The Bank of England has asked more than 50 City institutions to model the impact of a sharp movement in bond prices caused by a severe geopolitical shock as part of its first financial system-wide stress test.
The request comes after the September 2022 crisis in bond markets and sterling that followed Liz Truss’s mini-budget, when pension funds came under pressure and some were driven to near-collapse. A sharp shift in bond prices and the corresponding interest rates, or yields, laid bare major risks that certain kinds of liability-driven investing (LDI) posed to retirement savings.
Big banks, asset managers, hedge funds, pension funds and major insurers have now been asked to model how their operations might be affected by an unexpected swing in bond prices, sharing the results with the central bank by January.
The test will include sudden but sustained shifts in the value of corporate bonds and sovereign debt, including government bonds known as UK gilts.
The Bank’s test includes a 10-day long “shock to rates and risky asset prices”. It combines a triple whammy of: a shift in UK government borrowing costs similar to that seen during the LDI crisis; a shift in other governments’ debt prices that would match the biggest rise seen this century; and an uptick in corporate borrowing costs similar to the “dash for cash” in March 2020.
“The combination of the individual shocks, the fact that most of the market moves take place in the first three days of the exercise, and the persistence of the shock, result in the hypothetical stressed scenario being more severe than those seen in historical episodes,” the central bank said.
While the Bank did not detail exactly what might trigger such a severe shock to financial markets, the description it offers is on a par with the outbreak of a major war.
The scenario described to financial institutions is a “sudden crystallisation of geopolitical tensions” that shatters expectations for global economic output, “dominates headlines” and feeds fevered speculation about a financial sector meltdown on social media. As a result, market participants “begin de-risking, risky asset prices fall, and volatility sharply increases”.
The central bank has offered a detailed outline of how the situation would spiral and impact financial services. Among other major shocks, by day 2 of the imagined scenario, the UK would be on notice of a potential downgrade to its sovereign credit rating, forcing up the cost of government borrowing. On day 4, amid persistent negative news, a mid-sized hedge fund collapses. By day 10, the last day of the scenario, expectations are set for a recession worse than that seen in 2008.
As the influence of non-bank institutions such as asset managers and hedge funds has grown, central banks have sought to branch out from just testing the resilience of traditional banks, the more obvious risk to financial stability after the 2008 global financial crisis.
The Bank of England first announced plans to gauge the impact of a pan-market shock on UK financial stability in June.
Firms will not be singled out if the test reveals that they have particular vulnerabilities. Instead, only systemic findings that cut across institutions will be shared by the central bank.