(Bloomberg) -- The Bank of England warned that hedge funds, asset managers and pension providers could be “underprepared” in times of crisis, using the results of its review to push for international efforts to handle the growing risks in non-banking.
The BOE has spent over a year examining how banks and other market participants would respond to a “sudden, sharp, shock to global financial markets,” in the first global initiative of its kind.
It unveiled the results of the exercise — known as the System Wide Exploratory Scenario — on Friday and promised measures to mitigate risks, without spelling out any new policies in detail.
“It does rely on a very large amount of international coordination because of the nature of the risks and the nature of the sector we’re dealing with,” Governor Andrew Bailey said at a press conference. Regulators globally are seeing a “pushback on rule-making” that needs to be countered, he added.
The BOE highlighted issues in repo financing markets, where regulators vowed to carry out “further work” to increase resilience, and the sterling corporate bond market.
In repo markets, where hedge funds borrow tens of billions, the BOE said banks were “unlikely to provide all of the additional financing NBFIs ask for” and could “tighten terms for maturing financing” even when banks had ample capacity to lend and were themselves drawing on central bank facilities.
In the sterling corporate bond market, the BOE said there could be a “sudden jump to illiquidity due to the rapid speed of desired sales and limited bank market making capacity.” Such a development would reduce the gilt markets’ “effectiveness as a source of funding for the real economy.”
Overall, the BOE found that firms’ “collective actions amplify the initial shock” from the “sudden crystallisation of geopolitical tensions” which the firms were tested against.
“The value of the SWES is that it has shown us how stress in one market can cascade into stress in another, and we’re able to see that in peace time and do something about it before we find ourselves in that context,” Sarah Breeden, deputy governor for financial stability, said at the press conference.
The scenario featured two weeks of acute stress, with rates and risky asset prices moving sharply, counterparty credit risk soaring, and the default of a hedge fund that did not participate in the exercise.
The BOE said the exercise pointed to the need for “further work to increase repo market resilience” as well as better data collection and disclosure from pension funds, which The Pensions Regulator will “explore,” as well as investing further in the BOE’s own tools to monitor system-wide dynamics.
Market Dynamics
It also stressed the need for continuing monitoring of market dynamics, given that much of the resilience built up was held voluntarily by firms rather than required by regulators.
The BOE also published the outcome of its latest stress tests of UK lenders, which found that participants could continue to support lending during a severe but plausible crash.
The BOE has repeatedly warned about dangers from geopolitical events, higher interest rates and in private markets, including hedge funds’ bets on US Treasuries. In its October update, the bank’s Financial Policy Committee said overall stability risks were “broadly unchanged”.
Since then, the US has returned Donald Trump to the White House on a promise of tariffs and deregulation, turmoil in the Middle East has escalated, and Germany and France have both announced snap elections.
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On Friday, the BOE said global risks related to geopolitical tensions and global fragmentation remain material, while uncertainty and risks to the outlook increased. “We are living in a world that is, I’m afraid, more uncertain on a number of fronts with a number of very difficult events going on,” Bailey told reporters.
Just over 50 firms took part in the SWES exercise, including hedge funds Point72 Europe (London) LLP and Rokos Capital Management LLP, asset managers PIMCO Europe Limited, Blackrock Group Limited and abrdn Plc and pension funds including BT Pension Scheme Trustees Limited and The People’s Pension Trustee Limited.
The BOE’s efforts come as regulators across the world intensify efforts to better police activity in the “non-bank” corner of the financial sector, which now accounts for about half of all global financial assets.
The Financial Stability Board, the convening body for global watchdogs, is considering a deep dive into a handful of issues including hedge funds’ basis trade after their efforts to gather data on the entire system hit difficulties, Bloomberg reported earlier this month.
Repo Resilience
The BOE has been working to increase the resilience of the repo market, especially as liquidity is withdrawn from the financial system through quantitative tightening. Its Short-Term Repo facility, which allows banks to borrow cash by pledging gilts, has seen usage increase to over £40 billion each week.
It is also working on a separate repo facility that will be available to some NBFIs under stressed market scenarios.
The SWES was published alongside the BOE’s twice yearly Financial Stability Report, which warned that the threat posed by geopolitical tensions, fragmentation and sovereign debt levels remained “material.” But despite ‘’uncertainty around, and risks to the outlook,” having increased, risk premia were now at historically low levels, leaving asset valuations vulnerable to a sharp correction.
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The BOE also said that it was moving to stress testing banks every two years, rather than annually, a model already followed by the European Banking Authority for the EU’s exercises. The change “will ensure that the burden on participating banks is proportionate and supportive of the sector’s competitiveness and growth without compromising our assessment of the stability of the banking system,” Bailey said.
How hedge funds, pension funds and others responded to shock:
- The BOE said most hedge funds “take actions that are likely to be procyclical and so have the potential to amplify moves in market prices”
- Several reported that they had had breached their risk limits as the scenario evolved, prompting them to cut exposures. Others said they were cutting exposures “due to heightened levels of uncertainty”. Firms that follow a volatility targeting strategy also scaled back activity as the shock drove portfolio volatility higher
- Hedge funds with big positions in US Treasury cash futures would breach their internal limits and “a number” of firms said they would unwind positions in a way would trigger bigger mark to market losses than holding them
- The hedge funds that took part in the exercise are the market’s larger and more established players - they warned that other hedge funds might be “more vulnerable” to risks because of their investment approaches
- Dynamics in pension schemes’ LDI funds have “changed considerably” since their rapid selling of UK gilts triggered a market intervention in 2022, the BOE said, positioning them to better withstand shocks
- Open Ended Funds were found to suffer redemptions in the scenario, leading to asset sales which “can amplify price falls in some assets classes”. Both OEF and Money Market Fund managers noted “particular difficulty in assessing the likely scale of redemptions” during times of crisis.
--With assistance from Tom Rees and Irina Anghel.
(Updates with press conference comments throughout. A previous version corrected name of participating company in sixteenth paragraph.)
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