BoE director calls for greater regulatory oversight on leverage

Defined benefit pension funds scrambled for liquidity in the aftermath of September’s “mini” Budget, which pledged extensive unfunded tax cuts and precipitated a deterioration in markets. 

Gilt yields spiked and collateral calls poured in for schemes. The BoE launched a 13-day, £13.9bn bond-buying intervention in a bid to stabilise prices.

In a speech given on November 7, Sarah Breeden said the rise in gilt yields and the resulting drop in the net asset value of leveraged liability-driven investment funds caused their leverage to increase “significantly”. 

One wonders where the regulation focus will stop

Laura Charles, Gowling WLG

“And that created a need urgently to delever to prevent insolvency and to meet increasing margin calls,” she said.

During the turmoil, the Pensions Regulator issued guidance urging schemes to “review their liquidity, liability hedging and governance processes, suggesting that managers of their liability-driven investments could be granted power of attorney over some assets to quicken trading”.

The watchdog also told MPs that it had contacted the BoE and other regulators before the launch of the BoE’s gilt-purchasing programme, to establish what actions they could take in response to volatility in the gilt market.

With the dust settling and markets having calmed since the budget was largely abandoned, focus has turned to the measures that schemes and regulators should take to avert a repeat of October’s volatility.

“While this is an understandable position to take, one wonders where the regulation focus will stop,” Gowling WLG legal director Laura Charles said in response to Breeden’s comments. 

Pooled LDI funds had a particularly challenging time

In her speech, Breeden recalled explaining to journalists in late September “why a part of the pensions industry, unheard of to most of their readers, had posed such a large threat to financial stability that it warranted intervention in the gilt market from the Bank of England”.

Sections of the media have been criticised for their reporting of the crisis and their suggestion that some schemes faced insolvency, a view that has been widely rejected by the pensions industry.

Breeden, however, acknowledged the need at the time for leverage to come down in order to avoid insolvency. Liquidity buffers were exhausted, with funds having to sell into an illiquid market. Schemes were seeking additional cash from sponsors to protect hedging ratios.

“Since persistently higher interest rates would in fact boost the funding position of DB pension schemes they generally had the incentive to provide funds,” Breeden noted. “But their resources could take time to mobilise.”

The problem was particularly challenging for pooled LDI funds, she said, which make up 10 to 15 per cent of the LDI market.

“The speed and scale of the moves in yields far outpaced the ability of the large number of pooled funds’ smaller investors to provide new funds who were typically given a week, in some cases two, to rebalance their positions,” Breeden said. 

“Limited liability also meant that these pooled fund investors might choose not to provide support,” she added. Pooled LDI funds became compelled to sell gilts at a rate that would not have been absorbed in ordinary gilt trading conditions, let alone the market conditions of the period.

Breeden highlighted the systemic risk posed from leverage in the non-bank financial system — which is made up of financial institutions, including pension schemes, that do not have banking licences — arising through “two different channels of contagion”. These, she said, were markets and counterparties.

‘Others need to act’

Breeden acknowledged the role played by regulators in working with LDI funds during the crisis. LDI funds raised more than £40bn and sold over £30bn in gilts during the BoE’s intervention.

She repeated a claim made by the BoE’s deputy governor for financial stability, Sir Jon Cunliffe, who told MPs in October that LDI funds’ liquidity buffers would now stand them in better stead should yields spike again.

“The risk of LDI fund behaviour triggering ‘fire sale’ dynamics in the gilt market and self-reinforcing falls in gilt prices is — for now at least — significantly reduced,” Breeden said. “It is important that it stays that way.” 

“Others need to act too,” she continued.

Breeden pointed to the work carried out by the BoE’s Financial Policy Committee on the non-bank financial system, which has included specific work on LDI leverage and liquidity.

In 2018, a stress simulation was conducted and led to closer work with TPR and the Financial Conduct Authority.

Breeden stressed the need for greater transparency and said it is “vital that regulatory authorities have sight of leverage building up in the system, and what that means for resilience”. 

“That requires better regulatory disclosures for non-banks and investment in monitoring capabilities.”

“Beyond improving transparency, regulators will need to consider how best to ensure leverage is well managed,” she continued. 

“These could, for example, include broad market-wide measures such as market regulations to ensure excessive leverage is better controlled by market pricing and margins.”

Breeden emphasised that “lessons must be learned”, chiefly by non-banks, but also by their regulators. 

“Although this is not the first time the industry has faced this difficulty,” Charles said, “it again highlights the significance of political risk associated with pension scheme investment and raises the question as to if and how financial models can be updated to capture such dramatic market shifts so they can be considered and prepared for.

"It will be interesting to see if the BOE waters down today's call over the coming weeks as the reality (and background) to this scenario sinks in."

TPR has been contacted for comment.