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LDI fund turmoil prompts first stress test for non-banks

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LONDON — Investment funds and other non-bank financial institutions face their first ‘stress test’ next year to apply lessons from the near-meltdown in Britain’s pension fund sector, the Bank of England said on Tuesday.

The BoE had to step in from September to buy 19.3 billion pounds ($23.75 billion) of government bonds to stabilize markets after turmoil caused by the fiscal plans of Liz Truss’s short-lived government.

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Liability-driven investment (LDI) funds, used by pension funds to ensure their long-term payouts, struggled to meet collateral calls as bond prices tumbled.

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The BoE’s Financial Policy Committee (FPC), which monitors the financial system for risks, said on Tuesday that the LDI crisis showed the need to test how non-bank financial institutions (NBFI) cope with stresses.

“The Bank will run, for the first time, an exploratory scenario exercise focused on NBFI risks, to inform understanding of these risks and future policy approaches,” the FPC said in its half-yearly Financial Stability Report.

Further details will be set out in the first half of 2023.

“There is also a need to develop stress-testing approaches to understand better the resilience of NBFIs to shocks and their interconnections with banks and core markets,” the FPC said.

The test will focus on the UK government and corporate bond market and its main participants, which play a core role in financing the UK economy.

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Such market-based finance accounted for 776 billion pounds, or 55%, of all lending to UK businesses at the end of 2021 and nearly all of the almost 390 billion pound net increase in lending to the sector between the end of 2007 and end of 2021.

LDI funds are often listed in Ireland and Luxembourg, where regulators – along with their UK counterparts – have introduced quick fixes that forced funds to maintain far higher levels of cash.

They can now cope with a 300 to 400 basis point move in interest rates, well above the 150 basis point level held before September’s turmoil.

“Ensuring greater resilience has been a central priority for managers of LDI strategies in the aftermath of the unprecedented gilt market movements we saw in late September,” said Jonathan Lipkin, director for policy, strategy and innovation at the Investment Association.

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The sector plans to work with regulators “so that future stress tests are robust to a yield shock of this magnitude, and that any risk measures put in place are proportionate”, he added.

NEW GUIDANCE

The FPC said it will work with counterparts in the European Union to come up with mimimum cash buffer guidance on a longer-term “steady state” basis, which could potentially push up fees to absorb the cost or make the use of LDI funds unattractive.

Britain’s pensions regulator is due to update its guidance to the sector in April, which could include the new steady state cash buffer levels, data reporting and requirements for fund trustees to speed up decision-making in a crisis.

The FPC said it also backed a call from the Financial Conduct Authority to regulate consultants who advise pension funds.

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After regulators introduced tougher rules for banks in the aftermath of the global financial crisis more than a decade ago, attention is turning again to non-banks, such as funds and insurers, which account for about half of the global financial system.

Regulators worry there is too little data on hidden leverage in the system, as shown by LDI.

“The episode also exposed deficiencies in how banks monitor and manage risks with respect to LDI funds,” the FPC said.

The FPC said there will be a consultation paper in 2023 on likely moves to require money market funds – which struggled when economies went into COVID-19 lockdowns in March 2020 – to hold more cash. ($1 = 0.8127 pounds) (Reporting by Huw Jones and David Milliken Additional reporting by Carolyn Cohn Editing by David Goodman)

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