The Bank of England is racing to prevent future bond market crises from affecting mortgages and business lending as rising interest rates put the economy under increasing pressure.
Officials are launching a new stress test of whole swathes of the financial system, which will subject banks, pension funds and other institutions to a hypothetical global economic crisis to see how they resist – or amplify – the pressure.
The Bank wishes to better understand how institutions react in times of crisis to prevent economic shocks in financial markets from having repercussions on the real economy.
It comes after recent market shocks caused unexpected ripple effects that forced the Bank to step in and stabilize the situation.
At the start of the pandemic, uncertainty about what was to come caused a “race for cash” as investors sold assets to get their hands on cash. The momentum sent bond prices plummeting and interest rates skyrocketing, forcing the Bank of England to step in with a giant wave of quantitative easing to calm markets.
The Bank was again forced to step in and buy bonds to calm markets last October after soaring interest rates in the wake of Liz Truss’ mini-budget sparked a fire-selling of bonds bonds – known as gilts – by pension funds using liability-driven bonds. investment strategies (LDI).
Threadneedle Street is working to better understand the impact of economic pressure on the real economy as borrowing rates rise rapidly.
Government short-term borrowing costs rose above 5% for the first time since Monday’s financial crisis.
Mortgage rates have also risen rapidly, with the average two-year fixed mortgage now above 6% for the first time since December.
It comes as the Bank’s Monetary Policy Committee is expected to raise interest rates again on Thursday to 4.75%.
The purpose of the stress test is to study how a problem in a basic market, such as gilts, can get out of hand or spread from the City to the real economy.
The Bank said that “recent events have shown that market-based finance is increasingly subject to sudden liquidity strains during periods of market volatility.”
Sir Jon Cunliffe, Deputy Governor of the Bank, said: “We regularly hold scenario exercises with various businesses that support our efforts to protect and strengthen the stability of the UK financial system.
“The launch of this exercise will provide valuable insights into system-wide dynamics for banks and non-banks following severe but plausible stress in financial markets.”
The new “System-Wide Exploratory Scenario Exercise (SWES)” will first assess the risks facing financial institutions, then consider how a fictional global crisis could drain them of liquidity. It will identify how institutions would react, then run another phase of the stress test to determine how those responses would interact. This process should be completed next year.
The study will examine the markets, including gilts, corporate bonds and related derivatives.
This could highlight potential risks such as the danger of sell-offs in particular markets, or funds that are particularly vulnerable to panics.
The exercise is unlikely to stop future financial shocks. However, it could make it easier for banks, pension funds, asset managers and regulators to respond.
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