[8] The second vulnerability in the non-bank financial system relates to financial and synthetic leverage, which can amplify shocks and create spillover risks for banks. We saw an example of this with Archegos Capital Management, which defaulted on its losses from leveraged equity trades in March 2021. The fact that Archegos used total return swaps to generate synthetic exposures highlights another challenge in identifying leverage, as leverage can be embedded in derivative exposures. [9] While the Archegos default had only a limited impact on the broader financial system, the event nevertheless highlighted possible contagion channels to banks through the provision of synthetic leverage by prime brokers. The third vulnerability in the non-bank sector results from an insufficient preparedness to meet large demand for liquidity, especially from margin calls – as the recent stress episode in the UK pension fund sector has highlighted. In the United Kingdom, pension funds had made extensive use of leveraged strategies to hedge long-term interest rate risk and free up capital to generate higher returns in their investment portfolios. Many smaller pension funds had pooled their hedging activities in liability-driven investment (LDI) funds. But a sudden increase in UK government bond yields in September 2022 led to large valuation losses and margin calls, which meant these funds had to deleverage and raise additional cash from their pension fund trustees. As a result, pension and LDI funds were forced to sell assets, including gilts, which amplified gilt market movements and liquidity stress.

And in response, the Bank of England had to intervene on financial stability grounds through temporary purchases of long-dated UK government bonds. While these new risks and vulnerabilities are evident, the non-bank financial sector has remained largely stable in recent months, despite the stress in the banking sector that emerged in March. Fund investors shifted their exposure from higher to lower risk assets, especially from high-yield corporate to government bond funds. Portfolio de-risking has also been evident in insurance corporations and pension funds, as higher interest rates have reduced incentives for the non-bank financial sector to search for yield. But there are no grounds for complacency here. Structural vulnerabilities from liquidity mismatches and leverage remain elevated despite recent de-risking. Moreover, bank and non-bank financial institutions can be closely interconnected through funding channels, ownership linkages and common risk exposures. The non-bank financial sector remains particularly exposed to asset price corrections and credit risk should corporate sector fundamentals deteriorate substantially. In addition, non-banks’ exposure to property markets has increased markedly in recent years, rendering institutions vulnerable to ongoing price corrections in real estate markets. Fragile risk sentiment and elevated vulnerabilities in parts of the non-bank financial sector could amplify negative shocks. Strengthening the resilience of non-bank financial intermediation Given the vulnerabilities in the non-bank financial sector, it is vital to further enhance its resilience, also from a systemic perspective. To date, the macroprudential policy framework has mainly focused on the banking sector, while the policy framework for non-bank financial institutions still needs to be enhanced.