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LASH risk and interest rates

Author

Listed:
  • Alfaro, Laura

    (Harvard Business School)

  • Bahaj, Saleem

    (University College London)

  • Czech, Robert

    (Bank of England)

  • Hazell, Jonathon

    (London School of Economics)

  • Neamțu, Ioana

    (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.

Suggested Citation

  • Alfaro, Laura & Bahaj, Saleem & Czech, Robert & Hazell, Jonathon & Neamțu, Ioana, 2024. "LASH risk and interest rates," Bank of England working papers 1073, Bank of England, revised 01 Apr 2025.
  • Handle: RePEc:boe:boeewp:1073
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    References listed on IDEAS

    as
    1. Gabriel Jiménez & Steven Ongena & José‐Luis Peydró & Jesús Saurina, 2014. "Hazardous Times for Monetary Policy: What Do Twenty‐Three Million Bank Loans Say About the Effects of Monetary Policy on Credit Risk‐Taking?," Econometrica, Econometric Society, vol. 82(2), pages 463-505, March.
    2. Ms. Ruo Chen & Esti Kemp, 2023. "Putting Out the NBFIRE: Lessons from the UK's Liability-Driven Investment (LDI) Crisis," IMF Working Papers 2023/210, International Monetary Fund.
    3. Yiming Ma & Kairong Xiao & Yao Zeng, 2022. "Mutual Fund Liquidity Transformation and Reverse Flight to Liquidity," The Review of Financial Studies, Society for Financial Studies, vol. 35(10), pages 4674-4711.
    4. Maximilian Konradt, 2023. "Do pension funds reach for yield? Evidence from a new database," IHEID Working Papers 01-2023, Economics Section, The Graduate Institute of International Studies.
    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    Liquidity; monetary policy; non‑bank financial intermediaries; hedging;
    All these keywords.

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G10 - Financial Economics - - General Financial Markets - - - General (includes Measurement and Data)
    • G22 - Financial Economics - - Financial Institutions and Services - - - Insurance; Insurance Companies; Actuarial Studies
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors

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