The Bank of England will test so-called shadow banking institutions such as pension funds, that played a key role in recent UK bond market chaos, it said Tuesday.
The BoE was forced to buy UK debt in September in an emergency intervention to avert financial catastrophe, after a controversial tax-slashing budget by the government caused bond yields to soar and sparked panic.
The crisis, which sparked the downfall of former Conservative prime minister Liz Truss, threw the spotlight on non-banking financial institutions (NBFIs) and their risk to stability, the BoE noted Tuesday.
“There is a need to develop stress-testing approaches to understand better the resilience of NBFIs to shocks” and their links with commercial lenders and markets, it added in a report.
“The bank will run, for the first time, an exploratory scenario exercise focused on NBFI risks, to inform understanding of these risks and future policy approaches,” it revealed.
September’s turmoil, centred on the exposure of pension funds to UK debt market volatility, highlighted a “material risk” to stability, the BoE warned.
Some pension funds use Liability Driven Investments (LDIs), which are linked to financial derivatives and intended to help ensure that the income generated by the assets covers their long-term commitments.
However, the chaos caused the value of assets, notably government bonds, to tumble.
That forced pension funds to sell the bonds, known as gilts, to swiftly access liquidity, sending yields rocketing.
“The rapid and unprecedented increase in yields exposed vulnerabilities associated with LDI funds, in which many defined benefit pension schemes invest,” the BoE said.
“This led to a vicious spiral of collateral calls and forced gilt sales that risked leading to further market dysfunction, creating a material risk to UK financial stability.”
The BoE itself does not regulate LDIs, but wants pension fund watchdogs to ensure institutions have sufficient collateral in LDI funds to withstand further shocks.
Truss quit in October, replaced by Rishi Sunak and the new Conservative prime minister has reversed her unfunded budget that also sent the pound slumping to a record low against the dollar.
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