The Bank of England (BoE) published the results of its system-wide exploratory scenario (SWES) exercise, exploring how the UK financial system would respond to a market shock.
The shock was global, and modelling of the impact on firms and their actions was undertaken on this basis. BoE focused its market-level analysis on a set of financial markets that are core to UK financial stability: the gilt market, the gilt repo market, the sterling corporate bond market and associated derivatives markets.
Results showed that gilt repo market conditions tighten largely due to bank derisking and counterparty credit concerns, and some non-bank financial intermediaries (NBFIs) do not receive all the repo financing they expect. And, while the gilt market can largely absorb selling pressures, the sterling corporate bond market experiences a sudden jump to illiquidity due to the rapid speed of desired sales and limited bank market making capacity.
In the SWES firms are often not able to anticipate how their counterparties, investors, or markets they operate in behave in the stress, which could leave them underprepared in a real stress.
“Repo market resilience is central to supporting core markets in stress. During a market stress, banks are unlikely to provide all of the additional repo financing NBFIs ask for, despite their willingness to draw on central bank lending facilities,” according to the report.
Results also showed that central counterparties (CCPs) do not judge the scenario significantly changes the risks of their clearing members or counterparties. They do not undertake any extraordinary actions such as increasing haircuts on collateral received or changing how they invest receipts of initial margin (IM), continuing to lend a significant proportion of sterling collateral received via repo markets.
This is broadly consistent with behaviors in recent stresses. If increased counterparty risk were a concern, depositing receipts of IM in their reserves accounts at the Bank would be CCPs’ preferred alternative to lending in repo markets. Increases to CCP IM during the SWES scenario are relatively muted compared with recent stress episodes. NBFIs and banks overestimate the IM calls they will face in the SWES as they generally base these estimates on IM changes observed in historic stresses.
Members of the Alternative Investment Management Association (AIMA) were among the firms that took part in the SWES. AIMA CEO Jack Inglis said in a statement: “We commend the Bank of England for undertaking the Systemic Wide Exercise Scenario (SWES) as a market-wide initiative rather than focusing on specific subsectors. This approach ensures a more comprehensive understanding of the financial system’s resilience as well as areas of potential weakness. The collaborative, open and iterative nature of this exercise, with voluntary participation from institutions across the financial sector, underscores the industry’s collective commitment to strengthen risk management practices. We also note the encouraging findings regarding the resilience of hedge funds, which play a significant role in the UK financial ecosystem. We trust that the insights gained from this exercise will help foster a more robust and secure financial ecosystem.”
Other results showed:
- Firms’ collective actions amplify the initial shock. While non-bank resilience has increased in a number of sectors and firms over recent years, some of that resilience could deteriorate or change over time, risking greater amplification by the financial sector in the future.
- The SWES illustrates how actions taken by authorities and market participants following recent market shocks have improved gilt market resilience; but further work is required given the other vulnerabilities highlighted by this exercise.