Regulatory action should be taken by The Pensions Regulator (TPR), in co-ordination with the Financial Conduct Authority and overseas regulators, to improve the resilience of liability-driven investment (LDI) funds, the Bank of England’s Financial Policy Committee (FPC) says.
In its December financial stability report, published today, the FPC welcomed the guidance TPR issued on LDI resilience at the end of November as well as FCA guidance issued at the same time.
But it recommended that, given the identified shortcomings in previous levels of resilience and the challenging macroeconomic outlook, further steps should be taken to "ensure regulatory and supervisory gaps are filled" and make sure LDI funds remain resilient to the higher level of interest rates that they can now withstand.
The report said: "While it might not be reasonable to expect market participants to insure against the most extreme market outcomes, it is important that shortcomings are identified and action taken to ensure financial stability risks can be avoided in future. There is a clear need for urgent and robust measures to fill regulatory and supervisory gaps to reduce risks to UK financial stability, and to improve governance and investor understanding."
It added: "The FPC is of the view that LDI funds should maintain financial and operational resilience to withstand severe but plausible market moves, including those experienced during the recent period of volatility. This should include robust risk management of any liquidity relied upon outside LDI funds, including in money market funds."
It said regulators should also set out appropriate steady-state minimum levels of resilience for LDI funds more broadly - including in relation to operational and governance processes and risks associated with different fund structures and market concentration.
The FPC report also said it was important for defined benefit (DB) pension schemes to improve their liquidity management practices - adding that appropriate reporting and data collection was likely to be needed to monitor the resilience of LDI funds.
It said the BoE would continue to work closely with domestic and international regulators so that LDI vulnerabilities are monitored and tackled.
The report added that banks, as providers of funding to the LDI sector, should apply a prudent approach when providing finance to LDI funds - taking into account the resilience standards set out by regulators and likely market dynamics in relevant stressed conditions.
As a next step in tackling the risks posed by LDI funds, the FPC said it supports further work by the Prudential Regulation Authority and FCA to understand the roles of the firms that they regulate in the recent stress, focussing particularly their risk management, and to investigate lessons learned.
The FPC report also commented on investment consultants - noting they played "an important role by providing unregulated services that can significantly influence the investment strategies of asset owners and asset managers, including pension schemes".
In particular, it said investment consultants advise pension fund trustees on issues such as strategic asset allocation and asset manager selection - but noted that, currently, they are not required to be FCA-authorised for those activities.
It said: "The FCA have recommended that HM Treasury considers bringing investment consultants into the FCA's regulation, which would improve the effectiveness of intermediaries. In this regard, the FPC supports this recommendation by the FCA."
Current levels of resilience
The FPC noted the BoE's interventions in gilt markets in September and October had given stressed market participants time to build their resilience to insure themselves against any further disruption in long-dated gilt markets.
It said that, as a result of funds injected by investors and the falls in long-term gilt yields, the resilience of sterling LDI funds across Europe had subsequently improved, with an average yield buffer in the region of 300-400 basis points being built up, though noted many funds have resilience in excess of this. It said this would currently imply resilience to long-term gilt yields of around 7%.
The FPC is of the view that LDI funds should maintain financial and operational resilience to withstand severe but plausible market moves, including those experienced during the recent period of volatility. This should include robust risk management of any liquidity relied upon outside LDI funds, including in money market funds.
This episode demonstrated that levels of resilience across LDI funds to the speed and scale of moves in gilt yields were insufficient, and that buffers were too low and less usable in practice than expected, particularly given the concentrated nature of the positions held in the long-dated gilt market.
Commenting on the FPC's report, A spokesperson for TPR said: "We welcome the FPC's recommendations. We will continue to work closely with the Bank of England and other regulators on a longer term plan to ensure trustees who use LDI maintain an appropriate level of resilience in leveraged arrangements.
"We have already issued new guidance setting out expectations for trustees using LDI and we will be building on this in the months to come. This will include updated guidance in our 2023 Annual Funding Statement."
Scheme funding code
This comes as the Financial Times reported that TPR had said DB schemes would face stricter requirements around the use of leverage in their investment strategies under new scheme funding rules, which are due to come into force next year.
The FT said the regulator's executive director of regulatory policy, analysis and advice David Fairs had told viewers of an industry webinar that schemes would be expected to have liquidity buffers to withstand a shift of around 300 basis points in gilt yields.