Learning about Financial Markets with Systems Thinking

Why the financial crisis after the Mini-Budget needs some systems thinking

As Kwasi Kwarteng reverses his decision to abolish the 45p rate of income tax for anyone earning over £150k after only two weeks, the markets are perhaps understandably volatile. Where will this lead? How is the average non-economist to understand the situation?

UK bonds surged after the Bank of England said it would carry out temporary purchases of long-dated UK bonds and delay planned sales of debt. The response seemed at first sight to be a reversal of their current QT (Qualitative Tightening) monetary policy back to QE (Qualitative Easing) and simply a shifting of the deck chairs since the BoE is wholly owned by the UK Government.

Deeper examination exposes a much more complex system that requires better thinking about system behaviour.

In various articles, MMT economist Stephanie Kelton, historian Adam Tooze and former multi-asset fund manager Toby Nangle, have explained how overly complex financial instruments have created the chaos. The inevitable unintended consequences have exposed an unsuspected and dangerous trigger mechanism in the UK financial system – that of rapidly rising interest rates.

Hedging is a strategy designed to limit risks in financial assets. Last week pension funds that hold hedging bets against the possibility that interest rates will fall – so-called liability-driven investment strategies (LDI) – were called suddenly to find more capital. Pension funds have been holding around £1.5 trillion of assets which they hedged to match pension funds’ liabilities (future payments to pensioners).

According to Toby, the Pensions Regulator estimates that every 0.1 percentage point fall in UK gilt yields increases pension fund liabilities by £23.7bn. In the decade to December 2020, long-dated, 25-year gilt yields fell by more than 3.5 percentage points and so scheme liabilities increased by £960bn (about 40 per cent of GDP). Pension schemes can’t control wild swings in their liabilities. But using LDI they can invest their assets to reduce the effects. The funds hedge volatility by moving assets into bonds. Unfortunately, few pension schemes have the funds to do this. So instead, they invest a portion of their assets in liability-matching bonds and a portion in corporate credit, equities, and property. They then hedge the risks of that strategy with derivatives, with bonds as collateral. Derivatives are complex contracts that derive value from an underlying asset. The depend on price fluctuations of the asset in various ways depending on the contract. The pension funds hope that growth will deliver decent returns and make them fully funded while the derivatives will desensitize them to future interest rate swings. Historically the results have been good. However, pension funds became vulnerable to enormous quantities of leverage – the use of borrowed money.

That risk was starkly exposed when the trigger was pulled, and interest rates shot up. UK pension funds also invest in foreign bonds so as the pound sterling dropped, they faced margin calls on foreign exchange derivatives. A margin call occurs when a broker requires that you make a deposit into your investment account because your margin position—the amount you owe the brokerage firm—has become too large. Some commentators have seen similar vulnerabilities in the US market.

Why does this all show the need for systems thinking? The first and obvious reason is the need to be aware of and specifically look for unintended consequences within complex systems. It is difficult for any one individual to spot all that might emerge and ‘slap you in the face’ but that leads to the second reason -to expect and look for possible interdependencies. The third reason is the need for team working and good leadership. Teams can also suffer from groupthink – so the broader the mix of skills in the team and the more they are encouraged to question through critical discussion, the more they are like to spot potential problems. A tenet of systems thinking is that whilst it is sensible to mitigate risks, they can never be removed all together. So, a very close watching brief of unfolding processes is needed – especially when so much money is at stake. As the sociologist Barry Turner recognized in the 1960s situations like the one described do not just happen – they incubate or emerge from unknown or unexpected interdependencies.

The action by the BoE is akin to a superb cricketing catch at first slip. Financial systems are fortunate to have such a back stop – the BoE as a lender of last resort. People should note that had this been a physical engineering or medical system there would be no back stop to rescue the situation and lives as well as money would possibly be lost. I would suggest that those who design complex financial packages need to be more aware of, and actively look for, the unintended consequences of what they plan and the potential for harm to others.