Lessons have been learned from the 2022 gilts market shock, according to new analysis from the Bank of England – but the central bank is still working on ways in which to improve resilience for pension schemes, LDI managers and others.
The government bond market is more resilient to shocks than it was in 2022, the Bank of England found following a “system-wide exploratory scenario” conducted during this year.
It worked with pension schemes, liability-driven investment (LDI) managers, insurance companies, hedge funds, banks and others in the financial services industry to test the potential impact of a severe market shock driven by geopolitical tensions.
As a result, the Bank has begun work on a financing facility to allow it to lend directly to pension funds and other institutions outside of the banking sector to reduce the potential impact of a liquidity crisis.
In the report, the Bank stated that the “financial and operational resilience” of LDI funds and strategies had improved over the past two years. In September 2022 as gilt prices plummeted, some LDI funds were forced to call in extra collateral to meet margin calls – something many pension funds were unprepared for.
Leverage has been reduced significantly since then, the report stated, while many LDI clients had set up “waterfall” arrangements to give LDI managers access to a supply of liquid assets if further collateral is required.
LDI fund managers now had capital buffers “well above” the regulatory minimums, the Bank said, and were supplying more and better data to their clients.
Improved scheme funding and the continuing trend towards buy-in and buyout transactions also supported LDI strategies as they meant pension schemes were required to take less risk in order to achieve their aims.
Nausicaa Delfas, chief executive of the Pensions Regulator, said the Bank of England’s report showed that “pension schemes are now more resilient to extreme market movements”.
“We recognise the important role pensions play in the wider financial ecosystem and continue to guard against systemic risks by understanding how schemes act during stressed market conditions, as well as exploring improvements to our data collection to make sure we keep savers safe,” she added.
A warning on other fixed income markets
Despite the improvements, the Bank of England said in its shock scenario that defined benefit pension schemes would still be required to sell assets.
Corporate bond holdings could be affected by sales, with some areas of sterling fixed income becoming illiquid.
The Bank noted that a recent increase in allocations to asset-backed securities strategies meant these too could be sold during a crisis. Such investments tended to be more liquid than corporate bonds, the report said.
The Bank of England also highlighted the role of global portfolios and overseas assets. The September 2022 gilts crash was focused on sterling markets, so some pension schemes were able to raise cash by selling overseas assets.
However, the test scenario affected global markets, which meant that “the ability to switch to selling overseas assets was not as great”.
The report added: “While holding foreign-currency assets diversifies the markets which pension schemes can transact in to generate liquidity, it introduces other risks such as exposure to variation margin calls on exchange rate hedges.”
Bolstering the gilt market and LDI strategies
The Bank of England is developing a new financing system to allow it to provide liquidity directly to pension funds, LDI managers and other financial institutions in the event of a shock, it said.
The Bank’s report warned that the repo market – which supports short-term sale and buyback agreements to bolster liquidity – may not be able to meet the demands of all investors during a financial shock event.
While banks can lend in the gilt repo market, the report said they tend to “tighten terms” and withdraw from providing additional financing once a shock hits. However, non-bank financial institutions such as pension funds tended to expect that they would be able to access liquidity in the repo market.
The Bank of England’s new tool, which it began work on last year, is known as the Contingent NBFI Repo Facility, and is designed to facilitate lending to NBFIs – non-bank financial institutions.
It said the facility will “supply cash to eligible pension funds, insurance companies and LDI funds against UK sovereign debt (gilts) for a short lending term”.
However, the Bank also emphasised that “further work is required given the other vulnerabilities highlighted by this exercise”. These included limits on banks’ willingness to buy, lend and intermediate asset sales.
The scenario showed that LDI funds would still lean first on their pension fund clients for liquidity before turning to gilts sales.
The report said this finding “underlines the importance” of recommendations and guidelines brought in by the Financial Conduct Authority and the Pensions Regulator last year to “increase the financial and operational resilience of pension schemes’ LDI positions, and emphasises the importance of maintaining it”.
Pension schemes that participated in the exercise included the BT Pension Scheme, Greater Manchester Pension Fund, HSBC Bank Pension Trust, Lloyds Banking Group Pension Scheme, Railpen, the Pension Protection Fund, the People’s Pension, and the Universities Superannuation Scheme.
Further reading
How are DB schemes changing the gilts market? (7 March 2024)
Learning lessons from the gilts crisis (5 October 2023)
Budget 2024: Bond managers downplay gilt market volatility (31 October 2024)
LDI funds sold £23bn of gilts during market turmoil (18 January 2023)
