As announced in the December 2022 Financial Stability Report, the Bank of England (BoE) has launched its first system-wide exploratory scenario (SWES) exercise to improve understanding of the behaviours of banks and non-banks during stressed market conditions.

The exercise forms part of the Financial Policy Committee's (FPC's) medium-term objective to further improve risk identification in, and the functioning and resilience of, market-based finance (the system of equity and debt markets, non-bank financial institutions (NBFIs), and financial infrastructure).

Rationale behind the SWES

Market stresses in recent years have revealed the severe economic and financial stability impacts that can occur when intermediaries, investors and infrastructures fail to function properly. For example, material market dysfunction can lead to the tightening of credit conditions and reduced ability to provide finance to households and businesses, and poor secondary market liquidity in corporate bond markets can undermine new issuances by businesses looking to raise finance.
The BoE is also concerned about the speed at which liquidity conditions can deteriorate — as exemplified by the March 2020 'dash for cash' which revealed significant vulnerabilities in market-based finance.
The objectives of the SWES are to:
  1. Enhance understanding of the risks to and from NBFIs, and the behaviour of NBFIs and banks in stress, including what drives those behaviours; and
  2. Investigate how these behaviours and market dynamics can amplify shocks in markets and potentially pose risks to UK financial stability. 

The SWES 'markets of focus' will be the gilt market, gilt repo market, sterling corporate bond market and associated derivative markets (e.g. gilt and SONIA futures; and interest rate, cross-currency and inflation swaps).

The SWES will consider only system-wide dynamics and will not test the resilience of individual firms. The exercise is being conducted under the guidance of the FPC and the Prudential Regulation Committee (PRC), working closely with the FCA, The Pensions Regulator and other regulators. 

Which firms will be affected?

Participating firms have been selected to be representative of markets that are core to UK financial stability. The exercise will therefore include large banks, insurers, CCPs and a variety of funds (pension funds, hedge funds and funds managed by asset managers). The full list of participants will be published later in the year.

Timeline and scope

 The initial phase (launched on 19 June) will focus on information gathering from more than 40 participating firms to provide information to help in designing and executing an effective stress scenario. The stress scenario phase will be launched later in the year.

Throughout the exercise, firms will be asked to provide information which is relevant to three key transmission channels:

  1. Drivers of firms' liquidity under the market stress.
  2. Firms' actions in response to those liquidity needs, and the liquidity available to them.
  3. Additional actions to deleverage, reduce risk exposures or rebalance portfolios. 
Key Transmission Channels

The BoE expects to conclude the exercise and publish a report in 2024. The report will share system-wide (including sectoral) aggregated findings, their implications for the BoE's markets of focus and any conclusions for the BoE's assessment of risks to UK financial stability. No information relating to individual firms or commercially sensitive information will be published. Interim results will be shared via regular publications such as Financial Stability Reports.

How does the SWES fit into the stress-testing landscape?

The BoE has run banking and insurance-related stress tests for several years, including:

  • Annual stress tests for the largest banks and building societies — the Annual Cyclical Scenario (ACS).
  • Periodic biennial stress tests for specific life and non-life insurers — the Insurance Stress Test (IST).
  • Biennial exploratory scenarios (BES) — the focus of the BES changes from exercise to exercise, for example liquidity for major banks in 2019, climate in 2021 for major banks and insurers.

Supervisory stress tests for two of the three UK-authorised CCPs have been a more recent BoE initiative, starting in 2021. The EU is more experienced in this area, with ESMA recently launching its fifth CCP stress test, which includes 14 EU CCPs and two UK CCPs. In 2019, ESMA also carried out a stress simulation exercise of the EU fund sector and modelled how a shock affecting investment funds could impact on markets and investors. 

The SWES continues the trend of increasingly wide-reaching biennial exploratory scenarios — it is the first UK system-wide test and the first BoE-led stress test to capture buy-side market participants. This reflects the increasingly important role of NBFIs and concerns about potential spillovers to the wider financial sector and the real economy — concerns intensified in the wake of the March 2020 “dash for cash”, the subsequent focus on fund liquidity management (see our summary here) and the autumn 2022 LDI event (see our summary here).

The BoE has been considering cross-sector stress testing for some time. As far back as 2017, the BoE was considering how investment funds might impact corporate bond markets and the resilience of the financial system, and in 2019, it published a staff working paper on a system-wide stress simulation.

Implications for firms

This is an important exercise. Recent crises have shown clearly that there are interconnectivities across the UK financial services industry that can amplify market stresses and threaten market stability and confidence. Assessing the size and nature of these impacts is essential to deliver on the regulators' financial stability objectives and may, in turn, influence and inform future regulation.

Firms should therefore make every effort to engage with the exercise — the BoE has stressed that it will be taking a collaborative approach throughout the design and execution phases.

Notwithstanding the importance of the exercise at a system-wide level, there are likely to be resource implications for individual firms in contributing to the design of the test, sourcing and supplying the initial information requested, and then running the scenarios.

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