Stress test for many of the world’s biggest hedge funds

After being invited to participate in the stress tests, which are the first ever to include the shadow banking sector, many of the largest hedge funds around the world will reveal if their investments could amplify economic shocks or harm the UK financial system.

The Bank of England released the names of over 50 City institutions participating in the exercise. This will measure how banks and nonbank financial institutions, often referred as the shadow sector, affect financial stability.

List includes large banks like HSBC and Goldman Sachs; insurers such as Aviva and Legal & General, as well as asset managers, pensions funds and hedge funds, including Brevan Howard and Citadel; Millennium Capital Partners; Rokos Capital Management; and Capula Investment Management.

The announcement comes amid concerns over the role of shadow banks, which have doubled since the financial crisis of 2007-2008 and account for half of global corporate loans. However, they do not receive the same level of oversight as traditional banking institutions.

The shadow banking exercise, unlike bank stress tests, which measure the resilience and responsiveness of individual firms, is designed to help regulators better understand how firms respond to each other’s decisions in a downturn. It also helps them to better understand how their collective actions can “amplify shocks on UK financial markets, which are essential to UK financial stability”.

The Bank of England has warned that “given the fact that market-based financing plays an increasing important role in the financing of the real economy,” material market dysfunction could, for example lead to tightening of the credit conditions and a reduction of the provision of financial services to households and businesses.

The test is divided into two phases. First, it will examine how companies would respond to an economic shock. Next, it will present a second scenario based on collective group actions and then ask the firms how they would react to this increased financial stress.

The Bank of England’s Prudential Regulation Authority, along with the Financial Conduct Authority, and the Pensions Regulator are running the exercise. They plan to publish their findings in 2024. This is a decade after the first time traditional banks were subjected to similar scrutiny.

Shadow banking has been a threat to investors for many years. The recent panic at the beginning of the pandemic, in 2020, caused them to withdraw their money quickly.

The Bank of England also highlighted the UK pension fund crisis that occurred in September 2022, which was initially sparked by the government’s disastrous mini budget but led to a record-breaking drop in UK bond prices. The Bank of England was forced to intervene with emergency funding of £65bn to stabilize the bond market. This prevented the risk of spillover to other areas of the financial industry.

The chaos has contributed to higher rates of mortgages and borrowing costs across the nation for both companies and homeowners.

Brevan Howard, Citadel Capital Management and Rokos Capital Management declined comment. Millennium and Capula have not responded to requests for comments.