Liability-driven investment

For several years, central banks' interest in the non-bank sector has been increasing, due to its growth and the significant role it now plays in the funding of the real economy. The high market volatility in spring 2020 put in train a series of international regulatory workstreams looking closely at the sector, led by the Financial Stability Board (FSB). The fall-out from these workstreams is still ongoing, including supervisory focus on liquidity risk management and tools (such as swing pricing).

Volatility in the UK gilt market in September 2022 and associated challenges for Liability-Driven Investment (LDI) managers have further added to scrutiny of the non-bank sector. In their responses to events, regulators have set new expectations and laid out follow-up supervisory and policy work. All market participants should take this opportunity to reassess their risk management practices considering recent events.

LDI strategies are sometimes used in the management of defined benefit (DB) pension schemes where the present value of long-term pension scheme liabilities (payments due to retiring beneficiaries) exceeds the value of the assets. The strategy involves using leverage to mitigate interest rate and inflation risk, for example by using interest rate swaps. Asset managers manage LDI strategies in segregated accounts for single clients or in pooled funds on behalf of multiple clients.

As gilt yields rose and their prices fell in September 2022, the value of LDI portfolios also fell and their levels of leverage increased. This resulted in increased margin calls from their counterparties (banks). LDI portfolios needed to sell gilts quickly to raise cash to meet the resulting liquidity demands, leading to a `feedback loop' as the value of gilts fell further. The scale of selling forced the Bank of England (BoE) to intervene by purchasing gilts in order to restore market functioning.

In the wake of these events, UK and EU regulators have reiterated their expectations around LDI for asset managers, fund managers, pension fund trustees and banks.

UK LDI managers need to consider the expectations of various regulators:

• The Pensions Regulator regulates DB pension schemes
• The Financial Conduct Authority (FCA) regulates asset managers that manage those schemes
• The Prudential Regulation Authority (PRA) regulates banks (including where they act as counterparties to derivative transactions arranged by asset managers)
• Some pooled LDI funds are managed from the UK but are domiciled in the EU and regulated by the relevant national regulator

The BoE view, as set out in a speech by Sarah Breeden, was that the root cause of the recent LDI event was poorly managed leverage. The BoE indicated that it will work with other international regulators to improve banks' and non-banks' stress testing, supervise to limit risks from leverage, and build greater transparency around leverage through regulatory disclosures from non-banks and supervisory monitoring.

In December's Financial Stability Report, the UK's Financial Policy Committee (FPC) went further, stating that regulators should set out “appropriate steady-state minimum levels of resilience for LDI funds.” In practice this may translate into regulators setting out expectations regarding minimum liquidity buffers to be held by LDI portfolios, as well as ensuring that good governance is in place and operational processes are robust.

More broadly, the FPC remains concerned about risks arising from the non-bank sector and it reiterated strong support for urgent international and domestic policy responses. The FPC noted that banks “...should apply a prudent approach when providing finance to LDI funds.”

The FCA also published a statement regarding the resilience of LDI portfolios. It expects asset managers to take appropriate action to "learn lessons" from recent events and all market participants to factor recent market conditions into their risk management practices. The FCA will "maintain a supervisory focus" to ensure that vulnerabilities are addressed and will publish a statement on good practice towards the end of Q1 2023.

In parallel, The Pensions Regulator published a statement calling on scheme trustees who use LDI to maintain an appropriate level of resilience in leveraged arrangements to better withstand a fast and significant rise in bond yields. The statement also called on trustees investing in leveraged LDI to improve their scheme's operational governance.

As regulators of key fund jurisdictions, the Central Bank of Ireland and Luxembourg's Commission de Surveillance du Secteur Financier published and sent identical letters to local LDI fund managers, asking them to maintain the current level of resilience and the reduced risk profile of GBP-denominated LDI funds. The letters stated that LDI fund managers wanting to reduce GBP LDI funds' yield buffers below the current levels should notify the regulators in advance and provide a justification. ESMA welcomed these letters.

LDI managers and pension scheme trustees should read the relevant regulators' statements and take appropriate action, including factoring recent market conditions into risk management processes and adopting a wider horizon of extreme but plausible events.

There are also implications for market counterparties. Banks can expect scrutiny of their own risk management practices to increase again.

For the broader non-bank sector, the BoE will run a stress test exercise in 2023 for the first time — part of an enhanced focus that shows no sign of letting up. At the international level, the FSB will continue to lead work to enhance the resilience of the sector, including on improving transparency and the processes around margining practices.