When the Buffer Becomes a Transmission Channel

The subject is the same banking group that can preserve lending through an affiliated NBFI, but the focus now is what happens when one of the group’s bank–NBFI connections comes under stress. The useful judgment is not whether a link exists; it is whether a shock travels through collateral, ownership, risk transfer or funding, and whether a bank’s defensive response makes the wider problem worse. The Basel Committee’s four scenarios provide a way to follow those transitions without treating every crisis as the same event.

When protection accelerates the shock

The first scenario begins with stress at one or more NBFIs. The cause could be a loss on assets, a sudden repricing or a shortage of liquidity. Banks that face the troubled NBFI may respond rationally from the standpoint of their own balance sheet: raise margin requirements, demand more collateral, reduce credit lines or sell positions. Those actions lower the bank’s direct exposure, at least in principle. But they also make the NBFI’s liquidity problem more acute.

An NBFI that receives a larger margin call or loses bank funding may need to sell assets quickly. If several institutions hold the same assets, forced sales push prices down for everyone, including banks that hold similar positions or collateral. Lower prices produce new mark-to-market losses and additional margin calls. Other NBFIs and market participants then seek cash or sell assets, turning an attempt to contain one counterparty’s risk into a broader liquidity and market-volatility loop.

The sequence is important because it joins two kinds of exposure. The bank’s first concern may be counterparty credit risk: will the NBFI meet its obligation? The system’s next concern may be market liquidity: can the NBFI or bank sell an asset without depressing its price? Collateral can reduce the loss if a counterparty defaults, but a common collateral pool can also transmit the price decline. A hedge can offset one position, yet closing or selling the hedge during a stressed market can add to pressure elsewhere.

The September 2022 stress in UK liability-driven investment funds illustrates the mechanism. Banks were exposed to these funds through gilt repo borrowing and derivatives. As gilt prices moved sharply, banks issued margin calls. The funds’ effort to raise cash by selling gilts contributed to further market repricing. The case does not show that every margin call causes a systemic event. It shows why a bank’s protective action can be part of a feedback loop when many institutions need liquidity at the same time.

The early-2022 energy-market episode supplies a different starting point. A sharp increase in volatility raised margin requirements for commodity derivatives and created liquidity pressure for some traders. The asset class changed, but the mechanism was similar: a move in market prices increased the amount of cash needed to maintain positions, and the need for cash could spread beyond the original participants.

Archegos in early 2021 makes the link between derivatives and forced sales more concrete. After Archegos failed to meet margin calls, counterparties sought to reduce their exposures by selling securities used to hedge derivative positions. The Basel Committee cites roughly US$10 billion in losses spread among global investment banks with exposures to the firm. The event shows why a bank may not be able to exit a relationship quietly: several counterparties can sell similar securities in response to the same default, affecting market prices and one another’s positions.

Common credit exposures can activate a comparable loop outside derivatives. Banks and real-estate alternative investment funds can share exposure to commercial real estate.