The Bank of England is set to examine how private markets would respond to a catastrophic theoretical scenario that industry figures say surpasses the severity of the 2008 global financial crisis.
Watchdog officials will scrutinise how alternative asset managers react to a five-year deterioration in financial conditions, with inflation and the Bank’s central interest rate both rising to seven per cent.
The hypothetical scenario also projects the UK economy suffering its deepest recession since the 2008 crash, triggered by a theoretical fracturing of global trade.
Stock markets would be hit by a historic bear market causing shares to sink 35 per cent, while artificial intelligence’s disruption of software companies would simultaneously accelerate.
Some 46 companies with ties to private markets have volunteered to take part in what is the Bank’s first ever dissection of the UK’s ballooning private equity and credit industries.
Participants include alternative asset managers such as Ares, Carlyle, Blackstone, KKR and Oaktree, alongside traditional banks including Goldman Sachs and Barclays.
The probe, called the system-wide exploratory scenario, or Swes, is the first of its kind globally and follows growing regulatory concern over the opaque nature of alternative investing.
A succession of high-profile corporate failures, including Mayfair-based direct lender Market Financial Solutions, accelerated fears that lending standards were deteriorating across the sector.
Michael Moore, chief executive of UK Private Capital, said: “The Bank’s hypothetical scenario is very severe. So, it is important that in time the exercise is placed in context with the Bank’s testing of other parts of the financial sector.”
Moore added: “It matters that everyone can see how all parts of the financial system would react in the same circumstances, and how that would impact on the real economy on a comparable basis.”
The Bank expects to publish results of the exercise later this year, before launching a second round of testing to probe answers that regulators do not deem realistic or which require further explanation.
The simulation also devotes considerable attention to the potential for alternative investors’ bets on artificial intelligence and software companies to go badly wrong.
Several private equity and direct lending investors are already facing large haircuts on investments in software as a service firms, which until recently had been a popular destination for dealmakers’ capital.
Under the scenario, SaaS companies “judged as having weaker competitive advantages or a ‘smaller moat'” will shed a disproportionately large amount of their valuation.
The watchdog will also explore how alternative investors would react to an AI slowdown, were higher energy prices to weigh on demand across the sector.
Jiri Krol, deputy chief executive of the Alternative Investment Management Association, said the scenario was “deliberately very severe” and that the “evidence-based” test should help rid the industry of accusations that it is too opaque.
Krol added: “Too much of that debate currently rests on generalised, anxiety-inducing speculation.”