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Financial stability concerns

Financial stability concerns

In addition to Brexit, UK macro-economic concerns (the growth of consumer credit and higher spreads on corporate bonds) and global vulnerabilities (Italian government bond yields, tighter conditions in US dollar funding markets, trade tensions and debt levels in China), the latest Bank of England Financial Stability Report (PDF 5.86 MB)highlights three specific risks to financial stability - cyber incidents, replacing LIBOR and forced sales of illiquid assets.

Cyber incidents

The Bank of England's Financial Policy Committee intends to establish a severe but plausible `impact tolerance' for the length of any period of disruption to the delivery of vital services (payments, intermediation and insuring against risk) provided by the financial system. This has already been set out in more detail in the joint Bank of England/PRA/FCA discussion paper on operational resilience.

Working with others, especially the National Cyber Security Centre, the Bank will test that firms would be able to meet the FPC's standards for recovering services. Firms undertaking this stress testing will need to demonstrate their ability to meet the FPC's impact tolerance. In instances where that cannot be shown, remedial action plans will be agreed with supervisors.

The Bank plans to launch a pilot of the approach to stress testing in 2019, which will focus on payments. The Bank and the PRA will work with firms to develop the pilot approach. Further details will be published in 2018 Q4.

Replacing LIBOR

The Bank of England is not fully confident about the transition from LIBOR, especially for term maturities. It is noted that LIBOR panel banks have agreed to continue LIBOR submissions until the end of 2021, and that robust risk-free overnight rates are being developed (for example SONIA, administered by the Bank of England rate) which should help to facilitate the transition of new business away from sterling LIBOR in derivatives markets. However, this will not carry across to loan and bond markets that are referenced from longer maturity rates, and meanwhile market participants are continuing to accumulate LIBOR‑linked sterling derivatives for periods well beyond 2021. 

The Bank is also concerned that firms remain exposed to the possibility of different national solutions emerging, despite mechanisms for international coordination.

Forced sales of illiquid assets

The Bank of England continues to worry that markets may be vulnerable to large-scale redemptions from open-ended investment funds. Large-scale redemptions from funds with material liquidity mismatch could result in sales of illiquid assets, which could be amplified if resulting falls in prices lead to further asset sales.

The Bank notes that funds do have liquidity tools, such as fair value pricing and fund suspensions, which can be used to limit redemptions under stress; and recognises the various recommendations on liquidity risk management by funds from the FCA, IOSCO and the ESRB.

However, the Bank suggests that the use of such tools may not be sufficient to eliminate risks of large redemptions, while expectations that such measures could be imposed could encourage redemptions in a stress.

The Bank therefore continues to work on stress simulation models to explore how open-ended funds, hedge funds, dealers, insurance companies, unit-linked funds and pension funds might, through responding separately to their incentives and constraints, together amplify market shocks.

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