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As the tide goes out on a long era of low interest rates, no one can confidently predict where the next wave of financial market turmoil will spring from. And that “expect the unexpected” territory raises uncomfortable questions about modern financial regulation.
One is how much responsibility do regulators bear for the fallout from truly exceptional events? Another is, if they do have at least some responsibility, should they be doing more to discharge that?
The recent turmoil in UK pension and bond markets does not bode well for what might lie ahead for markets and the financial system.
The saga that prompted an emergency intervention from the Bank of England began with what has been aptly described as “unprecedented” moves in gilt prices following former chancellor Kwasi Kwarteng’s disastrous “mini” Budget. The 30-year gilt yield swung by 1.6 percentage points over a few days, a move that has never been seen before.
As keen followers of the financial sector will know, stress testing is at the heart of the risk management culture that emerged after the financial crisis.
The usual idea is you imagine a doomsday scenario like a recession or a house price crash, and then look at how it would impact your banks, insurance companies or whatever else you want to stress. If it would leave them short of liquidity, capital, operational capacity or anything else, you, as the regulator, order them to fill the gap.
The tests have to be adverse, but also plausible. Setting the scenarios is more art than science but one thing is certain — whatever regulators come up with will singularly fail to expect the unexpected. Such as a never before seen swing in gilt prices.
The Bank of England, which has responsibility for the UK’s financial stability, did actually stress test the Liability Driven Investment strategies that were at the heart of the recent pension fund troubles, back in 2018. They tested them against adverse but plausible 0.25, 0.5 and 1 percentage point instantaneous increases in interest rates across all currencies and maturities. The actual move in gilts was bigger, and so, the system cracked.
More recent tests probably wouldn’t have helped. As deputy Bank of England governor Jon Cunliffe put it in a recent letter to the UK Treasury select committee: “The scale and speed of repricing leading up to Wednesday 28 September far exceeded historical moves, and therefore exceeded price moves that are likely to have been part of risk management practices or regulatory stress tests.”
Exceptional events, one, stress test, nil.
That definitional issue — that a stress test is only ever as robust as the stress it imagines — was just one of the weaknesses of the 2018 work. The LDI stress test also failed to imagine the kind of behaviours that a sharp fall in gilt market prices would drive, prompting fund managers to sell before the worst of the stress had happened. And it didn’t capture the operational issues that would exacerbate the situation, compounding the case for the BoE to step in as a circuit breaker.
The UK Pensions Regulator, the Bank of England and the Financial Conduct Authority are now all working with pension funds to make sure they have buffers that would allow them to cope with an even bigger shift in interest rates than the one we have just seen. But what if there’s an even bigger one than that?
Andreas Dombret, who was on the Bundesbank and ECB supervisory boards from 2010 to 2018, says to really insulate a system against future risks, “you have to do a lot of creative thinking . . . you need to think the unthinkable”. That is precisely what the modern approach to stress testing doesn’t allow regulators to do.
An official at a eurozone central bank agrees that there’s “a lot to be said about the limits of modelling”. The alternatives are still a work in progress.
Regulators are scoping out ways to enhance stress testing so they can better prepare for “Black Swan” events such as the UK’s recent fiscal adventures. That demands a new way of thinking of the world and its risks. It also requires better data on key aspects of how money market funds, hedge funds and others in the broadly defined “shadow banking” world do their business.
The early fruits of their efforts will emerge in the coming months. History will ultimately judge whether they are sufficient.
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