The Bank of England is racing to prevent future bond market crunches hitting mortgages and business lending, as interest rate rises put the economy under increasing strain.
Officials are kicking off a new stress test of swathes of the financial system, which will subject banks, pension funds and other institutions to a hypothetical global economic crunch to see how they withstand – or amplify – the pressure.
The Bank wants to better understand how institutions react at times of stress to prevent economic shocks in financial markets filtering through to the real economy.
It comes after recent market shocks provoked unexpected knock-on effects that forced the Bank to intervene and stabilise the situation.
At the start of the pandemic, uncertainty about what would happen prompted a “dash for cash” as investors sold assets to get hold of money. The dynamic sent bond prices plunging and interest rates soaring, forcing the Bank of England to intervene with a giant wave of quantitative easing to calm markets.
The Bank was once again forced to step in and buy bonds to calm markets last October after surging interest rates in the wake of Liz Truss’ mini-Budget prompted a fire sale of government bonds – known as gilts – by pension funds using liability-driven investment (LDI) strategies.
Threadneedle Street is scrambling to better understand the impact of economic pressure on the real economy as borrowing rates rise rapidly.
Government short-term borrowing costs climbed above 5pc for the first time since the financial crisis on Monday.
Mortgage rates have also been rising rapidly, with the average two-year fixed mortgage now more than 6pc 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 4.75pc.
The aim of the stress test is to study how a problem in a core market, such as gilts, can spiral out of control or spread from the City to the real economy.
The Bank said that “recent events have shown that market-based finance has been increasingly prone to sudden liquidity stresses during periods of market volatility”.
Sir Jon Cunliffe, a deputy Governor at the Bank, said: “We regularly run scenario exercises with a variety of firms which support our efforts to protect and enhance the stability of the UK financial system.
“The launch of this exercise will provide valuable insight into the system-wide dynamics for banks and non-banks following a severe but plausible stress to financial markets.”
The new “system-wide exploratory scenario (SWES) exercise” will first assess the risks facing financial institutions, then look at how a fictional global crunch could drain them of liquidity. It will identify how institutions would respond, then run another phase of the stress test to work out how those responses would interact. This process is expected to conclude next year.
The study will look at markets including gilts, corporate bonds and associated derivatives.
It could highlight potential risks such as the danger of fire sales taking place in particular markets, or funds that are particularly vulnerable to runs in a panic.
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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Source: https://finance.yahoo.com/news/bank-england-races-prevent-future-112601223.html