Bank of England Governor Andrew Bailey has issued a stark warning about the "urgent need" to bolster resilience within the expansive network of financial firms operating beyond traditional banking boundaries. Speaking with notable concern, Bailey emphasised that while the financial sector demonstrates significantly greater robustness compared to pre-financial crisis levels, substantial risks persist within the realm of market-based finance.
Regulatory Vigilance Required
"Just because the banking system is in a far more resilient position now than in the past is no reason to rest on our laurels," Bailey wrote in a detailed article for The Banker publication. He elaborated that "there remains a particular and urgent need to increase resilience in market‑based finance globally given that the sector is very large and fast-growing."
The Governor highlighted the sector's inherently complex nature, describing it as "disparate in nature and opaque in important places, meaning that the international interlinkages are, perhaps unsurprisingly, complex and hard to observe." This opacity presents substantial challenges for regulators attempting to monitor systemic risks.
Understanding Market-Based Finance
Market-based finance encompasses a diverse array of financial entities including hedge funds, private credit firms, insurance providers, and pension funds. Since the 2008 financial crisis, this sector has experienced remarkable expansion as post-crisis regulatory measures inadvertently pushed riskier lending activities into less transparent financial channels.
According to recent data from the Financial Stability Board, non-bank financial institutions now represent a staggering 51 per cent of total global financial assets, underscoring their substantial influence within the international financial ecosystem.
Recent Crises Highlight Vulnerabilities
Regulatory concerns about market-based finance have intensified following several high-profile financial disruptions. The UK's bond market turmoil in September 2022 was significantly exacerbated by liability-driven investment strategies employed by pension funds. Meanwhile, last September witnessed the collapse of two US firms funded by private finance – First Brands and Tricolor – drawing renewed attention to the inherent risks within private credit markets.
The Bank of England's most recent financial stability report revealed that UK banks maintain exposure of approximately £173 billion to private market funds and corporates backed by financial sponsors, including private equity funds. This substantial exposure highlights the interconnectedness between traditional banking and non-bank financial entities.
Data Challenges and Regulatory Responses
A fundamental difficulty facing regulators involves obtaining accurate, comprehensive data about market-based finance activities. In response to this challenge, the Bank of England has initiated several major programmes designed to enhance understanding of this complex sector and its connections to the broader financial system.
Notably, the central bank launched a new system-wide exploratory scenario in 2023, with the initial examination concentrating on the gilt market. A second phase, introduced in December, focuses specifically on private markets, with particular emphasis on private credit arrangements.
Deputy Governor for Financial Stability Sarah Breeden emphasised the importance of these initiatives, stating during the test launch that "we need a robust understanding of how risks might flow through the financial system in a stress." This comprehensive approach reflects growing recognition that traditional regulatory frameworks require adaptation to address evolving financial market structures.
The Bank of England's warnings come amid increasing international scrutiny of non-bank financial intermediaries, with global regulators coordinating efforts to develop more effective oversight mechanisms for this rapidly expanding sector.
