The Bank of England’s system-wide exploratory scenario exercise

Background and objectives

The Bank of England (the Bank) has today launched its first system-wide exploratory scenario (SWES) exercise. The SWES will improve our understanding of the behaviours of banks and non-bank financial institutions (NBFIs) during stressed financial market conditions, and how those behaviours might interact to amplify shocks in UK financial markets that are core to UK financial stability. We are working closely with the Financial Conduct Authority (FCA), The Pensions Regulator (TPR) and other regulators on this exercise.

The actions of a range of intermediaries, investors and infrastructures collectively determine how important financial markets function. When such markets core to UK financial stability fail to function properly, it can have severe economic impacts. Given market-based finance (MBF) plays an increasingly important role in financing the real economy, material market dysfunction can, for example, lead to a tightening of credit conditions and reduce the provision of finance to households and to businesses. For example, UK government bonds (‘gilts’) are a benchmark for other borrowing rates for households and businesses, while the pricing of fixed-rate mortgages is closely related to overnight index swap rates. And poor secondary market liquidity in corporate bond markets can undermine new issuances by businesses looking to raise finance.

In recent years, events in a number of global markets have illustrated how liquidity conditions can quickly deteriorate – underlining some of the vulnerabilities in MBF. Examples include the market volatility experienced in March 2020, when underlying vulnerabilities in the financial system contributed to an abrupt ‘dash for cash’ in major global markets.^{footnote [1]} At the time, liquidity conditions tightened even in core markets (such as government bond markets); this required interventions by the Bank and other authorities internationally, given it threatened to spill over to the wider economy and amplify the economic impact of the Covid pandemic. There have also been domestic instances of stressed market dynamics – for example, in September 2022, the Bank intervened to restore market functioning in the gilt market and to reduce the material risk of an excessive and sudden tightening of financing conditions for the real economy.^{footnote [2]}

In light of these events, we have requested that a group of banks and NBFIs who are active in UK financial markets participate in a collaborative SWES exercise to:

1. enhance understanding of the risks to and from NBFIs, and the behaviour of NBFIs and banks in stress, including what drives those behaviours; and
2. investigate how these behaviours and market dynamics can amplify shocks in markets and potentially pose risks to UK financial stability.

The SWES is the first exercise of its kind, and it offers a novel opportunity to better understand system-wide dynamics. The Bank will bring together data and information from various parts of the financial system to develop system-wide (and sector-specific) insights – thereby accounting for interactions and amplification effects within the financial system that individual financial institutions working alone cannot assess.

We expect the SWES to also provide useful information relevant to a number of other priority issues. For example, we anticipate improvements in both our and participating firms’ understanding of risk management within the financial system. We expect that the SWES will support UK authorities in their work to address vulnerabilities in MBF domestically, and internationally through the work led by the Financial Stability Board.^{footnote [3]}

The exercise is not a test of the resilience of the individual firms we have asked to participate. Its focus is system-wide, including on important UK financial markets and their resilience in times of stress.

The Bank is conducting this exploratory exercise under the guidance of the Financial Policy Committee (FPC)^{footnote [4]} and the Prudential Regulation Committee (PRC) working closely with and with the full support of the PRA, FCA and TPR; both Committees support this exercise and consider it an important contribution to understanding and addressing vulnerabilities in MBF.

Participating firms

Participating firms in this exercise include large banks, insurers, 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 UK financial markets.

We have worked with the FCA and TPR to select a sample set of firms which are representative of markets that are core to UK financial stability. This selection was based on their activity, business models and investment strategies to ensure diversity within this sample.

Please see Table A below for a list of participating firms. As we progress through the exercise, we will update this list if we identify that the exercise would benefit from additional participants to contribute further perspectives.

Table A: List of SWES participants

abrdn PLC	AHL Partners LLP	Aviva Investors
Aviva Life & Pensions UK Limited	Banco Santander S.A. (London Branch)	Barclays
Blackrock Group Limited	BNP Paribas (London branch)	Brevan Howard Asset Management LLP
BT Pension Scheme Trustees Limited	Capula Investment Management LLP	Citadel Advisors
Citibank, N.A. (London branch)	Citigroup Global Markets Limited	Columbia Threadneedle Investments
Deutsche Bank AG (London branch)	Goldman Sachs International	Greater Manchester Pension Fund
HSBC	HSBC Bank Pension Trust (UK) Limited	ICE Clear Europe Limited
Insight Investment Management (Global) Limited	J.P. Morgan Securities plc	JPMorgan Chase Bank, N.A. (London branch)
LCH Limited	Legal & General Assurance Society Limited	Legal & General Investment Management Limited
Lloyds Banking Group	Lloyds Banking Group Pensions Trustees Limited	LMR Partners LLP
M&G Investment Management Limited	Man Group Investments Limited	Mariner Investment (Europe) LLP
Merrill Lynch International	Millennium Capital Partners LLP	Morgan Stanley & Co. International plc
NatWest Group	Pension Insurance Corporation plc	PIMCO Europe Limited
Point72 Europe (London) LLP	Railways Pension Trustee Company Limited	RBC BlueBay Asset Management
Rokos Capital Management LLP	Rothesay Life plc	Royal London Asset Management Limited
Santander UK	Schroder Investment Management Limited	Scottish Widows Limited
Standard Chartered	The Pension Protection Fund	The People's Pension Trustee Limited
The Prudential Assurance Company Limited	Universities Superannuation Scheme Limited	Vanguard Asset Management Limited

Scope and design of the SWES exercise

The exercise will focus on how the actions of individual financial firms can interact to exacerbate shocks. For instance, if a common response to the scenario is to sell the same asset, then fire sale-type dynamics may occur which can only be fully understood by taking a system-wide perspective. We are also interested in the role that firms might play in stabilising markets in the event of a shock.

To inform our objectives, we will ask banks, insurers, funds and CCPs to evaluate the impact of a severe but plausible stress to global financial markets.

The stress scenario phase of the SWES will comprise of two rounds, enabling us to account for system-wide interactions and amplification effects. Banks, insurers and fund managers will first be asked to model the impact of the shock, and their intended actions in response to it.^{footnote [5]} Once these firms have told us how they would respond to the initial stress scenario, we will identify how that scenario may be affected by their collective actions. We will then ask how an updated scenario which takes into account any potential amplification effects might lead them to take different actions.

CCPs will also contribute by helping us understand the liquidity impact of the market stress scenario. This will focus on providing us with data on CCPs’ margin calls implied by the scenario.

Though we will seek to build a picture of how firms in general respond to stress, we will narrow the focus of our detailed analysis to the resulting impact on a specific set of important UK financial markets – the SWES ‘markets of focus’. Our SWES markets of focus are the gilt market, gilt repo market, sterling corporate bond market and associated derivative markets (eg, gilt and SONIA futures; and interest rate, cross-currency and inflation swaps).

Throughout the SWES exercise, we will ask firms to provide information which is relevant to three key transmission channels:

1. Drivers of firms’ liquidity needs under the market stress. For example, during the stress, investors might make redemptions from funds which would lead to a direct reduction in their liquidity. Firms may also be required to post additional collateral (either in response to falls in value of previously posted collateral, or in response to collateral calls due to the heightened risk environment).
2. Firms’ actions in response to those liquidity needs, and the liquidity available to them. Firms may need to sell assets or draw down on credit facilities to meet their liquidity needs. They may also utilise liquidity management tools, for example to manage costs associated with redemptions. We also intend to explore the willingness and ability of firms – particularly banks – to intermediate in our SWES markets of focus and the impact that this has on participants’ access to market liquidity in stress. There may additionally be practical limits to the speed at which liquidity can be mobilised and converted into the right form to meet demands; though we intend to focus primarily on the financial elements of these transmission mechanisms, we will additionally ask firms about operational considerations given the strains those could place on intermediaries’ ability to mobilise liquidity.
3. Additional actions taken to deleverage, reduce risk exposures, or rebalance portfolios. We will investigate both actions taken to respond to the elevated risk environment and those that reflect a reduction in risk appetite. For example, during the stress, firms may take steps to limit their exposures to certain counterparties or reduce or exit positions in certain markets. Firms may additionally have mandates or internal limits that prevent them holding certain types of instruments or that require them to maintain a certain balance between holdings; firms may look to maintain compliance with these during the stress.

Figure 1 below introduces the key transmission mechanisms we propose to investigate in more detail.

Figure 1: Key transmission channels

We plan to launch the stress scenario phase of the SWES exercise later this year. Prior to that, we have today launched an initial information gathering phase.

The objective of the information gathering phase is for participating firms to provide information to help in designing and executing an effective stress scenario. In particular we will look to understand how participating firms consider, model and manage risks associated with the transmission mechanisms in Figure 1. This reflects the fact that this exercise incorporates a wide array of firms with very different business models and exposures, and with different approaches to considering and managing risk.

We intend to conduct this exercise collaboratively. With respect to the design and execution of the exercise, we will seek feedback from firms on how to gather material for the scenario phase. We intend to engage with firms on their submissions, potentially digging into specific areas of interest to learn more or providing feedback based on our review and assessment, and firms will also have the opportunity to feed into the system-level analysis.

Results and publications

We anticipate publishing a Bank report to conclude the SWES exercise in 2024. This will share system-wide (including sectoral) aggregated findings, their implications for our SWES markets of focus, and any conclusions for our assessment of risks to UK financial stability. We also expect to publish interim results via standard Bank/FPC communication tools such as Financial Stability Reports. This is essential for sharing lessons learned more widely – including with other policymakers both domestically and internationally. Published materials will not provide information on individual firms or any commercially sensitive information.