In two previous Insights, which can be found on our website here and here, we outlined the Bank of England (BoE) was launching its first financial system-wide exploratory scenario (SWES) exercise to help improve its understanding of how both banks and non-bank financial institutions (NBFIs) would behave under severely stressed financial market conditions.
The SWES exercise aimed to understand how the individual actions of these firms might interact to potentially amplify shocks and the impact on UK financial markets. Large banks as well as other entities including insurance companies, clearing houses, pension funds, hedge funds and pooled investment funds were included in the exercise.
The SWES scenario, which plays out over 10 days, starts with a sudden and sharp surprise to financial markets due to a sudden geopolitical shock. This event then causes interest rates and asset prices to move sharply and the shock is then amplified by the financial sector alongside counterparty risk rising sharply.
The final report and findings from the exercise were published in November last year and provides six conclusions.
The first is that firms’ collective actions amplify the initial shock as some need to rapidly sell assets, recapitalise, or limit their activities as an intermediary. While the resilience of some non-bank entities, including insurers and MMFs, have improved over recent years, this could change over time and potentially risk greater amplification by the financial sector in the future as the current higher levels of resilience in some sectors is not required by regulation.
Second is that repo market resilience is key to supporting core markets in stress. During a market stress, banks, despite their willingness to draw on central bank lending facilities, were unlikely to provide all of the additional repo facilities NBFI’s request, tightening terms for maturing financing and potentially not rolling maturing repo facilities.
Third, the exercise illustrated how actions taken by authorities and market participants following recent market shocks have improved gilt market resilience. Following the SWES shock, buying and selling pressures on gilts were deemed to be broadly balanced. But. however, that additional gilt sales would likely limit banks willingness to buy, increasing the chances of further price falls.
Fourth, the sterling corporate bond market may ‘jump to illiquidity’ when stressed, as rapid selling pressures exceeded buying capacity and prices needed to decline rapidly for trades to clear. Some of these rapid selling pressures are expected to come from pension schemes as they need to meet their capital obligations to liability-driven funds seeking to rebuild regulatory capital buffers. This highlights the importance of the pension sector to UK financial stability.
Fifth, system-wide exercises have given valuable insights for financial stability authorities to understand how the resilience, behaviours and interconnectedness of financial firms leads to system-level vulnerabilities. The BoE alongside the Financial Conduct Authority will use the SWES as a framework for future system-side analysis and how to conduct market-wide surveillance.
The sixth conclusion is that system-wide exercises are seen as important for regulators, firms and markets. All authorities that worked on the exercise apparently support its analysis and conclusions. The exercise is also expected to be beneficial for international authorities considering a similar exercise.
The report highlights a number of next steps in order to build greater resilience and reduce market stress. These include a proposal to introduce a Prudential Regulation Authority liquidity reporting regime for insurers, an emphasis of the need for market participants to be aware of the risks of not being able to access repo facilities during times of market stress, and the importance of resilience at some NBFIs to help reduce negative feedback loops in gilt markets (and the connectedness of gilt markets to other markets).
Overall, the BoE expects that the conclusions of the report will help support UK authorities in their work to address the vulnerabilities in the market-based financial system, and to help improve its safety for all participants.
At Arlingclose, we use a range of tools to help our clients manage their credit exposures and risks, analysing and monitoring individual institutions as well as the financial system. We can also advise clients seeking to limit their exposures to financial institutions by sourcing lower risk alternatives.
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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