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Britain’s shadow banking system is raising serious concerns after the storm in the bond market

Analysts are worried about a knock-on effect for Britain’s shadow banking sector in the event of a sudden rise in interest rates.

Photo by Richard Baker | In pictures | Getty Images

LONDON — After last week’s chaos in British bond markets following the government̵[ads1]7;s Sept. 23 “mini-budget,” analysts are sounding the alarm about the country’s shadow banking sector.

The Bank of England was forced to intervene in the long-term bond market after a sharp sell-off in British government bonds – known as “gilts” – threatened the country’s financial stability.

The panic was particularly focused on pension funds, which hold significant amounts of gilts, while a sudden rise in interest rate expectations also caused chaos in the mortgage market.

While the central bank’s intervention provided some fragile stability to the British pound and bond markets, analysts have flagged persistent stability risks in the country’s shadow banking sector – financial institutions that act as lenders or intermediaries outside the traditional banking sector.

Britain’s shadow banking system is raising serious concerns after the storm in the bond market

Former British Prime Minister Gordon Brown, whose administration introduced a bailout for British banks during the 2008 financial crisis, told BBC Radio on Wednesday that British regulators would need to tighten oversight of shadow banks.

“I fear that when inflation kicks in and interest rates go up, there will be a number of companies, a number of organizations that will be in serious trouble, so I don’t think this crisis is over because the pension funds were bailed out last week,” Brown said.

“I think there needs to be perpetual vigilance about what has happened to the so-called shadow banking sector, and I fear that there could be further crises.”

Global markets took heart in recent sessions from weaker economic data, which is seen as reducing the likelihood that central banks will be forced to tighten monetary policy more aggressively to curb soaring inflation.

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Edmund Harriss, chief investment officer at Guinness Global Investors, told CNBC on Wednesday that while inflation will be tempered by the slowdown in demand and the impact of higher interest rates on household incomes and purchasing power, the danger is a “painting and extension of weakened demand.”

The US Federal Reserve has reiterated that it will continue to raise interest rates until inflation is under control, and Harriss suggested that inflation prints of more than 0.2% would be viewed negatively by the central bank, leading to more aggressive monetary tightening.

Harriss suggested that sudden, unexpected changes in interest rates where leverage has built up in “darker corners of the market” during the previous period of ultra-low rates could reveal areas of “fundamental instability.”

“Going back to the pension fund issue in the UK, there was the requirement for the pension funds to meet long-term liabilities through their holdings of gold, to get the cash flows through, but ultra-low prices meant they weren’t getting the returns, and so they used swaps over the top — that’s the leverage to get this return,” he said.

“Financial institutions that are not banks, the problem is probably access to finance. If your business is built on short-term financing and one step back, the lending institutions have to tighten their belts, tighten credit terms and so on, and start moving towards a preservation of capital, so the people who are going to be starved are the ones who require the most short-term financing.”

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Harriss suggested that the UK is not there yet, as there is still plenty of liquidity in the system for now.

“Money will become more expensive, but it’s the availability of money that’s when you find a sort of crunch point,” he added.

The greater the debt held by non-banking institutions, such as hedge funds, insurance companies and pension funds, the higher the risk of a ripple effect through the financial system. The capital requirements for shadow banks are often set by the counterparties they trade with, rather than regulators, as is the case with traditional banks.

This means that when interest rates are low and there is an abundance of liquidity in the system, these collateral requirements are often set quite low, meaning that non-banks have to post significant collateral very suddenly when markets go south.

Pension funds triggered the Bank of England’s action last week, with some starting to receive margin calls due to the plunge in gold values. A margin call is a demand from brokers to increase the equity in an account when the value falls below the broker’s required amount.

Sean Corrigan, director of Cantillon Consulting, told CNBC on Friday that pension funds themselves were in fairly strong capital positions due to higher interest rates.

“They’re actually now ahead of funding on an actuarial basis for the first time in I think five or six years. They clearly had a margin problem, but who’s got thin margins?” he said.

“It’s the opposing parties who have passed it on and shuffled it around themselves. If there is a problem, we may not be looking at the right part of the building that is at risk of falling down.”

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