Probability & Partners: EU stress test for non-banks
This column was originally written in Dutch. This is an English translation.
By Gerd-Jan van Wiggen and Pim Poppe, Sector Lead Banking and Managing Partner at Probability & Partners, respectively
The recent turbulence in the financial markets – driven by geopolitical tensions, economic uncertainty and interest rate volatility – shows that traditional certainties are becoming increasingly unreliable. This emphasises the importance of better insight into systemic risks, including those outside the banking sector.
Since the financial crisis of 2008, a robust package of laws and regulations has been introduced worldwide to make banks more resilient. Capital requirements, liquidity standards, resolution mechanisms and more intensive supervisory structures have ensured that banks are now significantly better positioned to absorb shocks than they were before the crisis.
However, an unintended side effect of these reforms is that a growing proportion of lending has moved outside the regulated banking system. This so-called non-bank financial intermediation (NBFI), also known as the “shadow banking sector”, has grown explosively in recent years. Asset managers offer private credit on a large scale, while pension funds and insurers are increasingly investing directly or indirectly in illiquid markets, such as real estate and SME loans.
Although this shift in credit supply is not necessarily problematic in itself, it does pose new challenges for supervisors. While banks are subject to rigorous stress tests, this is not the case for many non-bank institutions. This leaves the question of how resilient the financial system as a whole is in a crisis situation largely unanswered.
Stress testing: from individual institutions to systemic thinking
Stress testing has become standard practice for banks and insurers.
They are required to periodically calculate the impact of scenarios drawn up by regulators. These scenarios include, for example, scenarios in which markets correct sharply, interest rate developments deviate significantly or economic growth suddenly stagnates. The results of these exercises are used to determine whether institutions have sufficient capital buffers and, if necessary, whether additional measures need to be taken.
Until now, however, most stress tests have focused on individual institutions or specific sectors. They therefore mainly provide insight into microprudential risks. In today's world, characterised by interconnected markets, complex chains of dependencies and rapidly spreading market shocks, a broader macro perspective is needed. Systemic risks require systemic solutions.
The Bank of England's SWES
In this light, the Bank of England's (BoE) System-Wide Exploratory Scenario (SWES) exercise, the results of which were published in November 2024, is an important step forward.
This stress test did not focus on determining the solvency of individual institutions, but on mapping interactions and feedback loops within the entire financial system during a hypothetical crisis scenario.
The scenario chosen was deliberately extreme: a sudden rise in inflation expectations led to a sharp rise in interest rates, sharp corrections in equity and bond markets, and a flight to liquidity. The test examined how different types of institutions – including insurers, pension funds, hedge funds and money market funds – would respond and what system dynamics this would generate.
One of the key findings was that many regulated institutions, including large insurers and money market funds, have clearly become more robust in recent years. In the scenario, they proved capable of managing their positions without resorting immediately to forced sales. Nevertheless, the test also revealed vulnerabilities. For example, it showed that in certain markets, particularly leveraged funds and the repo market, liquidity stress could become systemic within a short period of time. Another important finding was that banks might not be able to provide sufficient repo financing to non-bank parties, despite the possibility of using central bank facilities.
The exercise also showed that certain behaviours, such as the simultaneous reduction of risks by many parties, can lead to fire sales and price corrections that go far beyond the initial shock. In real life, this type of procyclical behaviour can trigger a negative spiral of market dynamics, which then also permeates the real economy.
Relevance for Europe
Following this exercise, European supervisors – presumably a collaboration between the European Central Bank and the European Securities and Markets Authority (ESMA) – are now working on a broader stress test focusing on the entire financial system. According to the Financial Times, this system test is to be carried out in 2026.
The ambition is to gain insight into systemic risks outside the traditional banking landscape in Europe as well, with a particular focus on risks in private markets, illiquid assets and the use of leverage.
The aim is not to publicly rank institutions or to take direct policy measures, but to gain insight into where vulnerabilities lie and how they may interact in a stress situation. These insights should help policymakers and institutions formulate measures to mitigate systemic risks, both through regulation and internal risk management.
Practical implications for institutions
For institutions with less experience in stress testing, such as some pension funds or smaller asset managers, participating in a system test can be a considerable challenge. It requires access to detailed data on assets, liabilities and underlying risks. In addition, it is necessary to be able to translate scenarios into concrete effects on capital, cash flows and liquidity positions.
Furthermore, such an exercise requires internal coordination: how do crisis committees function, what decisions are taken under stress, and how are these communicated? These insights are not only important for supervisors, but also for institutions themselves in order to increase their resilience.
Conclusion
The Bank of England's SWES is an important example of how stress testing is evolving from a technical exercise into a systemic tool. The focus is not on individual outcomes, but on collective behaviour and mutual interaction. The exercise has provided valuable insights into vulnerabilities outside the traditional banking sector.
With the increasing interconnectedness of financial institutions, products and markets, it is becoming increasingly important to adopt this systemic perspective. The upcoming European stress test is therefore an opportunity to make supervision future-proof in this area as well. For institutions, this means that risk management does not stop at their own books, but extends to understanding the broader market mechanisms in which they operate. We therefore recommend studying the results of the ECB/ESMA stress tests when they are made public.
