By: Udaibir Das
This article originally appeared in the OMFIF on June 30, 2023.
An important step on the path to a global macro-financial risk framework
The Bank of England has raised the bar in managing the UK financial system and launched ‘system-wide exploratory scenario exercises’ to understand market behaviour. A more profound grasp of market dynamics will enhance public confidence, with other central banks likely to follow suit.
Exploratory scenarios – first used by oil companies in the 1970s – analyse uncertainty in planning. The Bank’s proposed system-wide exploratory scenario exercise will study the behaviours of banks and non-bank financial institutions to understand how their actions might amplify stress in the UK financial markets. Financial firms are also able to incorporate systemic issues more informedly into their risk management frameworks. Therefore, not only will this help prepare for various future scenarios but it might also make market agents set aside deeply held assumptions and have an open mind to new dynamics.
The past 50 years have seen shifts in the global financial system’s behaviour. Major market crises, such as the 1997 Asian crisis and the 2008 financial crisis, have resulted in more robust financial policies focused on licensed entities.
However, an integrated system-wide oversight framework focused specifically on macro-financial risks has yet to be implemented. The International Monetary Fund’s Financial Sector Assessment Programs and the Bank for International Settlements annual reports have repeatedly highlighted the shortcoming.
This knowledge gap is a growing source of global financial instability, especially as technology and connectivity, between and within financial systems, advance. Such interplay has witnessed pulls and tugs, leading to market dysfunctions, collapsing firms and crises – often requiring recourse to public money.
Market agents behave differently under stress. Commonly practiced entity-level stress testing does not provide a view of these dynamics. The same applies for macroeconomic and supervisory early warning exercises. Therefore, the Bank exercise – which will be an interagency effort involving the Financial Conduct Authority and the Pensions Regulator – will go beyond standard entity-level-based stress testing to cover all large amplifiers and propagators of contagion. Market participants will share their behavioural patterns under stress and develop action plans to adjust to adverse dynamics.
Why is the UK taking the lead?
The BoE’s latest initiative to understand market behaviour through system-wide exploratory scenario exercises is particularly relevant for the UK. As a global financial centre, the city serves as an international public good, providing financial services to hundreds of sovereigns, central banks and finance and corporate firms. Several developing countries depend on London for financing, debt, risk and asset management. With its 300-year-old history, the system often comes across as labyrinthine so the more insights one can get, the fewer surprises there will be.
In its last post-Brexit FSAP assessment of the UK in 2021, the IMF saw a deepening of financial system interconnectedness. It suggested that the UK must further build on its systemic risk management practices to cover risks from market-based finance, private markets and cross-border channels in an integrated manner.
This will be an exacting exercise – to grasp risks in an ever-evolving world of money and finance. While the Bank can build on its experience with exploratory scenarios on climate risks, the exercise will be challenging for many reasons.
Relevance
Determining the core part of the financial system will require agreement from all agencies and market participants. Legal challenges may arise, especially for firms hosted in the UK. Academic approaches, such as using an interbank lending market or transactions in the payments system, could help establish a method. However, connectivity matrices often yield degenerate systemic importance scores. This is because not all market agents are identical from a systemic viewpoint.
Metrics and materiality
Developing monitorable metrics for this exercise will require drawing up the system’s critical nodes first. One particularly challenging metric to measure is the system-wide leverage in the core and its impact on the overall system. Sifting between relevant behavioural connections will be complex and the critical question is what fraction of economic value could be lost in distress and feed back into the real economy.
Limitations
Exploratory scenario exercises have inherent limitations, such as modeling behaviour risks while keeping market characteristics. Assumptions must capture portfolio shifts, risk tolerance and incentive problems that impact market behaviour.
Data gaps
Available time series and data gaps may impede a definitive assessment of market behaviour from models fit for policy purposes (such as agent-based modeling or those based on game theory or behavioural economics).
Policy toolkit
The exercise will be valuable when tools exist to preempt adverse market behaviour on time. The existing macroprudential toolkit must be completed and a clear set of systemic mitigation policies and backstops will become necessary over time.
Communications
A final challenge for the Bank will be explaining outcomes. Scenarios may only capture some potential factors influencing market agent behaviour, so stakeholder education must reflect that the exercise is not about definitive predictions of future market behaviour.
The BoE’s efforts to understand market behaviour through system-wide exploratory scenario exercises will be exciting. The benefits stand to be universal and could serve as a public good, but active engagement from cross-border authorities and financial entities is essential. It might also take some time before the exercises becomes policy-relevant. But the days of odd, self-serving market behaviour and compounding moral hazard must end. We must collectively focus on building an inclusive social order, which should be in the interests of all.