Bank of England encourages pension funds to be prepared for larger market shocks in gilt markets

The central bank recommends that liquidity requirements be increased to more than twice the level of stress tests after 2022 turmoilIn an attempt to avoid another year of gilt market turmoil, the Bank of England is urging pension funds to be prepared for a more severe bond market shock than they were previously tested against.

The BoE’s quarterly update on financial stability from the Financial Policy Committee included a recommendation about how to reduce the risk of future meltdowns. It was released Wednesday.

FPC advised pension funds to keep liquidity indefinitely to cope with future instability. The FPC concluded that the UK’s banking sector was “resilient” and that household indebtedness is better than expected. However, it warned of possible problems in the global private credit markets.

It reiterated that “urgent action” is needed to address financial institution risks beyond traditional banking.

The failures of Silicon Valley Bank, Credit Suisse and other financial institutions have been the focus of recent news. However, the FPC has been monitoring UK pension funds since September’s market turmoil.

After Liz Truss’s tax-cutting budget, the pension funds’ liability-driven strategy (LDI) of using government bonds as a way to manage risk went sour, the strategy of using these bonds by pension funds backfired.

The LDI funds did not have any specific requirements for liquidity management, but were stress-tested by BoE to determine their ability to withstand a 100 basis-points change in bond yields. They were then forced to sell government debt, creating a price spiral.

The BoE now recommends that the Pensions Regulator take immediate action to require LDI funds have liquidity buffers to allow them to deal with a 250bp increase in interest rates. They would not need to sell assets. The September jump was 160bp.

Simeon Willis is chief investment officer of XPS, the retirement consultants. He said that the 250bp threshold will not surprise the sector. “The minimum level for resilience is lower than what most pension schemes have been working towards and this shouldn’t be a problem for schemes whose funds are already in line with guidance.”

The BoE is working to reduce the risk of instability in pension funds as part of its wider efforts to limit the risks in nonbank financial institutions. This includes hedge funds and private credit.

The FPC updated to warn of risks in fast-growing global private debt market. Higher interest rates and borrowers with low credit ratings make loans more vulnerable to a “deteriorating macro environment”.

The FPC stated that signs of stress in these markets could lead to a rapid reassessment by investors, potentially leading to sharp revaluations.

FPC also provided details about previously announced plans to stress-test the wider financial system. This exercise, it stated, would “investigate banks’ and nonbank financial institutions’ behaviours following a severe but plausible disruption to financial markets”.

The exercise, unlike the annual banking stress test, will not identify specific firms but rather assess the system’s vulnerabilities.

FPC reiterated their call for urgent global work to strengthen non-bank financial markets. They warned that there were “vulnerabilities in certain parts of the ecosystem that could crystallize should there be more volatility or sharp movements of assets prices”.

The FPC in the UK decided not to permit banks to release a “counter cyclical buffer”, a capital buffer for crisis times, to support lending, but stated that it would “continue closely monitor the situation”.

The FPC stated that the buffer would be adjusted “in accordance with economic and financial conditions”. FPC stated that they have not seen any evidence of banks reducing lending and that it appeared to be related to the poorer health of some borrowers.

Charles Counsell, Chief Executive of the Pensions Regulator said that “We take note of the recommendations by the BoE’s Financial Policy Committee regarding LDI.

“The committee clearly outlined its expectations relating the minimum level of resilience trustees and fund managers should adhere to when using LDI. This builds upon the guidance that we and the National Competent Authorities, (NCAs) established in November.

“We will issue updated guidance on LDI starting in April.”

Separately, FPC recommended that the regulator for pensions take on a financial stability responsibility. Experts predict that this would lead to the watchdog reviewing major changes in funding rules for thousands upon thousands of defined-benefit schemes.