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
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