By Huw Jones
LONDON (Reuters) - The Bank of England is studying how funds and insurers could cope with sudden demands for cash to back trades without resorting to a destabilizing fire sale of assets, a senior BoE official said on Thursday.
Alex Brazier, the Bank's executive director for financial stability strategy, said the simulation exercises will check how the investment sector could deal with a big increase in margin or collateral, and whether they hold enough "liquid" assets to meet it.
"I use the word simulation rather than stress test because stress test implies a pass/fail exercise for an individual entity, the way we do it for banks," Brazier told a London Business School conference on asset management.
"Our work here explores the depths of 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," Brazier added.
The move is a sign of how the BoE's attention is turning to stability issues in other parts of the financial system now that it sees banks holding enough capital in the aftermath of the financial crisis.
The simulation exercise looks at how the investment sector acts as a whole, but no new rules are anticipated for now, Brazier said.
"I wouldn't say it's a precursor to anything at this stage. This is a diagnostic exercise, to dive beneath the surface and figure out whether this iceberg is growing," he said.
"The first step is always to diagnose before you get anything close to thinking about regulation."
The issue is also linked to the big rise in bond issuance to fund companies - rather than traditional bank loans.
Some bond funds offer fast redemptions to investors, putting pressure on them to come up with cash at short notice in stressed markets, which can also create a "liquidity mismatch".
But developments in the corporate debt market also need careful scrutiny to check whether banks continue to be resilient to any price adjustments, he said.
Corporate debt in Britain is around its long-term average level as a multiple of earnings.
"Nevertheless, developments in corporate debt bear close scrutiny because we cannot take for granted that it will stay this way," Brazier said.
Kanwardeep Ahluwalia, head of global markets risk (EMEA) at Bank of America Merrill Lynch (NYSE:BAC), said the main concern for bond markets is whether there be an orderly unwinding of central bank easy money.
"It’s pretty straight-forward, there’s been a lot of money in the market, interest rates have been low, it’s been easy to borrow money and (now) interest rates are going up, so let’s see, can people pay or not?" he said.
Brazier said if the recent developments he noted in corporate debt continue, the BoE will need to assess whether they increase risks faced by banks.
The BoE's risk watchdog, the Financial Policy Committee, will review in June whether to raise the banks' so-called counter cyclical capital buffer if such "domestic risk appetite" becomes worrisome.