LONDON, May 15 (Reuters) - Britain's banks will be tested this year on how they would cope with investors clammering to sell bonds in fragile markets, Bank of England Deputy Governor Andrew Bailey said on Friday.
Regulators are increasingly concerned that bond investors will stampede for the exits when interest rates begin rising, creating huge price swings because there won't be enough liquidity or inventory capacity to cope.
Bailey said central banks could, in exceptional circumstances, step in themselves to boost market liquidity.
Huge swings in U.S. Treasuries last October and in the Swiss franc in January deepened the concerns and Bailey said the BoE wants to see how such volatility feeds back into banks, key players in making markets.
"In order to enhance our protection against this risk, in this year's Bank of England concurrent stress test, we are taking a substantial step to enhance the coverage of market risks," he said in a speech.
Banks have cut their inventories of bonds for trading, blaming tougher regulation.
But Bailey said inventories have simply returned to more normal levels, though the global bond market has grown from $30 trillion in 2000 to nearly $90 trillion today.
The BoE's Financial Policy Committee has asked for an interim report on fragile liquidity for June.
Bailey said it was best to focus on activities that create markets risks like fragile liquidity before moving on to entities that house those activities.
UK regulators are studying whether automated trading using computer programs, which can exacerbate market moves, is properly controlled.
Britain's Fair and Effective Markets Review of trading, due to be published next month, will look at market structure standards, and effective competition and pre-emptive supervision, Bailey said.
Regulators are also looking at options for controlling risks from asset managers offering short-term redemptions to investors against potentially illiquid assets, Bailey added.
Potential responses could include requiring funds to hold larger liquid asset buffers, to apply stricter leverage limits, and to reflect liquidity risks in redemption terms.
"Last, central banks can back-stop market liquidity by acting as market makers of last resort," Bailey said. "Here too, there is a lot more to be done to consider the circumstances in which this tool could be used." (Reporting by Huw Jones Editing by Jeremy Gaunt)