Extreme market events put regulators to the test

Given the long era of low interest rates, no one can predict with certainty where the next wave of financial turmoil will come from. And this “expect the unexpected” territory raises uncomfortable questions about modern financial regulation.

One is how much responsibility do regulators have for the aftermath of truly extraordinary events? Another is if they have at least some responsibility, should they do more to meet it?

The recent turmoil in the UK bond and bond markets does not bode well for the future of the markets and the financial system.

The saga that sparked emergency intervention by the Bank of England began with what has been aptly described as “unprecedented” gilt price action following former Chancellor Kwasi Kwarteng’s disastrous “mini” budget. The 30-year gilt yield has fluctuated 1.6 percentage points in a matter of days, an unprecedented move.

As financial sector enthusiasts know, stress testing is at the heart of the risk management culture that emerged in the wake of the financial crisis.

The usual idea is that you imagine a doomsday scenario, like a recession or a home price crash, and then look at how that would affect your banks, insurance companies, or whatever else you want to highlight. If they were lacking in liquidity, capital, operational capacity or anything else, order them as regulator to fill the gap.

The tests must be disadvantageous, but also plausible. Scenario making is more art than science, but one thing is certain – whatever regulators come up with will uniquely fall short of the unexpected. Like an unprecedented swing in gilts.

Back in 2018, the Bank of England, which is responsible for the UK’s financial stability, stress-tested the liability-driven investment strategies that have been at the heart of recent pension fund woes. They tested them against unfavorable but plausible 0.25, 0.5 and 1 percentage point immediate rate hikes across all currencies and maturities. Actual movement in gilts was greater and so the system collapsed.

More recent tests probably wouldn’t have helped. As Bank of England Deputy Governor Jon Cunliffe put it in a recent letter to the UK Treasury’s selection committee: “The scale and speed of the reassessment by Wednesday, the 28th component of risk management practices or regulatory stress tests.”

Extraordinary events, one, stress test, zero.

This definitional problem — that a stress test is only ever as robust as the stress it envisions — was just one of the weaknesses of the 2018 work. The LDI stress test also failed to envision what kind of behavior a sharp drop in gilt would entail -Market prices, which would prompt fund managers to sell before the worst of the stress had occurred. And it failed to capture the operational issues that would exacerbate the situation, adding to the case for the BoE to step in as a circuit breaker.

The UK Pensions Authority, the Bank of England and the Financial Conduct Authority are all now working with pension funds to ensure they have buffers that would allow them to absorb an even bigger shift in interest rates than the ones we’ve just seen to manage something. But what if there is an even bigger one?

Andreas Dombret, who sat on the supervisory boards of the Bundesbank and the ECB from 2010 to 2018, says that in order to really secure a system against future risks, “you have to think a lot creatively. . . you have to think the unthinkable”. This is exactly what the modern stress testing approach does not allow regulators to do.

A eurozone central bank official agrees that there is “much to be said about the limitations of modeling”. The alternatives are still in the works.

Regulators are looking at ways to improve stress testing so they can better prepare for “black swan” events like the UK’s recent fiscal adventure. This requires a new way of thinking about the world and its risks. It also requires better data on key aspects of how money market funds, hedge funds and others do business in the broader world of “shadow banking.”

The first fruits of their efforts will become apparent in the coming months. History will ultimately judge if they are sufficient.

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