The Bank of England’s approach to financial stability focuses on the role the financial system plays in providing vital services to households and businesses. For this to happen, liquidity needs to flow to where it is needed most across the financial system so that financial institutions have the funding they need to operate effectively.
Non-bank financial institutions are playing a more significant role than in the past. NBFIs account for around half of assets in the financial system, both globally and in the UK. They play a key role in providing a range of financial services to households and businesses, operating both alongside, and in partnership with, banks. Their activities provide liquidity and depth in the gilt market which serves as the risk-free benchmark for a wide range of sterling-denominated debt, such as corporate bonds.
This has brought many positives, including cheaper and more diverse financial services to the real economy. But it has also come with the emergence of new types of risks emanating from the NBFI sector and therefore made it increasingly important to consider the liquidity needs of NBFIs – whereas traditionally the focus has been on the liquidity needs of banks.
These long-term structural changes are not new. But these different types of risks emerged against a backdrop of abundant liquidity, which dampened them somewhat. This may no longer be the case as the funding and liquidity environment has been changing over recent years.
The funding and liquidity environment has been changing over recent years
We are moving away from a post-2008 financial crisis monetary policy stance of very low interest rates and very large central bank balance sheets where central bank reserves are abundant. This is a significant change given the key role central bank reserves play in how liquidity flows through the system, as the safest and most liquid of financial assets and the ultimate means of settlement.
It’s not just banks who are affected. The change in funding and liquidity landscape has implications for the availability of liquidity for NBFIs as well. Banks play a significant role in the provision of liquidity to them, and banks’ own liquidity position is one factor affecting their willingness to on-lend liquidity to others (in addition to capital and counterparty risk considerations).
We need to think about the normalisation in the monetary policy environment and the shift in the provision of services from banks to non-banks together, not in isolation. The ‘new normal’ for funding and liquidity has to take account of the growing importance of market-based finance. Now more than ever, we need to consider the liquidity demands of NBFIs as well as banks given their significant role in the provision of vital services to households and businesses.
This has changed the nature of liquidity flows through the financial system and the types of liquidity risk we are most concerned about. The funding and liquidity landscape influences business decisions by NBFIs, including the level of leverage in the non-bank sector and the types of risks taken by NBFIs. So we need to think about how to support continued provision of financial services by NBFIs in normal times in a way that avoids unsustainable risk-taking and leverage, and that supports the financial system’s ability to self-manage increased liquidity demands and self-stabilise in severe but plausible stresses. To ensure the central bank needs to step in only in extreme scenarios, not more often.
Unlike banks, NBFIs are not able to hold central bank reserves. They do not have the power to create money (in the form of commercial deposits). And they do not have regular access to central bank facilities, reflecting the different role they play in the financial system. This poses a unique challenge in ensuring that liquidity flows to them as well as banks. And it means that banks will continue to play a major role in providing liquidity to them.
Key principles for the new funding and liquidity landscape
Our overarching goal is to deliver the Bank’s core statutory objectives of monetary and financial stability. But within that overarching goal, we can set out three objectives.
First, whatever frameworks we have in place, it is vital to maintain monetary control. Monetary control can be achieved under a range of different operating frameworks, although some frameworks may be more robust than others to account for unanticipated shifts in the demand for reserves.
Second, individual banks should maintain enough liquid assets, including reserves, to meet their own short-term stressed liquidity needs, taking into account their ability to liquidate these assets either with us or with the market. While this has always been important, management of liquidity risk prior to the 2008 financial crisis proved to be inadequate. Microprudential liquidity regulation and banks’ liquidity management practices have since improved substantially. And banks need to continue to adapt to changing liquidity risks, including the possibility of faster liquidity shocks in a digital world as highlighted by the experience of Silicon Valley Bank in March 2023.
And finally, it is important to supplement these monetary policy and microprudential aims with a macroprudential one. Namely that as well as ensuring that market rates remain close to Bank Rate, and that individual banks can withstand a liquidity stress, we seek to ensure that liquidity can flow around the financial system to get where it is needed most. By that, I mean that banks and other financial institutions are appropriately incentivised to lend to one another, including in stress, thereby achieving an effective degree of liquidity recycling across the whole ecosystem. While some impact on liquidity provision in a severe stress is inevitable, we want core liquidity markets to be resilient enough so that they help to absorb rather than amplify the initial stress.
Liquidity getting to where it is needed most
To meet these three objectives, we need to ensure that our decisions on the monetary operating framework and regulatory framework are coherent and tread a middle road. And we need to ensure that funding markets are liquid and resilient in both normal and stressed times, paying close attention to how our policy choices can affect this resilience. That means ensuring liquidity is cheap enough to allow sufficient market depth in normal times, but without encouraging a build-up of unsustainable leverage in the system which would unravel in a stress.
Primary responsibility for managing liquidity risks lies with financial institutions themselves, and this applies for both banks and NBFIs. When managing their liquidity needs, banks should take into account their ability to use our lending facilities regularly for routine liquidity management, which we encourage and welcome. We want to avoid any stigma around routine usage of these facilities in normal times, so that they can be more effective in stress.
That said, we also want to create a funding and liquidity environment which incentivises banks and NBFIs to participate actively in private sector funding markets, rather than hoarding liquidity excessively. We want to encourage the efficient distribution, or recycling, of liquidity across the financial system and to support the efficiency and depth of intermediation in core private sector funding markets.
The resilience of these core markets to stress remains crucial, as they underpin a wide set of transactions that ultimately support the provision of services to households and businesses. It is important that market participants, including NBFIs, maintain their own liquidity resilience so that these markets can self-stabilise in response to most shocks. The less efficiently private sector funding markets distribute liquidity in normal times, the less trained they are to cope with shocks, and therefore the more likely it is that central banks might have to step in.
Nathanaël Benjamin is Executive Director of Financial Stability Strategy at the Bank of England.
This is an abridged version of a speech given at an OMFIF-Bank of England lecture. Read the full speech here and watch the lecture here.
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