The UK’s central bank has introduced a wide range of measures to improve the resilience of non-bank financial institutions, including a new exploratory stress testing exercise for market-based finance, and warned against the use of derivatives for hedging or leverage purposes.
This week’s Financial Stability Report from the Bank of England, released on 12 July, warns of the dangers to both the banking and non-banking system of continued economic pressures: including rising interest rates, high inflation, a worsening economic outlook and geopolitical tensions. Since December 2021 the Bank of England has increased its base rate from 0.1% to 5% and it shows no sign of altering its hawkish policy.
While the recent string of bank failures, including Silicon Valley Bank in the US and Credit Suisse in Switzerland, have highlighted the pressures financial institutions are facing, the regulator reassured the market that there have been “no lasting effects from these global banking stresses” on UK banks. However, as interest rates continue to increase and with their future path uncertain, the Bank of England is now zeroing in on market-based finance (MBF) and the non-bank financing institutions (NBFI) that provide it, as a potentially weak point in the system – as highlighted by the gilts crisis last year.
“There remain vulnerabilities in market-based finance which could become more apparent as interest rates continue to increase,” confirmed the Bank. “For example, rapid changes in interest rates can lead to liquidity challenges for non-banks, as we saw in September 2022, when the impact of a shock in the liability-driven investment (LDI) sector led to further market dysfunction in UK government bonds.”
Cooperation
With situations such as these liable to push up the cost of borrowing, which can have a wider ripple effect, the Bank of England has highlighted an “urgent need” to increase resilience – an issue exacerbated by the fact that many of the institutions involved in market-based finance are not regulated under its own aegis, thus requiring cross-authority cooperation. Following the LDI crisis last year, the Bank’s Financial Policy Committee (FPC) made recommendations in March 2023 to increase the resilience of these funds to interest rates shocks, and multiple new guidance frameworks have since been published.
For example, the FPC recommended that The Pensions Regulator (TPR) take action as soon as possible to mitigate financial stability risks by specifying the minimum levels of resilience for the LDI funds and LDI mandates in which pension scheme trustees may invest. Since then, both the Financial Conduct Authority (FCA) and TPR have published detailed guidance on LDI resilience – guidance that appears to have been adopted, as the Bank of England notes that despite interest rates rising further in recent months, funds have in general maintained levels of resilience consistent with the minimum levels recommended by the FPC in March, and have initiated recapitalisation at higher levels of resilience than previously.
Stress tests
But resilience remains a concern – and as such, one of the key announcements this week was the launch by the Bank of England of a brand-new stress test, in partnership with the FCA, TRP and other regulators.
The system-wide exploratory scenario (SWES) test, the first of its kind in the UK, will seek to improve the regulator’s understanding of how banks and NBFIs behave during stressed financial market conditions, and how those behaviours might interact to amplify shocks and thus affect the UK’s overall financial stability. We are working closely with the Financial Conduct Authority (FCA), The Pensions Regulator (TPR) and other regulators on this exercise.
“In bringing together information from various parts of the financial system to develop system-wide (and sector-specific) insights, it will be able to account for interactions and amplification effects within and across the financial system that individual financial institutions working alone cannot assess. [We] support the SWES and considers it an important contribution to understanding and addressing vulnerabilities in market-based finance,” commented the FPC.
Derivatives warning
In the latest Financial Policy Summary and Record, also released on 12 July, the Bank of England additionally cautioned against the use of derivatives by NBFIs such as pension funds and insurance companies to hedge their interest rate exposure or to create leverage – both of which, it warned, could create “material liquidity risk” that must be managed.
“The risks from higher interest rates can also be amplified by NBFIs deleveraging and rebalancing their portfolios. The FPC will continue to develop its approach to monitoring such risks as the financial system adjusts to higher interest rates,” said the Bank.
“This report from the BofE highlights just how essential it is to get liquidity management right, especially when dealing with highly leveraged products,” said Joe Midmore, chief commercial officer at OpenGamma, speaking to BEST EXECUTION.
“If pension funds are committed to pursuing investing strategies linked to derivatives, they need to ensure that they can identify liquidity requirements in a timelier fashion. That way, they will be less likely in future periods of volatility to be forced into fire sales of assets in order to raise cash.”
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