Hedge funds, pension funds and other companies in the shadow banking sector are at risk of amplifying market shocks and triggering a £17bn asset sell-off, according to the Bank of England’s first ever stress test into the largely unregulated industry.
The landmark exercise, the first in the world by a central bank, tracked how non-bank financial institutions – often referred to as the shadow banking sector – would react in a short and sharp shock affecting financial markets.
The stress test showed that in this scenario, companies would rapidly sell off as much as £17bn worth of assets, as they scrambled to recapitalise or limit their activities, in a way that would “amplify the shock”.
There are concerns that risks are emerging in the shadow banking sector that could echo the problems experienced in the financial sector in the run-up to the 2008 financial crisis.
The Bank’s regulatory arm, the Prudential Regulation Authority, said that while industry standards had increased the resilience of companies in some corners of the shadow banking industry – including insurers, money market funds and liability-driven investing funds – a lack of regulation meant that resilience was shaky and could deteriorate over time.
Shadow banking refers to financial firms that face little to no regulation compared with traditional lenders, and includes businesses such as hedge funds, private credit and private equity funds.
More than 50 City institutions took part in the exercise, including large, regulated banks such as HSBC, Goldman Sachs, JP Morgan and Merrill; insurers including Aviva and Legal & General; as well as clearing houses, asset managers, pension funds and hedge funds including Brevan Howard, Citadel, Millennium Capital Partners, Rokos Capital Management and Capula Investment Management.
Separately, the Bank warned on Friday that higher trade barriers could hit global growth and feed uncertainty about inflation, potentially causing volatility in financial markets.
The Bank said the financial system could also be hit by disruption to cross-border capital flows and a reduced ability to diversify risk, although it stopped short of directly referring to Donald Trump’s return to the White House, which is expected to affect global trade.
“A reduction in the degree of international policy cooperation could hinder progress by authorities in improving the resilience of the financial system and its ability to absorb future shocks,” the Bank said.
