BoE acted to prevent a gilt market ‘fire sale’, MPs told

The central bank announced an emergency £65bn bond-buying programme following the so-called “mini” Budget on September 23, which saw falling government bond prices prompt a series of collateral calls from defined benefit pension funds that some feared would lead to a “doom loop” that would crash the market. 

Issues arose specifically around schemes’ liability-driven investment 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.

We started to become very aware that potentially we had a fire sale dynamic starting at the long end of the curve. And if it became established, it would start to push down into the conventional and other parts of the curve — and then the gilt market would basically break down

Sir Jon Cunliffe, Bank of England

There has been some dispute as to the true severity of the crisis. Several industry experts were quick to reject the suggestion that there could be a widespread collapse of pension funds, and the Pensions Regulator — which some felt should have been more proactive in addressing LDI and its role in the crisis — suggested that most schemes had “sensible waterfall measures in place” to face collateral calls.

Speaking to the Treasury Committee, Cunliffe confirmed that the BoE had not run stress tests on LDI funds.

‘A pretty thin market’

Cunliffe told the committee that the central bank had seen the potential for a “fire sale dynamic” and a “break down” in the gilt markets, prompting its intervention.

“What we saw after the fiscal event [‘mini’ Budget] was yields rising across the curve, and then they started to rise particularly at the long end of the curve, and particularly the index-linked element of the long end,” he explained.

“That is a pretty thin market. It’s not as liquid as other parts of the curve, and it’s populated very heavily by pension funds and insurance companies who want to match long-term liabilities with long-term assets.”

He said that some of the investment funds providing asset-liability matching for pension funds began facing solvency risk as the price of long-dated gilts dropped, and were facing margin calls.

“These are the pooled investment funds where a number of smaller pension funds will participate, and most of them needed to sell gilts to restore that solvency. The problem was it was a rising market, which meant as they sold gilts they drove the price down further, which affected their solvency, which meant they had to sell more gilts,” Cunliffe continued.

“A number of them were at the point where they would not have been able to restore solvency and would have had to wind themselves up. At that point the gilts would have passed to the banks that had lent, through repo, to these funds. The banks would have held the collateral, they wouldn’t want that collateral, particularly with prices falling, and they would have every incentive to sell.

“So basically, as the price goes down, it triggers more of a need to sell, and then you hit regulatory thresholds. That’s what we call the ‘fire sale spiral’. We started to get information about that on the evening [after the ‘mini’ Budget].”

Proper LDI stress tests not possible

Cunliffe stressed that the BoE was aware of the risk, its Financial Policy Committee having worked with TPR in 2018 on resilience to rising interest rates. But most schemes only stress-tested an instantaneous rise in long gilt yields of 100 basis points, while in the event they were facing a rise of 160bp over a five-year period, “and that was beyond them”.

“At that point we started to become very aware that potentially we had a fire sale dynamic starting at the long end of the curve. And if it became established, it would start to push down into the conventional and other parts of the curve — and then the gilt market would basically break down.”

He said that, though work had been done with the TPR and it had been following it up, he acknowledged that “non-bank finance” remained a “weaker area”.

“This is an area which we have been targeting and looking at for nearly 10 years now, because it’s an area which is much more difficult than banks to stress-test and actually to be completely accurate,” he explained. 

“We did not run a stress test on LDI funds as we run a stress test on banks. We ran a simulation on a number of pension funds, insurance companies and hedge funds of what they would do if liquidity dried up in that particular way, 100bps instantaneously.”

Cunliffe said there was a gap “between the powers of financial stability authorities, the data they see and receive, and the liquidity stresses in non-bank finance”, and that, though work had been done to improve things, “the banking system is quite resilient to considerable stress [...] whereas non-bank finance is not as resilient to liquidity problems, as we have just seen with LDI”.

Asked whether the BoE will carry out a “lessons learnt review”, he said “we will want to look at a number of things”.

He stressed that he saw the “reason for LDI strategies” and that they are “not subprime”, but he added that “liquidity resilience is really important”, and that there will be “lessons to be learnt” about stress-testing.

“TPR is responsible for how pension funds invest, the Financial Conduct Authority deals with investment funds [...] but I think we want to sit down with all the people who have an interest in this and say, ‘OK, we saw a risk. How should we manage those risks?’”

BoE denies miscommunication

It had been rumoured in the days immediately prior to October 14, when the BoE’s bond-buying programme was scheduled to end, that it may in fact continue beyond the advertised date. 

The Financial Times reported on October 12 that despite public signals that the scheme would come to a hard stop on October 14, officials had “signalled privately to bankers that it could extend its emergency bond-buying programme past [October 14’s] deadline, according to people briefed on the discussions, even as governor Andrew Bailey warned pension funds that they ‘have three days left’ before the support ends”.

The Pensions and Lifetime Savings Association said it knew of many schemes that would prefer the programme to be continued until the then-chancellor Kwasi Kwarteng set out the government’s fiscal plans on October 31.

This led BoE governor Andrew Bailey to insist that the scheme would not be extended. 

Asked about the origin of the rumours, Cunliffe said he knew of no one at the central bank who would have briefed contrary to the official line.

He said: “I do not know where [the rumour] came from. Nobody dealing with this briefed that, because that is not what we said.

“There’s a lot of chatter in markets. There’s a lot of Chinese whispers. But our communication was clear, the market notice was very clear, the governor was very clear, and we did what it said on the tin.”