’s a particularly pressing problem because British businesses now rely on financial markets and nonbanks for half their funding.

Any crunch or turmoil would therefore not only create problems in the City of London — it could have an immediate effect on thousands of people’s jobs.

The BoE doesn't want to wait for the next thing to go wrong. But it can’t go it alone, so it is pushing internationally for a global fix.

“The U.K. has been clearly pushing it because of the size of the NBFI [nonbank financial intermediation],” said an EU official, granted anonymity to speak freely.

The Bank hopes its own battle scars will create momentum for a global crackdown before the next episode of instability causes serious economic damage. It's embarked on its own journey to sort the issues but, without international cohesion, it may just be a constant game of whacking away the next emerging problem.

Mallet at the ready

The U.K. central bank has had a hard time of it recently. It notoriously had to bash problems at U.K. pension funds back down to size after former prime minister Truss’ mini-budget roiled government bond markets.

But it’s not the only time Threadneedle Street’s mallet has been at the ready.

There was the dash for cash at the start of the pandemic, the blowup of the Archegos hedge fund and turmoil in nickel markets after Russia’s invasion of Ukraine, which all threatened the stability of the financial system.

Each time, the City of London was particularly exposed.

In the U.K., and globally, nonbanks now account for half the financial system. While half of funding for U.K. businesses comes directly from financial markets and nonbanks, it's only 27 percent in the EU.

The worry is that since the 2008 global financial crisis this part of the financial system that sits outside of banks has absorbed all the risk. Comparatively, over the last 15 years, banks have been forced to become more resilient with reams of regulation since they shook the foundations of the global economy.

During the post-crisis decade of low interest rates, when oodles of money flowed around the system, nonbanks gorged on cheap debt to fuel returns for investors. Amid the changing economic backdrop of higher rates and tighter money, central bankers fear they are now vulnerable.

Lone wolf

Another major worry for the BoE is that it just doesn't really know much about who's overindulged on debt, and where exactly.

"Gaps in our knowledge have meant we are largely building resilience in market-based finance in response to crises, whereas we should be looking to build resilience ahead of vulnerabilities crystallizing," Sarah Breeden, deputy governor of the BoE, said at a February event at the central bank.

It's doing work on its own to find out more. Top BoE officials have recently warned of risks stashed in private equity and private credit — when investors buy or lend to companies away from public markets.

It will in June publish further details on the potential threat to stability from private equity, including how dominant the companies owned by the investment giants are in certain sectors of the U.K. economy and whether they are riskier than other businesses.

Nathanaël Benjamin, executive director at the BoE, in an April speech warned of “the growth in kinds and quantity of leverage, or ‘leverage on leverage’, throughout the ecosystem.”

Plus, the Bank is undertaking a stress test to probe how nonbanks would react to extreme potential stress in the markets — the first of its kind. Results are due later this year, which could prompt tougher rules

Solutions

But given the nonbank risks are inherently global, the U.K. central bank may be acting in vain. Really it needs the likes of the Financial Stability Board (FSB), a global watchdog, or its counterparts, to take immediate action.

That question of debt, and where it could blow up markets, is increasingly at the heart of the global reform agenda. It could mean a crackdown on how certain financial players use borrowing to juice returns — to stop the next explosion from reverberating globally.

“Excess leverage and illiquidity are typically at the heart of most failures, so you'd expect these to be areas of regulatory focus,” said Conor MacManus, director of financial services risk and regulation at PwC.

The FSB, through a group co-chaired by U.K. markets regulator Sarah Pritchard, will produce a consultation on leverage, where the aim will be to deal with the root of the problem, rather than just whenever it turns into a calamity.

That's not coming until December, though, and would be unlikely to turn into final policy for quite some time — not quite the urgency the Bank needs.

The BoE does have some allies in its push for action. The French central bank, in a presentation in Brussels in February seen by POLITICO, called for a broader approach at the FSB, and the EU will in May suggest some steps for a wider framework.

But, separately, a divide is emerging between central bankers and markets regulators on how far to go.

That split has tempered the extent of reforms in the past — and was on display again in the U.K. last week, as chief markets regulator Nikhil Rathi downplayed the BoE's concerns over private equity.

With a glacial pace emerging abroad, the last thing the central bank needs is opposition on its own turf.