In a previous Insight, which can be found on our website 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 aim of the SWES exercise is to understand how the individual actions of these firms interact to potentially amplify shocks and the resulting impact on UK financial markets. Large banks as well as other types of market participants including insurance companies, clearing houses, pension funds, hedge funds and pooled investment funds were included in the exercise.
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 then plays out over 10 days.
Following firms’ submissions for Round 1 of the exercise, Round 2 was launched in June 2024. As part of Round 2, the BoE has fed back to participants its findings from Round 1 and asked them how their response to the SWES scenario would change based on these findings.
The findings/observations gathered in Round 1 are summarised below.
The SWES scenario led most NBFIs to report significant liquidity needs. However, the impacts varied significantly, with some participants likely to be forced to obtain further capital, while others expected a much more limited effect. Of those reporting liquidity needs, around 80% were due to variation margin calls, where participants would require investors to provide additional collateral due to a decline in value of the associated contract.
The NBFIs reported they would endeavour to use existing financial resources to meet most of their liquidity needs. In the first instance this would be by pledging assets, before then using MMF investments, existing cash balances, asset sales, and repurchase agreements (repo) for the remainder. Round 2 of the exercise will involve further testing of the assumptions used by some of the NBFIs to determine how different assumptions might impact the actions taken.
Banks reported they would continue as market makers in repos but would roll clients’ existing agreements on stricter terms. Banks would expect rollovers to still occur over the two-week horizon of the SWES but at shorter tenors and with higher haircuts (the difference between the initial market value of an asset and the purchase price paid for the asset at the start of the repo). However, most banks expressed little desire to extend existing repo limits. Round 2 will investigate the implications of these tighter repo market conditions.
Submissions from Round 1 suggested that in response to the large shock to credit spreads, NFBIs and some banks would aim to sell a large volume of corporate bonds, putting the market under significant pressure. Conversely, purchases of corporate bonds were expected to be limited, with banks showing a more limited desire to continue acting as market markers. Round 2 will look at how deterioration in bond markets relative to Round 1 could impact participants behaviour.
From the responses, there was not the suggestion of similar selling pressure in the gilt market, but these were based on certain assumptions, which will be explored further by the BoE in Round 2.
Participants will provide their responses to Round 2 in this quarter (Q3) of 2024 and the BoE intends to publish its final report later 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. We can also advise clients seeking to limit their exposures to financial institutions by sourcing lower risk alternatives.
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