After the City regulator issued a warning about “significant deficiencies” in asset managers, the funds industry that was at the heart of the pension scheme meltdown during Liz Truss’ premiership will face a new clampdown.
Financial Conduct Authority issued tougher guidelines yesterday for companies that operate liability-driven funds. It also told asset managers it expects them to make the necessary changes “as soon as possible”.
The mini-budget of September caused a sell-off on UK government bond market. As a result of the fall in gilt prices, margin calls were increased at liability-driven funds. This forced pension scheme to sell assets in a fire sale. The Bank of England was concerned that government bonds could be caught in a “doomsday loop” of selling. Concerns about financial stability prompted the Bank of England to buy PS19.3billion in gilts to settle market.
The episode revealed weaknesses in the management of liability-driven funds. Last month, the Bank’s Financial Policy Committee urged The Pensions Regulatorto introduce minimum market-stress buffers to help liabilities-driven investment strategies absorb shocks. Yesterday, the regulator released new guidelines for liability-driven investments strategies. It expected retirement scheme trustees to “only invest in leveraged LDI agreements that have an appropriately sized cushion”.
The oversight of liability-driven funds is complex, as the Bank of England, the FCA and The Pensions Regulator have different responsibilities.
The authority stated that it found “significant deficiencies” in the management and control of risks, including scenario planning and stress testing; communication and client service; and operational arrangements at firms who use liability-driven strategies. The authority said that “all of these factors contributed to market dysfunction, and the threat to financial stability,” which was the result.
The report outlined reforms in the industry, including that clients of liability-driven investments should be able “to deliver collateral within five days or earlier” and that firms should conduct more rigorous internal stress tests.
Sarah Pritchard said that the FCA’s new guidance aimed to ensure “that necessary lessons are learned from last September’s extrem events”. She added: “Many lessons will be applicable to firms outside the LDI industry.”
Liability-driven funds, or shadow banks, are non-bank financial institutions. They include hedge funds and pension schemes. Shadow banks are typically less regulated and opaque than traditional lenders. As interest rates rise rapidly, global regulators worry that unexpected stress is starting to appear in this part of the financial system.
The speculation of gilt investors, that borrowing rates would rise dramatically after the mini budget, ultimately caused the liability-driven crisis. The Bank and other watchdogs are alert to problems in shadow banking.
The FCA stated: “Recent sustained periods of volatility have led to increased financial, credit and operation risks in many areas of the market.” In volatile environments, risk can change rapidly. Operational or counterparty risk can sometimes lead to new or elevated market risks.