BOE Is Looking Beyond Banks for Stress

Updated on
  • Central bank releases research paper on investment funds
  • BOE paper simulates fund losses in corporate bond markets

The Bank of England took a step toward a comprehensive gauge of the financial system’s ability to withstand stress, releasing research that shows investment funds could contribute to bond markets seizing up under severe conditions.

While regulators around the world have run stress-tests of banks since the 2008 financial crisis, a senior BOE official said the principles behind such health checks should be applied more broadly, since banks account for only half of the U.K. financial system.

“The core principle behind bank stress testing -- the need to assess whether the system could respond to severe economic shocks in ways that make them worse -- needs to be applied to the wider financial system,” Alex Brazier, an executive director at the BOE, wrote in a financial stability paper published on Wednesday.

The BOE research paper found that, under a severe but plausible set of assumptions, investors’ redemptions from funds could lead to material increases in spreads in the corporate bond market and, “in the extreme, in corporate bond market dislocation, threatening the stability of financial markets and institutions.”

“Investor redemptions one third higher than those observed during the crisis could be sufficient for this to happen -- an unlikely, but not impossible, event,” Brazier said.

‘Challenging Situation’

The simulation is a “first step toward building a holistic system-wide stress simulation framework,” the paper states. At issue is whether funds, during stressed markets, would race to dump assets in a fire sale that could then ripple across the financial system and prompt furthers sales and falls in prices.

“The disruption of important markets can have direct effects on the supply of finance for companies and, by creating a more challenging situation for banks at the core of the financial system, affect banks’ ability to lend,” Brazier said.

The BOE paper reflects an ongoing global effort to bolster oversight of the asset-management industry, which has grown in size significantly since the 2008 financial crisis. While regulators have said there is little history of funds stoking broader market panic, the industry’s growth and its move into more complex and less liquid assets have caught regulators’ attention and raised questions about whether funds could feed crises.

Assets under management in the industry rose to $77 trillion in 2015 from $54 trillion a decade earlier, according to the Financial Stability Board, a panel of regulators from around the world. The FSB, joined by other regulators, has called for policies to ensure funds can sell assets easily to meet investors’ demands to pull out money during volatile markets.

Open-ended funds allowing daily withdrawals have grown rapidly in recent years, even as they increase their holdings in illiquid securities, and they now hold almost a fifth of sterling-denominated corporate bonds, according to Brazier. Corporate bonds have become harder to trade since the financial crisis as regulations have discouraged dealers from stepping into a selloff and taking debt onto their balance sheets.

The ability and willingness of dealers to make markets and the behavior of investors are factors the BOE has analyzed to show the sensitivity of the corporate bond market to redemptions.

BOE Governor Mark Carney, in his capacity as head of the FSB, said in a July 3 letter to leaders of the Group of 20 nations that the industry’s growth “is a fundamentally positive development,” but that certain types of funds have “grown particularly rapidly” and could pose a threat to the financial system.

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