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More work is needed to tackle risks outside the banking sector, according to a Bank of England study which found that a market crisis would be amplified by fire sales of assets by pension funds, hedge funds and other investors.
The BoE said a sharp rise in sovereign and corporate bond yields caused by “a sudden crystallisation of geopolitical tensions” would cause “significant losses” for non-bank institutions — such as pensions funds, hedge funds and private equity firms — forcing many to sell assets and amplify the shock.
The exercise required a group of more than 50 City of London institutions to model how a period of intense stress would ripple through the increasingly important non-bank sector. It underlines how regulators are shifting their focus to the vulnerabilities in the financial system arising from outside the banking system.
The so-called system-wide exploratory scenario (SWES) — which included the theoretical default of a hedge fund — comes after several market upheavals following the pandemic and increased geopolitical turmoil.
Andrew Bailey, BoE governor, said on Friday that the “world-leading” exercise had “revealed several mismatches in expectations among market participants”, adding that it also “highlighted a number of remaining risks and vulnerabilities that will be important to address”.
The BoE said resilience was relatively high in some areas, including money market funds, insurers and liability-driven investment (LDI) funds in pension schemes, because of lower debt levels.
But it said non-banks could still cause “greater amplification” of future shocks. One concern is the risk of liquidity drying up in the repo market, in which financial groups can raise money against assets such as gilts. Another worry, according to the BoE, is that the corporate bond market could seize up due to heavy selling by investors.
The BoE also addressed rising concerns about the interconnectedness between private equity and life insurance. Large US buyout groups including Apollo Global Management and KKR have expanded into insurance since the financial crisis as the sector offers low cost and long term financing that private equity firms can use to boost their lending.
But regulators and policymakers have urged caution and warned that such firms could be more vulnerable to a credit downturn because they are leveraged and typically own a larger proportion of illiquid assets.
“Complexity and lack of transparency in these arrangements mean they have the potential to increase the fragility of parts of the global insurance sector and to pose systemic risks if the underlying vulnerabilities are not addressed,” the BoE said.
The findings were released alongside the results of the BoE’s latest stress test of banks, which showed they could comfortably withstand two crisis scenarios, as the central bank said it would shift to doing such tests every two years instead of annually.
The central bank said it would work with other regulators to use the results of its exercise looking at non-bank risk “as a framework for future system-wide analysis”. It also said that “greater transparency through improved data collection and disclosures could help to mitigate these risks”.
The scenario modelled in the exercise was more severe than the crisis triggered in 2022 after the then-UK prime minister Liz Truss’s “mini” Budget, which forced the BoE to intervene to contain surging gilt yields and a sharp fall in sterling.
Overall, the BoE said UK financial stability had increased, noting that long-term government bond yields had risen after the government’s Budget last month and the US election earlier this month, while stock market valuations had climbed.
“Valuations and risk premia are vulnerable to a sharp correction, particularly in the context of risks to global growth and inflation, and uncertainty about the future path of policy rates and long-term government bond yields,” it said.
But its latest banking stress test found the system was “well capitalised, maintains high levels of liquidity and asset quality remains strong”.
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