Assessing the three largest finance crises in recent history, Ree Chen, David Chen and Susan Siew look at their common themes, and lessons to be drawn.
In July 2007, Chuck Prince, then CEO of Citigroup, told the Financial Times: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We are still dancing.” We, of course, know that the music stopped when the global financial crisis hit shortly after Prince gave his famous quote.
Since the implementation of Solvency II, much of the insurance and pension industries’ focus has been on capital adequacy. Liquidity risk management came into the spotlight following the impacts of the 2020 Covid market shock and September 2022’s mini-budget on pension funds. Here, we reflect on the three main financial and liquidity crises of recent UK history to draw key lessons for insurers and wider market participants. We have focused on the impact sustained by the UK market, although the lessons can be interpreted in a wider context.
Crisis 1: The global financial crisis of 2008
The 2008 global financial crisis was one of the worst in history and had a deep and lasting impact on the global economy. What began as a housing market shock unfolded to reveal that financial institutions had been engaging in excessive risk-taking behaviours for an extended period. This triggered:
- Issues in funding liquidity – the demand for liquidity spiked to meet immediate funding needs while supply was limited when lenders stockpiled liquidity
- Drying up of market liquidity – there were severe disruptions in the credit market at the height of the crisis, with elevated risk premia and squeezed access to credit
- Opaque liquidity risk exposure associated with collateral – liquidity risk was amplified by the use of complex assets such as mortgage-backed securities as collateral, as opacity in the valuation of the collateral assets further choked funding for financial institutions. As the quality of such structured assets deteriorated, banks and other financial institutions such as Northern Rock faced mounting liquidity pressure. Insurers that took material positions in credit default swaps, such as AIG, suffered significant margin calls
- Excessive use of leverage – the most memorable case was Lehman Brothers, whose bankruptcy could be attributed to high financial leverage (borrowing to invest in mortgage-backed securities) combined with a high debt-to-equity ratio on the balance sheet.
The UK government took swift measures to fund the banking sector, supporting banks such as the Royal Bank of Scotland (now a NatWest subsidiary), Lloyds Banking Group, Bradford & Bingley and Northern Rock. It launched programmes to enhance market liquidity, including the credit guarantee scheme to guarantee unsecured debts and the asset protection scheme to insure bank assets from losses.
Following the crisis, regulations have been tightened to increase banks’ resilience by introducing stronger capital and liquidity buffers. Banks around the world have increased their use of stress testing, and many have opted for more stable funding sources and adopted more prudent investment strategies. To reduce the opacity caused by extensive use of derivatives, reforms were implemented so that ‘standardised’ derivatives (such as interest rate swaps) are now centrally cleared, and over-the-counter derivatives must move towards a more prudent margining approach.
Crisis 2: The Covid crisis of spring 2020
The tighter regulations brought in after the 2008 financial crisis have helped to improve the banking system’s resilience. However, non-banking financial sectors were still exposed to the high volatility of the financial market and material asset price shifts in March 2020. This was exacerbated by a breakdown of perceived economic correlations, with the pound depreciating despite rising interest rates.
Institutional investors’ use of derivatives to hedge their market risk exposures led to materially increased liquidity pressure from margin calls. This was painful for a handful of insurance firms, which may have tried to align their liquidity risk management with capital management frameworks that had similar risk correlation assumptions and risk management horizons. While there was no headline news about failed institutions during the March 2020 crisis, the liquidity risk did manifest, and we consider it a near-miss for some non-banking financial institutions. It should serve as a warning for the industry.
The Prudential Regulation Authority had warned insurers of the risk in 2019; in its Supervisory Statement 5/19, it stated: “insurers should pay particular attention to the liquidity risks associated with material use of derivatives. While hedging programs may limit the impact of market shocks on an insurer’s capital position, they can also create liquidity needs, thus transforming capital risk into liquidity risk.” Such risk materialised in March 2020.
Since March 2020, we have seen more UK insurers turning to banks for alternative liquidity risk management solutions, including increased use of corporate Credit Support Annex arrangements to reduce margining pressure on cross-currency swaps, paired with income investments that are not fixed to the pound.
With hindsight we can see that many insurers and pension funds, including liability-driven investment (LDI) funds, could have reviewed their liquidity risk management practices after the March 2020 market volatility. This may have prepared LDI funds better for the mini-budget fiasco…
Crisis 3: The mini-budget crisis of September 2022
For years, pension schemes have adopted LDI strategies to improve their funding levels while managing volatility from market exposure. This is achieved via extensive usage of financial derivatives such as repurchase agreements (repos) or swaps. However, the other side of the coin is increased liquidity exposure from taking leveraged positions.
The mini-budget in September 2022, which featured unfunded public spending commitments, triggered rapid rises in gilt rates. When forced to meet margin calls from the gilts repo and interest rate swap positions, many LDI funds were forced to sell down gilts, creating a downward gilt price spiral, until the Bank of England intervened with a temporary asset purchase scheme. Following the crisis, the Bank committed to work with the Pensions Regulator and the Financial Conduct Authority to strengthen the standard and ensure LDI funds are better prepared for future stresses.
Lord Hollick, chair of the Industry and Regulators Committee, has said: “We are calling for regulators to introduce greater control and oversight of the use of borrowing in LDI strategies and for the government to assess whether the UK’s accounting standards are appropriate for the long-term investment strategies that are expected of pension schemes. This will help ensure that the turbulence that followed the September 2022 fiscal statement doesn’t happen again.”
Pension funds may also be encouraged to reassess their wider investment strategies and the appropriateness of using repos and derivatives, to ensure there is sufficient allocation to liquid assets such as cash, or to review the set-up of the funds – for example, in many cases, LDI pooled funds faced challenges in receiving liquidity from schemes in the timeframe allowed.
What conclusions can we draw?
There are significant differences between these crises’ trigger events. The financial crisis was driven by a lack of regulatory oversight or transparency in risk management, and was a slow-moving prolonged stress. The Covid crisis was caused by an event outside the financial system, but the financial industry fared reasonably well after the initial shock. The mini-budget crisis unfolded at speed, partly because market participants were so used to low interest rates. Policy changes were not a surprise to the market, but the timing and lack of communication could be blamed for the kneejerk reaction. This highlights government policies’ influence on the financial markets.
Risk management developments appear driven by regulation. An identifiable pattern would be: a crisis hits an industry or sector; lessons are learnt and understanding improved in the sector affected; this leads to regulatory change and better frameworks.
The banking sector has been ahead of other financial market participants in the liquidity risk management maturity cycle, followed by insurance firms. Pension schemes are lagging behind due to a relative lack of scrutiny. It is worth mentioning that the recent Silicon Valley Bank failure has highlighted the lack of regulatory attention and risk management around medium-sized financial firms.
The UK financial sector is far from self-reliant in terms of risk management. It still depends on timely and adequate regulatory intervention – a key dependency risk.
Liquidity risk featured strongly in all three crises, albeit over different time horizons and with different sectoral scopes. Both government intervention during a crisis and regulatory review afterwards are important in fostering systemic resilience and building public confidence.
At the time of writing, the Silicon Valley Bank crisis is still evolving. Its short-term impact on the US banking system and longer-term repercussions for global financial services remain uncertain. The trigger of the bank’s demise was remarkably like the one that finished Northern Rock: poor investment strategy, concentration risk and inadequate liquidity management, coupled with failures in internal risk governance and regulatory oversight, led to a collapse of public confidence in the banking system.
This is rippling to other banks with vulnerabilities – some as large as Credit Suisse. While central banks have acted to stabilise the market, there are questions around the moral hazard that such actions may signal. Fear of contagion has left the market wondering if the music has stopped again – and who will be left without a chair this time.
Ree Chen is an executive director at Gallagher Re
David Chen is head of market and capital risk at Just
Susan Siew is senior investment risk manager at Aviva