Amundi warns on hidden leverage in the financial system

Europe’s largest asset manager has warned that the tremors in the UK pensions market should be a “wake-up call” to investors and regulators about the dangers of hidden leverage in the financial system.

Vincent Mortier, chief investment officer at Amundi, which has €1.9tn in assets, said in an interview that the recent turmoil unleashed by the UK government’s “mini” Budget was “a reminder that shadow banking is a reality. I don’t believe that anyone before the crisis had any idea of the magnitude of this shadow banking in the pension fund industry.” 

Former chancellor Kwasi Kwarteng shocked markets with £45bn of unfunded tax cuts on September 23, driving up UK government bond yields and wreaking havoc on the country’s £1.4tn defined benefit pensions industry, which uses specialised hedging strategies to help schemes better match their assets and liabilities.

The strategies, known as liability-driven investing, have leverage embedded within them because they use a variety of derivatives that allow pension schemes to increase their exposure to gilts, without necessarily holding the bonds outright.

The drop in gilt prices led to a rush of margin calls as counterparties demanded more cash as collateral to keep the hedging arrangement in place. Funds were forced to sell assets, including gilts, to meet the calls, depressing prices further in a vicious circle that eventually led to an intervention from the Bank of England.

Reliable data on leverage within the UK pension fund market is hard to come by, but experts estimate that LDI leverage turned £500bn of underlying assets into £1.5tn of invested money.

“The amounts at stake were huge and it’s a further reminder of the depth of leverage in the system, which is in multiple places that are difficult to track,” said Mortier.

Increased capital requirements imposed on banks to make them safer following the financial crisis have moved risk off their balance sheets to less heavily regulated parts of the financial system, namely asset managers, insurance companies and pension funds. Investors have fuelled the shift by pouring money into alternative strategies such as private credit as they searched for yield in a low interest rate environment.

In 2000, non-banks held $51tn of financial assets, compared with banks’ $58tn, according to the Financial Stability Board. Its latest data showed non-banks hold $227tn in financial assets at the end of 2020, outstripping banks at $180tn. 

Mortier said that the shift in leverage from banks to non-banks made it very difficult for regulators to have a true picture of the risks.

“It’s much more difficult than in 2007, when leverage was predominantly in the banks,” he said. “The issue is that we don’t know exactly where it is. When you can’t measure something it’s difficult to act upon it.”

Mortier singled out several areas where hidden leverage might be a concern: over-the-counter derivatives, which are negotiated privately, away from exchanges; real estate, and parts of the private credit market including leveraged loans.

The BoE’s Financial Policy Committee recently warned of risks lurking in the US private credit markets. It noted that leveraged lending increased from about $2tn in 2017 to $3tn at the end of last year, and said that companies with such debt “were likely to be particularly vulnerable to the tightening in financial conditions and the weaker growth outlook”.

Mortier also highlighted collapsed family office Archegos Capital Management as an example of how leverage can build up under the radar. Archegos founder Bill Hwang borrowed billions of dollars from blue-chip banks to amass huge positions in US-listed companies. By using derivatives, where the bank it traded with bought or sold stocks on Archegos’s behalf, the firm left no visible footprint of its activity to the investing public.

Archegos’s collapse caused billions of dollars of losses for investment banks including Credit Suisse, UBS, Nomura and Morgan Stanley after it defaulted on margin calls, with more than $100bn wiped from the valuations of nearly a dozen companies as Archegos’s positions were unwound.