Bank of England calls for LDI regulatory action from TPR

In its Financial Stability Report, published on December 13, the central bank’s Financial Policy Committee analysed the market turmoil in September, concluding that “levels of resilience across LDI funds to the speed and scale of moves in gilt yields were insufficient”, and that “buffers were too low and less usable in practice than expected, particularly given the concentrated nature of the positions held in the long-dated gilt market”.

The BoE announced a £65bn bond-buying programme on September 28 in an attempt to stabilise markets, after falling government bond prices prompted collateral calls for pension funds.

This intervention followed the so-called “mini” Budget on September 23, which saw falling government bond prices prompt a series of collateral calls from defined benefit schemes that some feared would lead to a “doom loop” that would crash the market.

There is a clear need for urgent and robust measures to fill regulatory and supervisory gaps to reduce risks to UK financial stability

Bank of England

Issues arose specifically around pension funds’ LDI strategies, designed to protect against falling interest rates. Most schemes had conducted stress tests for a scenario in which there was a 1 per cent rise in long-term gilt yields, but the 4 per cent rise exceeded the contingency plans of several, prompting the BoE’s intervention.

While considering “it might not be reasonable to expect market participants to insure against the most extreme market outcomes”, the central bank noted “it is important that shortcomings are identified and action taken to ensure financial stability risks can be avoided in future”.

“There is a clear need for urgent and robust measures to fill regulatory and supervisory gaps to reduce risks to UK financial stability, and to improve governance and investor understanding,” the BoE stated.

More regulation needed

The bank’s committee believes that LDI funds should maintain financial and operational resilience to withstand severe but plausible market moves, and this should include “robust risk management of any liquidity relied upon outside LDI funds, including in money market funds”.

In this sense, the BoE welcomed the guidance published by TPR on November 30, which sets out the watchdog’s expectation that liquidity buffers be maintained across pooled and leveraged LDI mandates.

Sterling-denominated LDI funds across Europe have now secured an average yield buffer of around 300 basis points to 400bp, according to the Central Bank of Ireland and Luxembourg’s Commission de Surveillance du Secteur Financier.

This buffer refers to the level of yield adjustment on long-term gilts that an LDI fund is insulated from, or may absorb, before its capital reserves are depleted. LDI funds trading in the UK are based exclusively in the Republic of Ireland and Luxembourg.

Despite acknowledging that TPR intends to issue a further update in 2023 setting out longer-term expectations on scheme liquidity requirements, the central bank recommends that regulatory action be taken by the watchdog, in co-ordination with the FCA and overseas regulators, “to ensure LDI funds remain resilient to the higher level of interest rates that they can now withstand”, and DB scheme trustees and advisers “ensure these levels are met in their LDI arrangements”.

While noting the “regulatory regime is complex and fragmented”, the BoE stated that further steps will be needed “to ensure regulatory and supervisory gaps are filled, so as to strengthen the resilience of the sector and improve governance and investor understanding”.

As an example, the central bank explained it is important for DB schemes to improve their liquidity management practices, and “appropriate reporting and data collection is likely to be needed to monitor the resilience of LDI funds”.

Due to this, it is recommending that regulators “set out appropriate, steady-state minimum levels of resilience for LDI funds, including in relation to operational and governance processes and risks associated with different fund structures and market concentration”.

In response to the report, a spokesperson for TPR said: “We welcome the FPC’s recommendations. We will continue to work closely with the Bank of England and other regulators on a longer term plan to ensure trustees who use LDI maintain an appropriate level of resilience in leveraged arrangements.

“We have already issued new guidance setting out expectations for trustees using LDI and we will be building on this in the months to come. This will include updated guidance in our 2023 Annual Funding Statement.”

BoE supports FCA consultants’ supervision

On November 7, FCA chief executive Nikhil Rathi and interim chair Richard Lloyd appeared before the Treasury Committee, where they highlighted a “gap in regulation” concerning investment consultants who advised schemes trustees to invest in LDI funds.

Rathi reiterated his call for investment consultants to be brought “into the regulatory perimeter”, a stance that the FCA has held since 2018.

In its report, the BoE committee noted that investment consultants “play an important role by providing unregulated services that can significantly influence the investment strategies of asset owners and asset managers, including pension schemes”.

In particular, the central bank noted that these consultants advise trustees on issues such as strategic asset allocation and asset manager selection, and they are not required to be FCA-authorised for those activities.

The committee is therefore supporting the FCA’s recommendation to HM Treasury to bring these intermediaries into their regulatory remit.

Hargreaves Lansdown senior pensions and retirement analyst Helen Morrissey noted that the BoE report “highlights real gaps in how schemes and their managers responded to the crisis”.

“Many simply weren’t able to respond to the situation quickly enough and important governance lessons need to be learned,” she said.

“Looking ahead, schemes will need to prepare to hold more liquidity and react more quickly to changing conditions – smaller schemes, in particular, may need to ask themselves some hard questions on whether these strategies remain appropriate for them in the future.”