Speech By Sarah Breeden, Bank Of England Executive Director, Financial Stability Strategy And Risk, Given At ISDA & AIMA

On the afternoon of 28 September, I found myself in a rather unusual position: having to explain to journalists why a part of the pensions industry, unheard of to most of their readers, had posed such a large threat to financial stability that it warranted intervention in the gilt market from the Bank of England.

Financial markets globally had been volatile for months. But in the days leading up to that fateful Wednesday and following the announcement of the Government’s growth plan on 23 September, long-dated gilt yields in particular had moved with extraordinary and unprecedented scale and speed.

Now volatility itself does not warrant Bank of England intervention. Indeed, it’s essential that market prices are allowed to adjust to changes in their fundamental determinants efficiently and without distortion.

However, some liability-driven investment (LDI) funds were creating an amplification mechanism in the long-end of the gilt market through which price falls had the potential to trigger forced selling and thereby become self-reinforcing. Such a self-reinforcing price spiral would have resulted in even more severely disrupted gilt market functioning. And that would in turn have led to an excessive and sudden tightening of financing conditions for households and businesses.

In response to this threat, the Bank of England intervened on financial stability grounds. But what led to that intervention?

The root cause is simple – and indeed is one we have seen in other contexts too – poorly managed leverage.

So today I’ll set out how leverage outside the banking sector can create risks to financial stability, starting with that small corner of the pensions market. And then I’ll set out what needs to be done – by participants, by their regulators and by financial stability authorities – if we are to ensure those risks to financial stability are reduced.

How did a small corner of the pensions industry threaten financial stability?

Many UK DB pension schemes have been in deficit, meaning their liabilities – their commitments to pay out to pensioners in the future – exceed the assets they hold. DB pension schemes invest in long-term bonds to hedge the interest rate and inflation risk that arises from these long-term liabilities. But that doesn’t help them to close their deficit. To do that, they invest in ‘growth assets’, such as equities, to get extra return to grow the value of their assets. An LDI strategy delivers this, using leveraged gilt funds to allow schemes both to maintain material hedges and to invest in growth assets. Of course that leverage needs to be well managed.

The rise in yields in late September – 130 basis points in the 30-year nominal yield in just a few days – caused a significant fall in the net asset value of these leveraged LDI funds, meaning their leverage increased significantly. And that created a need urgently to delever to prevent insolvency and to meet increasing margin calls.

The funds held liquidity buffers for this purpose. But as those liquidity buffers were exhausted, the funds needed either to sell gilts into an illiquid market or to ask their DB pension scheme investors to provide additional cash to rebalance the fund. Since persistently higher interest rates would in fact boost the funding position of DB pension schemesfootnote[1], they generally had the incentive to provide funds. But their resources could take time to mobilise.

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