The Financial Conduct Authority has told MPs that it previously pointed to the risks associated with liability-driven investments and suggested the existence of a “gap in regulation” linked to investment consultants, in response to questions over October’s market turmoil and its impact on pension schemes.
On November 7, FCA chief executive Nikhil Rathi and interim chair Richard Lloyd appeared before the treasury committee to discuss its recent work.
Earlier in November, the Bank of England’s executive director for financial stability strategy and risk, Sarah Breeden, called on regulators to review how leverage is managed, in the wake of a liquidity crisis in October triggered by a spike in gilt yields.
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.
If their advisers had been more sensitised to dealing with such levels of stress, then some of that risk may have been managed a bit more effectively
Nikhil Rathi, FCA
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.
At the treasury committee hearing, Conservative MP Harriett Baldwin put to the FCA’s representatives that the FCA “had been on the record pointing out the risks in liability-driven investing and that there was an absence of swimming trunks around in these leveraged portfolios for pension funds,” in reference to comments previously made by investor Warren Buffett about the risks of LDI.
“We had pointed to the risk, and also that there was a gap in regulation, which is investment consultants, who were advising pension trustees,” Lloyd replied.
‘It was wholly exceptional’
During the market turmoil, the Pensions Regulator issued guidance calling on 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 ascertain what actions they could take in response to the gilt market volatility.
Baldwin asked Rathi and Lloyd if the regulation of investment consultants would have “solved the problem”.
“It is hard to know whether that would have stopped the problem,” Lloyd responded, “in particular because the trigger for the particular issue that week was unexpected, to say the least”.
Lloyd disclosed that Rathi had raised the crisis with him “at least a day” before the BoE’s intervention, which commenced on September 28.
“Certainly in that week, we saw movements of 30-year gilt yields that were unprecedented,” Rathi said.
“We had never seen those in the history of the gilt market; they were twice as large as March 2020 and three times as large as any historical norm.
“It was beyond anything that any of us had experienced before in terms of price movements, and that led to the risk of a self-reinforcing spiral as some of that leverage was being unwound, and as margin calls were being made for derivatives as collateral needed to be accessed.
“It is difficult to say with hindsight what particular measure may have prevented that situation, as it was wholly exceptional.”
More data required
Rathi told the committee that in the future the FCA would want to see more data reporting on liquidity and the management of leverage.
When asked by Baldwin if there was a lack of data on which pension funds had a leveraged exposure, Rathi replied that this would fall within TPR’s remit.
He added that TPR “does not collect systematic data on pension funds and leverage, relying explicitly on the trustees in its regulatory framework to manage those risks”.
“I think there will also be some questions about margin requirements,” he continued.
“There has been a lot of international work to try to manage the procyclicality of margin requirements, so that when prices move in a particular way, you don’t — through the collection of margin — aggravate the situation that you are dealing with.”
Rathi also pointed to “operational issues” that unfolded during the crisis.
“To address your point about whether the regulation of investment consultants would have made a difference, part of the challenge in some of these stress situations is that sometimes there are operational challenges in managing the situation,” Rathi told the committee.
“We need to see stronger resilience and stronger reverse stress testing so people think about how they would work in a world where the system could be broken, and how they would plan and manage their resilience in those situations.
“To that extent, if investment consultants were more actively regulated, there would be a greater focus on those issues from those parties, and they obviously play a role in advising pension funds and trustees.”
Baldwin asked whether it was the case that if pension fund consultants were regulated by the FCA the crisis would not have unfolded. Rathi rejected this suggestion.
BoE director calls for greater regulatory oversight on leverage
The Bank of England’s executive director for financial stability strategy and risk has called on regulators to review how leverage is managed, in the wake of a liquidity crisis in October triggered by a spike in gilt yields.
“There were challenges related to the resilience of the management of the situation by managers and pension funds,” he continued.
“Perhaps if their advisers had been more sensitised to dealing with such levels of stress, then some of that risk may have been managed a bit more effectively. I wouldn’t go so far as saying that that, in and of itself, would have prevented such a situation.”
He added: “We saw a movement in gilt prices that was beyond anything we had experienced in history”.
