The Bank of England is set to launch the first-ever stress test on financial institutions outside the banking sector after the recent turmoil in the mini-budget market saw some pension funds near collapse.
More needs to be done to ensure the non-banking financial sector is more resilient and does not pose a threat to UK financial stability, the Bank’s Financial Policy Committee (FPC) has said.
The Bank is already stress testing eight of the UK’s leading banks, such as Barclays, NatWest and Lloyds Banking Group, to see how well they can withstand economic shocks.
This involves placing them under hypothetical worst-case scenarios like high inflation, rising interest rates, high unemployment and economic decline, to see if they could still effectively support households and businesses. .
But until now, such a scenario has not existed for non-banks, such as pension funds, hedge funds, insurers and private equity lenders.
The FPC said the stress tests will be exploratory and consider potential scenarios that go beyond historical experience.
It comes after UK government debt yields hit historic highs in September after former Chancellor Kwasi Kwarteng’s disastrous mini-budget caused market chaos.
The Bank of England was forced to step in and buy around £19 billion worth of gilts to stabilize the market and prevent some pension funds from collapsing.
In particular, it exposed the instability of liability-driven investment (LDI) funds – the investment strategies at the center of the pension crisis, the FPC said.
It is important that these risks to financial stability are avoided in the future, he stressed.
Bank of England Governor Andrew Bailey said there had been a number of “incidents” in the sector which needed to be addressed, and the Bank needed to better understand the causes of these.
He said: “The post-financial crisis reforms were very, and rightly, focused on the banking sector.
“But we have now had a whole series of non-banking incidents in different jurisdictions, and I think it is absolutely essential to recognize that this is a very diverse sector internationally.
“LDI’s mutual funds, which were the main source of the challenge we had, are in almost all cases actually based outside of this country. So that underscores why it’s so important that we act.
Sir Jon Cunliffe, Deputy Governor for Financial Stability, underlined the exploratory nature of stress tests and the importance of having an overview of how banks and non-banks work together.
He added: “I think the things we’ve seen…have made people much more aware of how liquidity resilience in non-banking finance can cause systemic issues, and I think there’s much more willingness to solve these problems.
“But we will know by the end of next year what we have found.”