What to expect from the new BoE system-wide stress test

The Bank of England (BoE) has launched its first system-wide exploratory scenario (SWES) exercise. The system-wide analysis would cover a broader range of organisations outside the banking industry, a few of which are insurers, asset managers and pension funds. BoE intends to use the exercise to gain a better understanding of the behaviors and interactions of banks and non-bank financial institutions (NBFIs) during stress. In this write-up, we provide an outline of the exercise complemented by our insights on what this exercise may mean for financial institutions and regulators alike.

Objectives

The BoE run exploratory exercises typically focus on testing system-wide resilience and NOT the resilience of the individual firms participating. The stated objectives of the exercise are to:

• Enhance understanding of the risks to and from NBFIs, and the behaviour of NBFIs and banks in stress, including what drives those behaviors; and
• Investigate how these behaviors and market dynamics can amplify shocks in markets and potentially pose risks to UK financial stability.

Participants

Participating firms include large banks, insurers, central counterparties (CCPs), and a variety of funds (including pension funds, hedge funds, and funds managed by asset managers). This reflects the wide range of institutions engaged in the UK financial markets.

BoE has published a list of 53 participating firms, which is much larger than the scope of previous exploratory exercises. As the exercise progresses, the BoE may include additional participants who could help in contributing further perspectives.

Markets of focus

Although the BoE will seek to assess how firms respond to the overall stress, their detailed analysis will focus on a specific set of important UK financial markets. These are gilt markets, gilt repo markets, sterling corporate bond markets and associated derivative markets (e.g. gilt and SONIA futures; and interest rate, cross-currency and inflation swaps).

Design

The exercise will comprise two rounds:

• Initial information-gathering phase (launched on 19 June) – Firms are asked to provide information to support the design and execution of the stress scenario. Particularly, the BoE will look to gather insights on the following (aligned with transmission mechanisms depicted in Figure 1 below) – i) drivers of firms’ liquidity needs under the market stress, ii) firms’ actions in response to those liquidity needs, and the liquidity available to them, iii) and the additional actions taken to deleverage, reduce risk exposures, or rebalance portfolios.
  
  
• Stress scenario run (scheduled for later this year) – Banks, insurers and fund managers will be asked to model the impact of the shock and their intended responses to it. The BoE will then identify how that same scenario could be affected by firms’ collective actions and responses. Thereafter, the participants will be asked how the updated scenario, which considers any potential amplification effects, might lead them to take different actions.

The key transmission mechanisms which will be investigated in more detail are shown below:

Figure 1

Source: Bank of England, The Bank of England’s system-wide exploratory scenario exercise, Link

Timelines

Deloitte insights

The SWES is collaborative. It appears the BoE is particularly interested in firms’ views and wants to work with them to design and execute the exercise. This reflects the novel nature of the risks being considered and the range of participants. Firms should use this as an opportunity to influence the shape of the exercise, to ensure they can meaningfully contribute to it and obtain relevant insights in return.

The SWES is likely to be as much about the qualitative as the quantitative. PreviousExploratoryexercises have, by nature, been more qualitatively focused than standard stress tests, with the BoE’s feedback and public communication highlighting weaknesses in “how” firms have responded and not just the financial impacts. The BoE is likely to assess how institutions have considered the risks posed by financial market stress ex ante (e.g. through stress testing), and how they manage them in practice. Therefore, firms should pay careful attention to areas like data, governance, risk management capabilities and considerations of linkages across different risk types.

The SWES is likely to focus on management actions. BoE run exploratory scenarios typically focus on how individual institutions’ reactions to the initial stress can impact the financial sector and potentially amplify the initial shock. Firms will be expected to consider what actions they would expect to take and how they would come up with those actions.

The SWES is an opportunity to take stock of recent stresses in liquidity conditions. Recent events, including the market volatility of March 2020 that resulted in a global ‘dash for cash’, the LDI crisis and market events in H1 2023 are likely to influence the objectives and design of the scenario. Firms should reflect on these recent experiences as they participate in the exercise. This will help them better explore the interlinkages between capital, interest rate risk, funding and liquidity under stress which is also under heightened regulatory focus in light of recent stress events.

We expect increased focus from firms to enhance their capabilities across technology, processes and controls to produce accurate liquidity stress outputs at higher frequencies (daily), underpinned by higher degree of automated processes and granular data (e.g. ISIN level for collateral on derivatives, secured financing and prime brokerage).

We anticipate enhanced collaboration between Treasury and front office teams for (a) increased visibility of available high-quality collateral and securities, and (b) assessing the ability of firms to perform monetisation testing (sell / repo of liquid asset buffer securities) under BAU and stressed market conditions. These activities will help define appropriate Management Actions particularly under the amplified stress scenario under SWES.

Consider results of SWES for potential updates to the firms’ business strategy and planning. SWES results could feed into firms' strategic and operational planning exercises and impact the firms' risk profile, risk appetite and broader risk management framework.

The risks of NBFIs is on agenda of other regulators (ECB) and standard-setters (FSB) alike. The risks being explored in the SWES and the SWES itself are therefore relevant for participants and non-participants alike. This highlights the need for firms across sectors to assess the adequacy of their risk management and wider stress testing capabilities to explore various credit, counterparty and liquidity risks, depending on the nature of their business model and exposures.