FPC assessment of required resilience for systemic risk
Last autumn saw moves in UK government bond yields the speed and scale of which were unprecedented. That period saw two daily increases in 30-year gilt yields of more than 35 basis points; the biggest daily increase before that week in data that goes back to 2000 was 29 basis points. Measured over a four-day period, the increase in 30-year gilt yields was more than twice as large as the largest move since 2000, which occurred during the ‘dash for cash’ in 2020. It was more than three times larger than any other historical move.
This caused significant falls in the prices of long-dated gilts held by liability-driven investment (LDI) funds (in this document, ‘LDI funds’ refers to leveraged LDI funds and LDI mandates), which pushed up their leverage and resulted in the funds having to post additional collateral on their secured borrowing or pay margin calls on derivatives. To meet margin and collateral calls, as well as reduce leverage, LDI funds had to rebalance their portfolios sharply by selling liquid assets or asking their defined benefit pension scheme investors to provide more collateral.
Where this rebalancing could not be achieved quickly enough, LDI funds were forced to sell gilts into an illiquid market. This was a particular problem for many pooled LDI funds, given operational lags and the large number of smaller investors. Forced deleveraging into an illiquid market risked reinforcing the downward pressure on gilt prices. This downward spiral risked spilling over to broader market dysfunction, leading to an unwarranted tightening of financing conditions for businesses and households.
In response to the material risks posed to UK financial stability, the Financial Policy Committee (FPC) recommended that action be taken, and welcomed the Bank’s plans for a temporary and targeted programme of purchases of long-dated UK government bonds until 14 October. The introduction of the facility improved market conditions and allowed LDI funds to deleverage through rebalancing, and so build their resilience to future volatility in the gilt market. The FPC welcomed the timely and orderly unwind of the Bank’s portfolio of conventional and index-linked gilts purchased during the temporary and targeted financial stability operations between 28 September and 14 October 2022.footnote 
Following this, in December 2022, the FPC recommended that regulatory action be taken, as an interim measure, by the Pensions Regulator (TPR), in co-ordination with the FCA and overseas regulators, to ensure LDI funds remained resilient to the level of interest rates they could withstand at that point – around 300–400 basis points. It also said that regulators should set out appropriate steady-state minimum levels of resilience for LDI funds. The FPC welcomed guidance published by TPR in this regard, as well as statements by the FCA and overseas regulators on the resilience of LDI funds. So far, LDI funds had largely maintained these levels of resilience.
However, this requirement was explicitly temporary, and the level of resilience might erode over time in the absence of a clear long-term approach. The FPC, as the UK body with objectives for identifying, monitoring and addressing risks to the resilience of the UK financial system as a whole, has a responsibility to ensure the financial stability risks posed by LDI funds are addressed. Overall, the regulatory approach to LDI funds will cover a broad range of factors, including but not limited to financial stability. It will be for relevant regulatory authorities to determine and implement an approach whilst taking into account other objectives.
The FPC’s aim in considering a framework for steady-state LDI resilience is to promote financial stability by preventing forced deleveraging and gilt sales from LDI funds and pension schemes in the event of severe but plausible moves in yields. This would mitigate transmission of stress to financial markets or institutions, and so businesses and households.
To support the implementation of appropriate long-term minimum levels of resilience, the FPC recommended in March 2023 that TPR take action as soon as possible to mitigate financial stability risks by specifying the minimum levels of resilience for the LDI funds and LDI mandates in which pension scheme trustees may invest. In doing so, TPR should continue its effective collaboration with other domestic and overseas regulators. The FPC asked TPR to report back on how it intended to implement the recommendation.
As part of an appropriate steady-state minimum level of resilience, the FPC judged that:
- LDI funds should be able to withstand severe but plausible stresses in the gilt market;
- LDI funds should be able to meet margin and collateral calls without engaging in asset sales that could trigger feedback loops and so add to market stress;
- pension schemes might need to improve their operational processes to provide collateral to their LDI funds more swiftly when needed; and
- LDI funds should take into account the nature of their exposures, including on duration, leverage, and concentration of holdings, and the liquidity, duration, and convexity of collateral, in modelling their resilience to yield moves.
The FPC recommended that those severe but plausible stresses to which LDI funds should be resilient should account for historic volatility in gilt yields, and the potential for forced sales to amplify market stress and disrupt gilt market functioning. The FPC judged that these factors meant that the size of the yield shock to which LDI funds should be resilient should be, at a minimum, around 250 basis points, on which more detail is set out below.
This minimum level of resilience should be maintained in normal times, but could be drawn down on in stress. Minimum resilience around this level would ensure that funds could absorb a severe but plausible historical stress and still have a remaining level of headroom necessary to operate during a period of recapitalisation. This would ensure that funds have a level of resilience that they can draw down on in stress without having to sell assets. Where the resilience level has been breached, funds should determine appropriate action to take to return to the minimum.
To be able to maintain the minimum level of resilience in normal times, manage day-to-day volatility in yields and account for other risks they might face, including operational risks, funds would need to maintain additional resilience over and above the minimum. While these are expected to vary between funds, this approach would imply that total resilience levels should be broadly consistent with those currently prevailing in the market.
Until an appropriate framework incorporating these elements is put into place, the FPC judged that TPR, in co-ordination with the FCA and other overseas regulators, should continue to ensure that LDI funds maintain the resilience that has been built up as set out in the FPC’s November 2022 recommendation. The FPC noted that collaboration between regulatory bodies, including overseas regulators, had been effective in addressing LDI issues to date.
Bank staff’s assessment of appropriate resilience
While the FPC does not have specific regulatory responsibility for pension schemes or LDI funds, Bank staff have considered the design and calibration of resilience levels to illustrate how it might work in practice to deliver the outcomes set out above. These initial considerations are set out below, as an input into the process to be taken forward by other regulatory authorities when implementing the appropriate steady-state minimum levels of resilience.
The FPC judged that these factors meant that the size of the yield shock to which LDI funds should be resilient should be, at a minimum, around 250 basis points. This comprises two components (Figure 1).
Figure 1: LDI resilience should capture both systemic and idiosyncratic risks
The baseline resilience would aim to reflect the idiosyncratic risks of assets held by LDI funds. As an indication, staff suggest this could be calibrated similarly to the baseline price volatility that central counterparty (CCP) style initial margin models intend to absorb: in particular, the 99.8th percentile of a 10-year look-back window of rolling five-day shocks. For 30-year index-linked gilt yields, this is currently around 80 basis points.
The systemic resilience component would aim to ensure that all LDI funds are able to absorb a severe but plausible historical stress over the period of time needed to recapitalise the fund without the need for forced asset sales. Such forced selling disrupts gilt market functioning, tightening credit conditions for UK households and businesses and increasing risk to the financial system. Such a shock is of a similar scale to the largest ever historical move in gilt yields seen over a five-day period as occurred in September 2022; staff suggest this might be expressed as a 1-in-100 year five-day shock to 30-year index-linked gilt yields, which is around 170 basis points.
This level of resilience should allow LDI funds to remain resilient to severe but plausible systemic shocks without triggering forced deleveraging and feedback loops which threaten financial stability, while continuing to operate and meet margin and collateral calls and remaining resilient to idiosyncratic risks throughout.
In outlining these components, Bank staff have used five-day stresses to align with the FPC’s judgement that schemes should be expected to be able to deliver collateral to their LDI vehicles within five days; funds and schemes unable to implement these operational standards should be required to be resilient to a larger shock, calibrated to their own operational timelines.
In building their resilience to the yield shock, liquid assets held to ensure resilience in the event of such a shock should be unencumbered and immediately available. However, fund managers should have scope to consider additional assets, which investors had authorised them to use to meet collateral demands, as part of their resilience. Managers should apply appropriate prudence in doing this, for example by applying suitable haircuts.
In addition, no single regulatory standard is sufficient to ensure resilience. Therefore funds should consider a broader range of stresses such as a non-parallel shifts of the yield curve and more extended stresses when managing their overall resilience level.
While there is a cost to holding this additional liquidity, this should be balanced against the benefits to end-investor pension schemes from appropriate risk management of their leveraged LDI strategies. The resilience levels outlined here would allow funds and schemes to continue using leverage in their LDI strategies, but to do so in a way which avoids the risk of disorderly sales of pension scheme assets. It intends to allow schemes to maintain their hedges through periods of market volatility, ensuring their solvency positions can remain protected through market turbulence, rather than hedges being unwound when they are most needed. Finally, the resilience levels outlined here are also broadly consistent with the levels of resilience firms have been maintaining since the co-ordinated regulatory action in 2022 Q4.
The resilience levels proposed for LDI funds are consistent with the regulatory approaches in place for other systemically important financial institutions, where their standards are designed to allow institutions to continue operating after withstanding a severe stress. For example, bank capital requirements are informed by the Bank of England’s annual cyclical scenario, which in the current risk environment is calibrated using a 1-in-100 tail outcome to guide some of the variable paths, such as unemployment and house prices. Expectations on capital held by insurers are designed to allow them to continue meeting solvency capital requirements (calibrated to a 1-in-200 year loss in own funds over a year) following a shock. Finally, CCPs hold financial resources calibrated to absorb an ‘extreme but plausible’ stress scenario and continue operating.
The FPC agreed this by written procedure in January 2023.