The impetus for this request follows the bond market and sterling turmoil witnessed in September 2022, subsequent to Liz Truss’s mini-budget announcement. During this episode, pension funds faced considerable strain, with some teetering on the brink of collapse. The pronounced shift in bond prices and corresponding interest rates underscored the substantial risks associated with certain forms of liability-driven investing (LDI), particularly concerning retirement savings.
A diverse array of financial entities, encompassing major banks, asset managers, hedge funds, pension funds, and prominent insurers, has been tasked with modelling the potential impacts on their operations in the event of an unforeseen swing in bond prices. The results of these simulations are to be shared with the central bank by January.
The stress test encompasses abrupt and sustained fluctuations in the values of corporate bonds and sovereign debt, including UK government bonds (gilts). The Bank’s examination involves a 10-day scenario featuring a “shock to rates and risky asset prices.” This involves a confluence of factors, including a shift in UK government borrowing costs akin to the LDI crisis, a surge in global government debt prices matching the century’s most substantial rise, and an increase in corporate borrowing costs resembling the “dash for cash” observed in March 2020.
The hypothetical scenario, outlined by the Bank of England, combines individual shocks, substantial market movements in the initial three days of the exercise, and the sustained impact of the shock, rendering it more severe than historical episodes. This morning, the Euro made significant gains on the British Pound.
While the central bank refrained from specifying the precise triggers for such a severe shock, it equated the described situation to the outbreak of a major war. The scenario envisions a “sudden crystallisation of geopolitical tensions,” disrupting global economic expectations, dominating headlines, and sparking intense speculation about a financial sector meltdown on social media. Consequently, market participants initiate de-risking efforts, causing risky asset prices to plummet and volatility to surge.
The Bank of England has meticulously outlined the cascading effects of this imagined scenario on financial services. Noteworthy events include a potential sovereign credit rating downgrade for the UK by day 2, resulting in elevated government borrowing costs. By day 4, amidst ongoing negative news, a mid-sized hedge fund collapses. The scenario culminates on day 10, with expectations set for a recession surpassing the severity of the 2008 financial crisis.
In light of the growing influence of non-bank institutions such as asset managers and hedge funds, central banks have broadened their stress-testing scope beyond traditional banks. The Bank of England’s initiative to assess the impact of a pan-market shock on UK financial stability was initially disclosed in June.
Crucially, firms will not be individually targeted if vulnerabilities are exposed during the test. The central bank will only disseminate systemic findings that transcend individual institutions.
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