BoE Paper Examines Impact of Systemwide Stress on Market-Based Finance
BoE published a working paper that presents a model for assessing the behavior of market-based finance in UK under system-wide stress. The core of this model is a set of representative agents, which correspond to key sectors of the financial system in UK. These agents interact in asset, funding (repo), and derivatives markets and face a range of solvency and liquidity constraints on their behavior.
Market-based finance has been an increasingly important source of credit to the real economy since the financial crisis. The working paper describes characteristics of the market-based finance sector in UK, also presenting details of the assessment model, data used to parameterise the model, and results from the model. The model generates "tipping points" such that, if shocks are large, or if headroom relative to constraints is small, lower asset prices can cause solvency/liquidity constraints to bind, resulting in forced deleveraging and large endogenous illiquidity premia. The findings highlight the key role played by broker-dealers, commercial banks, investment funds, and life insurers in shaping these dynamics.
The model can generate an adverse feedback loop in which lower asset prices cause solvency/liquidity constraints to bind, leading intermediaries to pull funding, greater deleveraging, pushing asset prices lower still. This feedback loop has been illustrated via a stress scenario in which a deteriorating corporate sector outlook coincides with heightened redemptions from investment funds and tighter leverage limits at key intermediaries. This scenario highlights the potential interplay between solvency and liquidity constraints in shaping the response of asset prices in the model. The result notes that the reaction of a broker-dealers, which pulls significant reverse repo provision to "downstream" investors to meet its leverage limit, amplifies the shock substantially. Similarly, the behavior of the commercial bank intensifies the funding squeeze further. The results point to the solvency position of a life insurer as the key tipping point for the system. The authors of the paper suggest several avenues for future research. There may be value in using insights from this model to build summary indicators of the resilience of the system. One such indicator might involve keeping track of the stock of "unlevered" funding that might support market prices in an actual stress event.
Related Links
Keywords: Europe, UK, Banking, Insurance, Securities, Stress Testing, Market-Based Finance, Solvency and Liquidity Constraints, Repo, Systemic Risk, BoE
Featured Experts
María Cañamero
Skilled market researcher; growth strategist; successful go-to-market campaign developer
Emil Lopez
Credit risk modeling advisor; IFRS 9 researcher; data quality and risk reporting manager
James Partridge
Credit analytics expert helping clients understand, develop, and implement credit models for origination, monitoring, and regulatory reporting.
Previous Article
IASB Releases List of Planned Consultations for 2020Related Articles
BIS and Central Banks Experiment with GenAI to Assess Climate Risks
A recent report from the Bank for International Settlements (BIS) Innovation Hub details Project Gaia, a collaboration between the BIS Innovation Hub Eurosystem Center and certain central banks in Europe
Nearly 25% G-SIBs Commit to Adopting TNFD Nature-Related Disclosures
Nature-related risks are increasing in severity and frequency, affecting businesses, capital providers, financial systems, and economies.
Singapore to Mandate Climate Disclosures from FY2025
Singapore recently took a significant step toward turning climate ambition into action, with the introduction of mandatory climate-related disclosures for listed and large non-listed companies
SEC Finalizes Climate-Related Disclosures Rule
The U.S. Securities and Exchange Commission (SEC) has finalized the long-awaited rule that mandates climate-related disclosures for domestic and foreign publicly listed companies in the U.S.
EBA Proposes Standards Related to Standardized Credit Risk Approach
The European Banking Authority (EBA) has been taking significant steps toward implementing the Basel III framework and strengthening the regulatory framework for credit institutions in the EU
US Regulators Release Stress Test Scenarios for Banks
The U.S. regulators recently released baseline and severely adverse scenarios, along with other details, for stress testing the banks in 2024. The relevant U.S. banking regulators are the Federal Reserve Bank (FED), the Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency (OCC).
Asian Governments Aim for Interoperability in AI Governance Frameworks
The regulatory landscape for artificial intelligence (AI), including the generative kind, is evolving rapidly, with governments and regulators aiming to address the challenges and opportunities presented by this transformative technology.
EBA Proposes Operational Risk Standards Under Final Basel III Package
The European Union (EU) has been working on the final elements of Basel III standards, with endorsement of the Banking Package and the publication of the European Banking Authority (EBA) roadmap on Basel III implementation in December 2023.
EFRAG Proposes XBRL Taxonomy and Standard for Listed SMEs Under ESRS
The European Financial Reporting Advisory Group (EFRAG), which plays a crucial role in shaping corporate reporting standards in European Union (EU), is seeking comments, until May 21, 2024, on the Exposure Draft ESRS for listed SMEs.
ECB to Expand Climate Change Work in 2024-2025
Banking regulators worldwide are increasingly focusing on addressing, monitoring, and supervising the institutions' exposure to climate and environmental risks.
