LASH risk and interest rates

Laura Alfaro (), Saleem Bahaj (), Robert Czech, Jonathon Hazell () and Ioana Neamțu ()
Additional contact information
Laura Alfaro: Harvard Business School
Saleem Bahaj: University College London
Jonathon Hazell: London School of Economics, Postal: Bank of England, Threadneedle Street, London, EC2R 8AH
Ioana Neamțu: Bank of England, Postal: Bank of England, Threadneedle Street, London, EC2R 8AH

No 1073, Bank of England working papers from Bank of England

Abstract: We introduce a framework to understand and quantify a form of liquidity risk that we dub Liquidity After Solvency Hedging or ‘LASH’ risk. Financial institutions take LASH risk when they hedge against losses, using strategies that lead to liquidity needs when the value of the hedge falls, even as solvency improves. We focus on LASH risk relating to interest rate movements. Our framework implies that institutions with longer duration liabilities than assets – eg pension funds and insurers – take more LASH risk as interest rates fall, because solvency concerns rise in a low rate environment. Using UK regulatory data from 2019–22 on the universe of sterling repo and swap transactions, we measure, in real time and at the institution level, LASH risk for the non‑bank sector. We find that at peak LASH risk, a 100 basis points increase in interest rates would have led to liquidity needs close to the cash holdings of the pension fund and insurance sector. Using a cross‑sectional identification strategy, we find that low interest rates caused increases in LASH risk. We then find that the pre‑crisis LASH risk of non‑banks predicts their bond sales during the September 2022 LDI crisis, contributing to the yield spike in the bond market.

Keywords: Liquidity; monetary policy; non‑bank financial intermediaries; hedging (search for similar items in EconPapers)
JEL-codes: E44 G10 G22 G23 (search for similar items in EconPapers)
Pages: 66 pages
Date: 2024-08-05
New Economics Papers: this item is included in nep-cba and nep-ifn
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Working Paper: LASH risk and Interest Rates (2024)
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Persistent link: https://EconPapers.repec.org/RePEc:boe:boeewp:1073

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