Sarah Breeden, BoE Executive Director of Financial Stability, Strategy and Risk, has delivered a speech on resilience within Liability Driven Investment (LDI) funds at Westminster Business Forum policy conference.
The speech opened with a recollection of how poorly managed leverage at some LDI funds last year amplified a sudden repricing of assets following the Government’s growth plan, creating a “self-reinforcing price spiral” in the gilt market. BoE then intervened as part of its financial stability objective, which allowed LDI funds time to build their resilience.
While BoE’s Financial Policy Committee (FPC) does not have regulatory responsibility for pension schemes or LDI funds, it has recommended a framework for steady-state resilience within LDI funds, and asked that The Pension Regulator (TPR) enforce minimum levels of resilience. TPR took a first step towards this in April. FPC wants to ensure that core markets can continue operating even while suddenly repricing, requiring LDI funds to be resilient enough to prevent forced deleveraging and gilt sales in the event of severe but plausible stresses in gilt yields.
FPC judged that LDI funds should be resilient to a yield shock of 250 basis points, at a minimum, and that they should also hold additional resilience over and above this according to their own individual risks. This figure was based on the following three ‘building blocks’:
- Baseline resilience component
- Captures idiosyncratic risks of assets held by LDI funds.
- Calibrated similarly to the baseline price volatility that central counterparty style initial margin models tend to absorb, by looking at the tail of the 10-year distribution of 30-year index-linked gilt yields.
- Currently sits at around 80 basis points.
- Systemic resilience component
- Aimed at ensuring all LDI funds can absorb a severe but plausible historical stress, over the period of time needed to recapitalise the fund, without the need for forced asset sales.
- Calibrated by looking further into the tail of a longer distribution of 30-year index-linked gilt yields.
- Currently sits at around 170 basis points.
- Additional resilience component
- Calibrated by funds according to assessments of their own exposures and operational capabilities, as well as interest rate trends and levels of market volatility.
The baseline and systemic components make up the 250 basis points minimum. In calculating this figure, FPC expected pension schemes to be able to deliver collateral to their LDI vehicles within 5 days. Those unable to do so should be resilient to a larger shock, calibrated to their own timelines.
Breeden noted that BoE will shortly be launching an exploratory exercise to enhance understanding of the risks to and from non-banks, their behaviours, and how these behaviours can amplify shocks.