System-Wide Exploratory Scenario (SWES) Unveiled: Navigating Market Risks & Financial Dynamics

Introduction

The System-Wide Exploratory Scenario (SWES) exercise, led by the Bank of England (BoE), is conducted to assess global market vulnerability to rapid liquidity deterioration. This article summarises the exercise, the factors leading to its launch, the involvement of banks and other financial institutions, and its oversight by the BoE.

Background & Objectives

The SWES analysis is the first of its kind, and therefore will offer an original opportunity to discern the dynamics and complexities of such an event. It explores how individual financial firms and their actions during stressed financial conditions interact with one another which may lead to amplifying the shocks further in respect to the financial markets and more widely, the UK financial stability.

The SWES focuses on UK’s gilts, gilt repo, sterling corporate bonds, and derivatives. It has the following objectives:

1. Enhance the understanding of the risks associated with NBFIs and the behaviour of both NBFIs and banks under stress, including underlying drivers of these behaviours.

2. Investigate how these behaviours and market dynamics can amplify shocks in markets, potentially posing risks to UK financial stability.

Additional benefits of the exercise include:

1. Improvements in both BoE and participating firms’ understanding of risk management within the financial system.

2. Support the UK authorities in addressing vulnerabilities in market-based finance, both domestically and internationally, through the global efforts led by the Financial Stability Board.

The SWES draws inspiration from historical triggers, such as:

• March 2020 – underlying vulnerabilities in the financial system prompted a “dash for cash,” resulting in liquidity tightening. BoE and authorities intervened to avert broader economic repercussions during the Covid-19 pandemic.

• September 2022’s proposed mini budget resulted in a significant decline in gilt prices, which impacted the hedging in liability driven investment (LDI). The hedges required cash for margin/collateral calls and in an attempt to raise cash, LDI managers and clients sold gilts, exacerbating the price drop and leading to a cycle of further gilt sales, the Bank of England intervened the following week.

SWES Dynamics

The participants are required to go through several stages and provide detailed information about their business, exposures, and risk management strategies.

A breakdown outlining the key stages and activities involved in the exercise are listed below:

1. Information-Gathering Stage:

In the foundational phase, firms shared vital data shaping the stress scenario. Insights on exposures, market risks, and liquidity strategies were meticulously gathered, cultivating in a collaborative design for significant liquidity redistribution.

2. Stress Scenario Phase:

As of 10 November 2023, the SWES exercise transitioned from “Information gathering” to the “Scenario phase,” encompassing 2 rounds.

Round 1:

As a baseline, participants were required to use their financial positions as of 31 October 2023, and from that baseline, apply shocks from the scenario crafted by the BoE. Focused on geopolitical tensions, the 10-day scenario simulates severe yet plausible shocks for regulator insight.

Scenario Details:

The 10-day SWES stress test unveils unfolding events, such as geopolitical tensions, heightened counterparty credit risk, hedge fund defaults, and a prolonged unstable situation. The scenario delves into the gilts market, gilt repo market, sterling corporate bonds, and derivatives. On day one, a major geopolitical shock caught markets off guard, causing a decline in the economic outlook and a decrease in financial asset prices, resulting in the realization of 40% of the 10-day shock. With worsening of geopolitical events on day 2, marked by falling asset prices and heightened counterparty credit risk, 55% of 10-day shock was realised. Day 3 sees this increase to the shock being 75% realised with increased gilt yields and liquidity impact. Day 4 saw that move to 85% of the shock realised due to a hedge fund default. Inability to find a medium-term resolution to the unstable geopolitical situation from day 5–10 raised concerns about its evolution into a downturn comparable to the severity of the 2007/08 global financial crisis resulting in the realization of 100% of the 10-day shock.

Transmission Channels

The SWES exercise assesses three transmission channels:

1. understanding triggers for firms’ liquidity needs.

2. Examining how firms react to liquidity needs and available resources.

3. Assessing measures taken to decrease leverage, reduce exposures, or rebalance portfolios.

Round 2 and Next Steps:

Scheduled for Q2 2024, Round 2 of the SWES exercise is a crucial continuation, incorporating the actions of participants from Round 1.

The BoE, in collaboration with the Financial Conduct Authority (FCA) and the Pensions Regulator (TPR), plans to publish a final report on the SWES by the end of 2024.

Summary

The SWES evaluates institutions’ responses to stress scenarios, emphasizing system-wide interactions. This dynamic exercise, transitioning through stages, provides insights into market movements, institutional responses, and transmission channels. Led by the BoE, FCA, and TPR, the initiative enhances risk management practices and regulatory measures for a resilient financial ecosystem.

Further reading: The Bank of England’s system-wide exploratory scenario exercise