The Bank of England has issued a significant warning regarding the preparedness of hedge funds, asset managers, and pension providers in times of crisis. In a comprehensive review, the BOE has emphasized the need for international efforts to handle the growing risks in non-banking sectors. This comes as part of the first global initiative of its kind, spending over a year examining how banks and other market participants would respond to a sudden, sharp shock to global financial markets.

Highlighting Key Areas of Concern

The BOE has highlighted several issues in key markets. In repo financing markets, where hedge funds borrow billions, banks are unlikely to provide all the additional financing needed by non-bank financial institutions (NBFIs). Even when banks have ample lending capacity and are using central bank facilities themselves, they may tighten terms for maturing financing. In the sterling corporate bond market, there is a risk of a sudden jump to illiquidity due to the rapid speed of desired sales and limited bank market making capacity. This could reduce the effectiveness of the gilt markets as a source of funding for the real economy.

Repo Market Resilience

The BOE is working to increase the resilience of the repo market, especially as liquidity is withdrawn through quantitative tightening. Its Short-Term Repo facility, which allows banks to borrow cash by pledging gilts, has seen increased usage to over £40 billion each week. It is also developing a separate repo facility for some NBFIs in stressed market scenarios. The SWES exercise has pointed to the need for further work in this area to ensure market stability.

Market Dynamics and Stress Testing

The BOE emphasizes the need for continuous monitoring of market dynamics as much of the resilience built up is voluntary rather than mandated by regulators. It has published the outcome of its latest stress tests of UK lenders, showing that they can continue to support lending during a severe but plausible crash. The BOE has also moved to stress test banks every two years instead of annually, following a model used by the European Banking Authority. This change aims to balance the burden on participating banks with the assessment of banking system stability.

How Different Players Responded to Shock

Most hedge funds take actions that are likely to be procyclical, potentially amplifying market price moves. Some have breached risk limits as the scenario evolved and have cut exposures due to heightened uncertainty. Hedge funds with large positions in US Treasury cash futures may face challenges and trigger bigger mark-to-market losses. The larger and more established hedge funds have warned that other funds might be more vulnerable due to their investment approaches. In pension schemes, the dynamics of LDI funds have changed since 2022, positioning them better to withstand shocks. Open Ended Funds suffered redemptions in the scenario, leading to asset sales that can amplify price falls. Both OEF and Money Market Fund managers face difficulties in assessing redemption scales during crises.Overall, the BOE's efforts and findings highlight the importance of international coordination and ongoing work to enhance market resilience and manage risks in the non-banking sector.