Readers will hopefully be familiar with the Bank of England’s stress testing of the largest UK banks and building societies. This is the annual ‘health check’ to determine whether these institutions have sufficient capital to withstand extreme market shocks while continuing to support the economy.
While these tests are focused on individual financial institutions, last year the Bank announced it was launching its first system-wide exploratory scenario (SWES) exercise to help improve its understanding of how both banks and non-bank financial institutions would behave under severely stressed financial market conditions.
For this exercise, as well as large banks, the scope includes other types of market participants including insurance companies, clearing houses, pension funds, hedge funds and pooled investment funds.
The SWES exercise is aimed at trying to understand how the individual actions of these firms interact to potentially amplify shocks and the resulting impact on UK financial markets.
The SWES scenario is based on a sudden and sharp surprise to financial markets following a significant geopolitical shock. This event causes rates and asset prices to move sharply. The shock is then amplified by the financial sector alongside counterparty risk rising sharply.
The scenario plays out over 10 days as detailed below.
On the first day there is a sharp deterioration in the economic outlook with risky asset prices falling and gilt yields rising (10-year gilt yields up by 45 basis points). Sovereign wealth funds become the main sellers of government debt and media coverage is dominated by the shock, leading to retail investors to start selling investments.
On day 2 the geopolitical event worsens, and asset prices continue to fall, with sovereign wealth funds continuing to sell government bonds, as well as some hedge funds as they attempt to de-risk their portfolios. Some sovereign jurisdictions as well as many financial institutions and corporates are placed on negative watch by credit rating agencies.
A sovereign wealth fund indicates it will continue selling government bonds on day 3 and counterparty credit worries continue to rise. Liquidity in markets, including the interbank market, is thin, causing gilt yields and repo rates to increase significantly. Continued falls in asset prices causes some forced selling from some of the distressed funds, heightening concerns of the creditworthiness of these funds.
On day 4 a non-SWES participant mid-sized hedge fund defaults and firms sell collateral in the market, pushing asset prices down even further. Extensive media coverage continues, and retail investors continue to sell investments.
From day 5-10 and onwards, the geopolitical situation remains uncertain and there are concerns it could lead to a downturn similar in severity to the global financial crisis. The asset price falls seen in previous days do not rebound and remain elevated in the following days and months. The sovereigns placed on negative watch on day 2, together with the financial institutions and corporates, are all downgraded at the same time. Further downgrades in the coming months are expected.
It is worth highlighting that the Bank has stated this is not its forecast of what may happen in the future, but a tool to allow it to assess the impact of hypothetical shock on a range of market participants. The SWES scenario does combine elements of the ‘dash for cash’ seen in March 2020 during the Covid pandemic and also the September/October 2022 LDI ‘crisis’, but the shocks tend to happen quicker, and are wider ranging and more persistent.
In terms of the timeline, In November last year, the Bank launched round 1 of the scenario phase whereby participating firms were asked to consider the impact of the scenario, how it would affect their business, and the actions they would take.
The Bank should have received these responses from the participant firms last month and will use these data to inform the second round of scenario testing, set to take place in the second quarter of this year. The Bank then plans to publish the final results by the end of this year.
At Arlingclose, we use a range of tools to help our clients manage their credit exposures, analysing and monitoring individual institutions as well as the financial system. If you would like to hear more about how we may be able to help you, please get in touch at info@arlingclose.com.
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