Hedge fund and private equity lending will be scrutinised by the Bank of England in the world’s first stress test of the shadow banking sector, amid fears the underregulated industry could put the UK’s financial stability at risk.
The tests are meant to help the Bank understand the weaknesses within, and risks posed by, non-bank lenders including hedge funds and money market investment funds, a sector that has doubled in size since the 2007-08 financial crisis and accounts for about half of the loans currently issued to companies globally.
While international regulators such as the Financial Stability Board have been voicing concerns about the threat of shadow banking for more than a decade, the fact the central bank is pushing ahead with its own stress tests signals how serious it views the potential threats posed by the industry, which does not face as stringent oversight as traditional banks.
The Bank of England governor, Andrew Bailey, said the issue had become “more pressing” given how the shadow banking sector had amplified a series of recent market shocks. “I think it is different now because of … a whole series of non-bank ‘incidents’,” he said.
They include the UK’s pension fund crisis in September that was originally sparked by the government’s disastrous mini-budget, but caused UK bond prices to plunge at a record rate. It eventually forced the Bank to step in with £65bn in emergency funding to prop up the bond market and avoid risks spilling out to other parts of the financial sector.
The Bank is pushing for more stringent regulation of the pensions market, partly because of the apparent problems caused by high levels of borrowing.
But it said the potential threat posed by the shadow banking sector was much wider, and had also been illustrated by the market turmoil caused by the collapse of the hedge fund Archegos last year, the dash for cash at the start of the pandemic in 2020 – which resulted in investors pulling their money at speed – and the wider impact of commodity market stress that followed Russia’s invasion of Ukraine in February this year.
The increased scrutiny of the shadow banking sector comes as the UK government faces criticism over its plans to relax regulation for traditional banks and other financial institutions across the City in an attempt to increase growth.
Many non-bank lenders have their headquarters abroad or fall outside the Bank of England’s remit. While it could mean the Bank of England will be limited in the policies it can roll out after the stress tests, it is hoping the exercise will provide more information and help accelerate international coordination.
The central bank said it would run the tests “to inform understanding of these risks and future policy approaches. There is also a need to develop stress-testing approaches to understand better the resilience of NBFIs [non-bank financial institutions] to shocks and their interconnections with banks and core markets.”
Although the Bank hopes to roll out the tests as soon as possible, particularly in light of the looming recession, it has not yet settled on which institutions will be included in the tests or how it will deliver the results.
It will start designing the tests for non-bank financial institutions in early 2023, meaning the sector will probably face its first tests more than a decade after traditional banks first came under similar scrutiny in 2014.
The stress tests were announced alongside the release of the Bank’s biannual financial stability report on Tuesday, which showed that traditional British banks, such as NatWest and Lloyds, were resilient enough to continue lending through the oncoming downturn.
The bank noted that a drop in real incomes, surging mortgage costs and higher unemployment would place “significant pressure” on household finances and weigh on their ability to repay debts.
About 4 million households are expected to face higher mortgage costs next year owing to rising interest rates, including those remortgaging on to new fixed-term loans. The Bank estimated that the average borrower would face an extra £250 in monthly payments as a result, taking the average payment from £750 to £1,000 and costing households an extra £3,000 a year.
