The Central Bank has warned firms in the Republic’s €4 trillion-plus international funds hub that they need to regularly stress test portfolios to make sure they are able to meet customer withdrawal requests and margin calls at a time of volatility in financial markets.
The bank said in its latest annual risk outlook report for the securities market that falling asset prices globally, amid rising interest rates and economic concerns, is affecting funds with high levels of borrowings in particular.
These often face calls by the lenders to post more collateral to support borrowings – in what are known as margin calls – resulting in forced sales of assets.
“At the outset of the war in Ukraine, derivative data collected by the Central Bank showed higher margin requirements for most fund types,” the report said, adding that this can have knock-on consequences between the nonbank sector and wider financial system.
“Investment funds can generate systemic risk via their collective actions, especially in periods of market stress.”
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While much of the stress early last year affected funds with exposure to energy and commodity financial contracts known as derivatives, a crisis in the UK pensions market last September and last week’s failure of Silicon Valley Bank underscored how increasing interest rates can give rise to shocks.
A UK tax giveaway budget under then prime minister Liz Truss last September prompted a spike in government borrowing, affecting defined pension benefit funds, which had so-called liability-driven investment (LDI) strategies that were propped up by hidden leverage.
While plain-vanilla LDI strategies use bonds – which generate predictable interest income – to match their payout liabilities, a raft of UK pension funds had used high levels of leveraged financial derivatives to increase their exposure to bonds they didn’t hold, resulting in margin calls as bond values dropped.
Silicon Valley Bank succumbed to a full-blown deposits run last week after the bank made a loss selling €19.7 billion ($21 billion) bonds to fund customer withdrawals. The SVB loss was due to the average market interest rate on the portfolio being less than half the prevailing 3.9 per cent rate on 10-year US government bonds. Bond values move in the opposite direction to bond yields.
The Central Bank said that there had been a net outflow of investor money in Irish-domiciled bonds – particularly so-called high-yield funds invested in risky companies – last year as investors weighed the effects of rising borrowing costs globally.
“Credit risk for funds is heightened in an environment characterised by increasing interest rates, weaker demand prospects and challenging financial conditions,” it said. “As financing costs go up, heavily indebted firms will have larger payments due, and therefore are more likely to default.”
It added: “Funds investing in corporate debt, in particular in the high yield sector, need to factor in this increased credit risk in their investment strategies and have appropriate risk management frameworks in place to identify, mitigate and manage the credit risks to which their portfolio is exposed.”