The Bank of England is pushing pension funds to prepare for a bond market shock more than twice as severe as what they were previously tested against in an effort to avoid a repeat of last year’s gilt market turmoil.
The recommendation for how to mitigate the risk of future blow-ups was included in the BoE’s quarterly financial stability update from the Financial Policy Committee, released on Wednesday.
The FPC urged pension funds to permanently hold liquidity to deal with future instability. It concluded that the UK banking sector “remains resilient” and the outlook for household indebtedness was better than expected, while warning of potential issues in global private credit markets.
It also reiterated the need for “urgent action” to address risks in financial institutions beyond the perimeter of traditional banking.
While the failures of Silicon Valley Bank and Credit Suisse have dominated recent headlines, UK pension funds have been in the FPC’s crosshairs since last September’s market turmoil.
Pension funds’ liability-driven investment (LDI) strategy of using government bonds to manage risk backfired after former prime minister Liz Truss’s tax-cutting Budget triggered an unprecedented rise in UK borrowing costs.
The LDI funds, which did not have any fixed requirements on liquidity management but had been stress-tested by the BoE against their capacity to withstand a 100-basis-points move in bond yields, were forced to fire-sell government debt, leading to a price spiral.
The BoE has now recommended the Pensions Regulator act “as soon as possible” to require LDI funds to hold liquidity buffers that would allow them to cope with a 250bp move in interest rates without having to sell assets. The jump in September was about 160bp.
Simeon Willis, chief investment officer at XPS, the pension consultants, said the 250bp threshold won’t surprise the sector. “The minimum level of resilience is lower than most pension schemes have been working to and as such this shouldn’t cause any issues for schemes whose funds were already in alignment with guidance.”
Reducing the threat of instability in pension funds is part of the BoE’s wider work on containing the risks in non-bank financial institutions, which includes hedge funds, private credit, asset managers and crypto.
In its update, the FPC pointed to risks in the fast-growing global private credit market, where higher interest rates, combined with the fact that borrowers are typically small and do not have credit ratings, mean loans are “more vulnerable to a deteriorating macro environment”.
“Signs of stress in these markets could cause a rapid reassessment of risk by investors potentially resulting in sharp revaluations,” the FPC said.
The FPC also gave further detail of previously announced plans for stress-testing the wider financial system, an exercise it said would “investigate the behaviours of banks and non-bank financial institutions following a severe but plausible stress to financial markets”.
Unlike the annual banking stress tests, the exercise will not make findings on specific firms, rather it will assess the vulnerabilities of the system.
The FPC reiterated its call for “urgent” global work on the resilience of non-bank financial markets, warning there were “vulnerabilities” in parts of that ecosystem that “could crystallise should there be further volatility or sharp movements in assets prices”.
In the UK, the FPC opted not to allow banks to release a crisis-time capital buffer, known as the “counter cyclical buffer”, to shore up lending but said it would “continue to monitor the situation closely”.
It added that it would be ready to adjust the buffer “in line with the evolution of economic and financial conditions”. The FPC said they had seen only limited evidence of banks cutting back on lending, and that this appeared to be linked to poorer health of some borrowers.
Charles Counsell, chief executive of the Pensions Regulator, said: “We note the recommendations from the BoE’s Financial Policy Committee on LDI.
“The committee has clearly set out its expectations relating to the minimum level of resilience it wants trustees and fund managers to adhere to when using LDI, and I am pleased this builds on the guidance that we, and the National Competent Authorities (NCAs), put in place in November.
“We will be issuing updated guidance on LDI in April.”
