Bank of England's SWES reveals financial system shock amplification

The Bank of England's system-wide exploratory scenario (SWES) exercise, a global first, explores how the UK financial system would respond to a severe market shock.

Around 50 diverse financial firms, including banks, insurers, and hedge funds, evaluated their reactions to a sudden, sharp, and persistent global financial market stress.

This hypothetical shock caused significant losses, triggering spikes in variation margin calls and increased initial margin requirements for central counterparties.

Consequently, a substantial redistribution of liquidity occurred across the financial system.

Many non-bank financial institutions (NBFIs) rapidly depleted and then sought to rebuild their liquidity buffers, often driven by internal risk limits or a precautionary 'risk off' stance.

These collective actions, including deleveraging and derisking, significantly impacted other financial firms and market outcomes, revealing complex interconnections and potential amplification effects.

The SWES revealed specific vulnerabilities in core UK markets.

Gilt repo market conditions tightened significantly due to bank derisking and counterparty credit concerns, resulting in some NBFIs not receiving their expected financing.

The exercise concluded that banks are unlikely to provide all additional repo financing NBFIs request during a stress, despite their capacity to draw on central bank lending facilities.

The sterling corporate bond market could also face a 'jump to illiquidity' where rapid selling pressures from various sectors, including pension schemes, overwhelm limited purchasing capacity, necessitating sharp price falls for market clearance.

The Bank is responding by expanding its tools, such as the Contingent NBFI Repo Facility (CNRF), to support gilt market function.