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.
Keywords: Europe, UK, Banking, Insurance, Securities, Stress Testing, Market-Based Finance, Solvency and Liquidity Constraints, Repo, Systemic Risk, BoE
ESAs published the final draft implementing technical standards on reporting of intra-group transactions and risk concentration of financial conglomerates subject to the supplementary supervision in EU.
EBA published the annual report on asset encumbrance of banks in EU.
FED updated the reporting form and instructions for the FR Y-9C report on consolidated financial statements for holding companies.
EBA issued a consultation paper on the guidelines on monitoring of the threshold and other procedural aspects of the establishment of intermediate EU parent undertakings, or IPUs, as laid down in the Capital Requirements Directive.
EC published Regulation 2021/25 that addresses amendments related to the financial reporting consequences of replacement of the existing interest rate benchmarks with alternative reference rates.
BIS published a bulletin, or a note, that examines the cyber threat landscape in the context of the pandemic and discusses policies to reduce risks to financial stability.
HM Treasury, also known as HMT, has updated the table containing the list of the equivalence decisions that came into effect in UK at the end of the transition period of its withdrawal from EU.
EBA published an erratum for technical package on phase 1 of the reporting framework 3.0.
APRA updated a frequently asked question (FAQ), for authorized deposit-taking institutions, on the measurement of credit risk weighted assets.
ECB published a letter from Andrea Enria, the Chair of the Supervisory Board of ECB, answering questions raised by the President of the Bundestag (the German federal parliament) on how ECB assesses the financial stability of the euro area in the context of the significant level of nonperforming loans.