Bank of England to stress test risks in non-bank financial markets

In a global first the Bank of England will carry out a stress test of vulnerabilities in non-bank financial markets next year, after September’s implosion of UK pension funds exposed gaps in policymakers’ understanding of systemic risk in key markets.

The BoE announced the exercise in its latest financial stability update, in which it noted that while UK households were being “stretched” by rising interest rates and soaring inflation, they were not yet showing “widespread signs of financial difficulties” or an inability to repay loans.

The UK’s corporate sector and banks were both described as well positioned to withstand the country’s worsening economic outlook.

But the senior bank officials and external experts who make up the BoE’s Financial Policy Committee warned of risks in the non-banking financial sector.

The FPC said international regulators needed to “urgently . . . develop and implement appropriate policy responses” to tame risk stemming from non-bank financial institutions, whose share of the global financial services market has more than doubled since the 2007-08 financial crisis.

“We’ve had a whole series of non bank incidents across different jurisdictions and I think it is absolutely critical first of all that to recognise this is a sector that is highly internationally diversified (and needs global rules),” BoE governor Andrew Bailey told reporters. 

In the meantime, the BoE is planning a global first — a “deep dive into specific risks” into financial markets dominated by institutions such as hedge funds, mutual funds and pension funds so that policymakers can assess the scale of risks “and propose solutions”.

The tests will look at issues such as how a shock in one financial market can ripple through another, the dangers of highly concentrated risks and how behaviours evolve through a crisis, with further details to be revealed in the first half of 2023.

Those areas were noted as weak points in the BoE’s evaluation of the “lessons learned” from September’s liability-driven investment crisis, when a surge in UK government bond yields led to a rapid sale of gilts by pension funds in the wake of then prime minister Liz Truss’s poorly received “mini” Budget.

Other issues identified by the BoE include “deficiencies” in how banks, which were involved in LDI derivative trades, “monitor and manage risks” as well as “a lack of regular and granular data”.

The BoE ultimately had to step in with an £65bn bond-buying programme to stabilise UK government bond markets.

Unlike the annual banking stress tests the BoE has been running since 2014, the non-bank institution stress tests will not publish results of individual companies or funds, or order them to take actions, such as raising capital or withholding dividends.

Jon Cunliffe, deputy governor for financial stability, said that while the BoE did not have powers to supervise some non-banks, it could request such powers at a later stage and could make “pretty strong recommendations”.

The central bank is separately calling for more stringent oversight of LDIs in the wake of the turmoil that roiled gilt markets in September.

On Tuesday, it asked regulators in Ireland and Luxembourg that oversee most of the UK pension industry’s LDI funds, and The Pensions Regulator, which monitors the pension funds themselves, to set out a permanent safety net that funds should maintain to withstand shocks.

LDI funds have been ordered to temporarily increase those buffers, but have not been told what their medium-term requirements will be.

The FPC also stressed that the risks faced by UK consumers, corporates and banks were far lower than they were on the eve of the 2007/8 financial crisis. Even after absorbing mortgage increases due to rising interest rates, the share of households with high cost-of-living adjusted debt is expected to be just 2.4 per cent by the end of next year, versus a peak of 3 per cent before the financial crisis.

UK corporates’ debt to earnings ratios have also improved to 315 per cent versus 340 per cent during the pandemic, and 370 per cent before the 2007/08 crisis. Moreover, UK banks have significantly increased their capital as a result of post-crisis reforms.