The Bank of England launched its first system-wide stress test today of the financial sector as it attempts to shed light on the shadow banking sector.
Through the tests, the Bank of England hopes to better understand how, during a period of market stress, the behaviour of shadow banks could amplify financial shocks.
Shadow banks include a variety of financial institutions that provide similar services to banks but without equivalent regulation. They do not take deposits and instead generally relying on short-term funding.
Institutions like insurers, central counterparties and a wide variety of investment funds will be included in the Bank of England’s survey alongside traditional banks.
Shadow banks have played an increasingly important part in the financial sector since the financial crisis.
Globally, assets in shadow banking have increased to $68tn from about $30trn in the immediate aftermath of the financial crisis, representing 14 per cent of global assets.
As interest rates rise, many have suggested that more attention should be paid to the role they play in the economy and the risks they pose.
Recent events, such as the LDI blow-up following Liz Truss’s mini-budget and the ‘dash for cash’ at the beginning of the pandemic, have demonstrated how shadow banks can be prone to “sudden liquidity stresses” during periods of market volatility.
Deputy governor for financial stability, Jon Cunliffe, said: “We regularly run scenario exercises with a variety of firms which support our efforts to protect and enhance the stability of the UK financial system.
“The launch of this exercise will provide valuable insight into the system-wide dynamics for banks and non-banks following a severe but plausible stress to financial markets,” he said.
Participants in the survey will be asked to assess the impact of a “severe but plausible stress” to financial markets before considering how they would respond.
The Bank will then collate the responses to evaluate if collective actions across the sector might amplify the initial stress, for example if there is a fire-sale of certain assets as occurred in the LDI crisis.
“The exercise is not a test of the resilience of the individual firms participating,” the Bank added.
A final report on the findings is due to be published in 2024.