Ideally, nobody would have to worry about the burgeoning and multifaceted realm of nonbank finance: Let hedge funds, securities dealers and the like take whatever risks they want, as long as they bear the full consequences. Yet time and again in recent years, concentrations of leverage — or borrowed money — have collided with unexpected events to wreak havoc, catching authorities off guard and sometimes requiring emergency measures to avert broader economic damage.
Unexpected events will keep happening, particularly in today’s chaotic geopolitical environment. Lest the next one trigger a systemic crisis, regulators need to get a better grip on leverage.
Leverage is the two-edged sword of finance. The ability to borrow multiples of their own capital empowers people to buy homes, businesses to invest, and banks and other intermediaries to profit by making it all go smoothly. But it also allows them to lose more money than they have. The more levered financial institutions are, the greater the risk that losses will cascade from one to another. Limits are crucial to ensure the system’s resilience.
In nonbank finance, the most common limit on leverage is the margin or haircut — funds that must be pledged to gain a given amount of exposure. It’s typically determined by brokers or central counterparties. A hedge fund might put up $20 to get $100 in exposure to stocks via derivatives (an initial margin of 20%), or $100 in US Treasury securities for a $99 overnight “repo” loan (a haircut of 1%). As prices move, it might face added collateral calls, requiring more cash on short notice.
This arrangement has some serious weaknesses, as the events of recent years illustrate. Brokers looking to maintain relationships might demand too little margin: That’s what happened with Archegos Capital Management, which precipitated more than $10 billion in losses for several banks when it imploded in 2021. Collateral calls can become overwhelming in volatile times, forcing mass selling and triggering further collateral demands in a vicious cycle. That’s what happened to US hedge funds in the Treasury market in 2020, and to UK pension funds and gilts in 2022 — requiring the countries’ central banks to provide emergency, taxpayer-backed funding to avert financial crises.
The resilience of nonbanks matters, given their growing role in the global economy. As of 2023, their assets amounted to an estimated $239 trillion, or more than 225% of global gross domestic product — compared with 178% for traditional banks.
