Bank of England Will Stress Test Financial Markets

England’s central bank is planning on gauging the resiliency of non-bank financial markets.

As one of its most important protective functions, the Bank of England (BoE) runs various stress tests on the U.K.’s banking system to measure its resilience and inform policy measures intended to safeguard the U.K. economy.

Stress tests take the form of exploratory exercises that involve the U.K.’s largest banks. Their primary purpose is to ensure that banks have sufficient capital to survive a severe economic downturn without failing.

In its biannual financial stability report published on Tuesday (Dec. 13), the BoE announced that it will run a scenario exercise focused on risks to the economy associated with non-bank financial institutions for the first time. Further details will be set out in the first half of 2023, the BoE said.

As the report explains, tightening financing conditions and greater volatility, alongside a number of economic shocks, have exposed vulnerabilities in market-based finance.

Among those economic shocks, the BoE pointed to the late September market turmoil that dramatically drove up the cost of government borrowing. In turn, this created “a vicious spiral of collateral calls and forced gilt sales that risked leading to further market dysfunction, creating a material risk to U.K. financial stability,” the report said.

Of particular interest to the BoE are liability-driven investment (LDI) funds, to which many of the U.K.’s pension schemes are exposed. It was largely out of fear that pension funds would collapse that the bank was forced to intervene in September’s market meltdown.

“This episode demonstrated that levels of resilience across LDI funds to the speed and scale of moves in gilt yields were insufficient, and that buffers were too low and less usable in practice than expected,” the BoE report noted.

“There is a clear need for urgent and robust measures to fill regulatory and supervisory gaps to reduce risks to U.K. financial stability, and to improve governance and investor understanding,” it added.

To prevent a similar scenario from being repeated, the report called for new regulations to set minimum levels of resilience for LDI funds. It also refers to anticipated guidance that the pensions regulator is set to issue next year on the liquidity requirements of pension schemes.

Beyond pension schemes, the BoE’s report also highlighted challenges faced by small- to medium-sized businesses (SMBs) as their liquidity positions have fallen back in recent months. It said that total outstanding SMB debt has increased by around 20% since 2019, while the cost of new SMB bank debt has risen from 2.5% at the end of 2021 to 4.7%.

Just as pension schemes suffered from turmoil in the market for government debt, a concurrent devaluation in the pound hit small businesses, especially those operating across borders, which rely on predictable foreign exchange markets to forecast revenues.

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