Pension schemes must learn lessons from LDI crisis, says BofE

Bank of England (BofE) executive director, financial stability strategy and risk, Sarah Breeden, has emphasised that while the BofE remains ready to act where tail risks to financial stability materialise, pension schemes must also 'play their role'.

Speaking at the Westminster Business Forum Policy Conference, Breeden said liability-driven investment (LDI) managers and pension schemes “must ensure lessons from the crisis are learned and fully embedded into their operations and onto their balance sheets”.

During her speech, Breeden reflected on the Financial Policy Committee’s (FPC) recent recommendations on a framework for the steady-state resilience of LDI, and what pension schemes need to do to reduce financial stability risks.

In particular, she said that LDI funds need to be resilient enough to prevent forced deleveraging and gilt sales in the event of severe but plausible stresses in gilt yields, to ensure gilt markets can continue operating even while suddenly repricing.

"Funds should hold enough assets, which can meet collateral demands, to be able to absorb such a shock without having to sell assets," she explained.

"This will avoid feedback loops that threaten financial stability. Importantly, the FPC intends for LDI fund’s resilience to be usable. And after withstanding a stress, LDI funds should be able to continue operating during a period of recapitalisation by pension schemes."

Breeden also emphasised that "this is not just a financial stability issue", stating that it is not in the interests of pension schemes or their corporate sponsors for LDI funds to unwind their hedges in periods of market turbulence, when they are most needed.

"And neither is it in their interests for LDI funds to sell assets at temporarily depressed prices," she added. "So pension schemes have no reason not to invest in LDI funds if they use their resilience to meet margin and collateral calls."

In addition to this, Breeden argued that while LDI funds are not expected to self-insure against all possible shocks, there needs to be the right balance between private self-insurance and a public backstop.

Breeden stated: “Central banks cannot be a substitute for the primary obligation of LDI funds to manage their own risk.

“The FPC’s recommendations for building resilience in LDI funds – a form of private insurance – are aimed at ensuring there is the right balance between public backstop and private insurance and are an important step to removing the moral hazard that could be introduced by a public backstop.

"Ensuring financial stability is not only a job for financial stability authorities and regulators such as TPR, but also for participants."

Breeden also highlighted the recent volatility as demonstration that the resilience framework recommended by the FPC is functioning “broadly as intended”, with funds holding significantly larger buffers than last year on average and initiating recapitalisation at “far higher” levels of resilience than they did previously.

However, while Breeden suggested that it has been “so far so good”, she confirmed that the BofE will look to assess whether there are any lessons to be learned from this recent experience for the implementation of the FPC recommendations and The Pension Regulator's guidance.

She also emphasised that "in situations where tail risks to financial stability materialise, the Bank remains ready to act", stating that providing backstop liquidity insurance when tail risks to financial stability crystallise is a "core part of central banks’ job".

Commenting more broadly, Breeden highlighted the framework as a “suitable framework for addressing non-bank vulnerabilities more generally”, which can be used to contain non-bank vulnerabilities and so to mitigate their financial stability impact.

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