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The Bank of England has asked a group of 53 major financial institutions to model the impact of a sharp rise in sovereign and corporate bond yields, in an effort to understand how the market as a whole would react to a severe geopolitical shock.
The so-called system-wide exploratory scenario (SWES) comes after recent market stresses caused by the pandemic. It also follows last year’s “mini” Budget, set out by then UK prime minister Liz Truss, which led to a surge in gilt prices and sterling to plunge.
The BoE wants to understand how reactions at individual institutions affect markets and can amplify shocks to overall market stability. It introduced the test in addition to its normal bank stress-testing regime so it could explore the wider impact on asset managers, insurers, pension funds, exchanges and hedge funds.
The scenario the BoE has chosen includes a 115 basis point increase in gilt yields, a 130 basis point rise in investment-grade borrowing costs, and a 75 basis point rise in US Treasury yields.
The central bank on Friday said it was “a severe, but plausible, stress scenario” that was “faster, wider ranging, and more persistent than those seen in recent periods of market instability”, including the tumult in pensions in the wake of the “mini” Budget and the so-called dash for cash at the height of Covid.
“The SWES scenario comprises a sudden, sharp shock to global financial markets due to sudden crystallisation of geopolitical tensions,” the BoE said. “The shock is amplified by the financial sector, counterparty credit risk becomes elevated and eventually crystallises.”
The chosen scenario envisages that the majority of the market move would take place in the first three days after the initial shock, and a 10-day blow to rates and risky asset prices.
Institutions taking part in the test include Barclays, JPMorgan, Goldman Sachs, Aviva, Pimco and Man Group, although the BoE said the exercise would not assess the resilience of individual firms.
It will launch a second phase of the scenario after participants submit their responses in January and produce a final report on the exercise by the end of next year.
“The scenario reflects lessons learned from events such as last year’s pensions crisis and pandemic-related market stresses,” said Peter Rothwell, head of banking at advisory firm KPMG UK.
“The move to widen the scope of stress testing coincides with concerns that the next global financial crisis may stem not from actions within the financial sector, but from geopolitical events that shake market stability.”
Additional reporting by Akila Quinio in London