The chair of a UK parliamentary committee investigating last autumn’s crisis in the government bond market - which forced the Bank of England to intervene - says gearing in LDI structures should be reduced and capital liquidity buffers introduced.
Lord Hollick, chair of the House of Lords’ Industry and Regulators Committee, wrote to the government today following the panel’s scrutiny of the issues around the LDI (liability-driven investment) crisis, with a series of recommendations.
Hollick said the committee was calling for regulators to introduce greater control and oversight of the use of borrowing in LDI strategies and for the government to assess whether the UK’s accounting standards were appropriate for the long-term investment strategies that are expected of pension schemes.
“This will help ensure that the turbulence that followed the September 2022 fiscal statement doesn’t happen again,” he said.
In an interview today, IPE asked Hollick what the key changes were that now needed to happen.
“I think the first and most important reaction is going to be the Bank of England’s view which is going to be published in the next few weeks on steps that need to be taken in order to de-risk LDI structures,” he said.
“Clearly the the level of gearing is an important issue, it could be substantially reduced,” the UK peer said.
“There’s a question of whether or not capital liquidity buffers need to be put in place, because if you look at the defined-benefit (DB) plans that have been put in place by insurance companies, they’re regulated by the Prudential Regulation Authority and they’re regulated in the way that insurance products are generally - there’s a capital buffer,” Hollick said.
While this would increase the cost of pension funds, he said, it would also help pension funds withstand a liquidity crisis.
“So I think those are possibly the two areas that could be changed quickly,” he said.
“The longer-term question of whether the accounting pushes you into bad behaviour, and whether there’s a potential change there, whether or not LDIs should form such a large part of the portfolio now that we’ve moved out of a period of quantitative easing and longer term flat interest rates - those are more medium-term discussions,” Hollick told IPE.
In his letter to Andrew Griffith, economic secretary to the Treasury, and Laura Trott, pensions minister, Hollick said: “The fundamental issue is that leveraged LDI has been created as a solution to an artificial problem created by accounting standards, but in the real world its application creates downside risks.”
The committee found that the use of borrowing and derivatives by pension schemes to hedge volatility was not permitted by the relevant underlying EU legislation, and this appeared to have been “permissively transposed in a way that allows pension schemes to continue using such strategies”.
Hollick said it was likely that some pension scheme trustees had not been aware of the potential implications of their LDI strategies and their decision-making struggled to match the pace of markets.
This had led them to become dependent on advice from investment consultants, whose advice to schemes was currently unregulated, and might not be comprehensive over the whole portfolio or cover operational requirements, he said.
Regulators in the sector seemed to have been slow to recognise the systemic risks caused by the concentration of pension schemes’ ownership of assets such as index-linked Gilts, and the increasing use of more complex, bank-like strategies and instruments by pension funds, according to the letter.
Recommendations in the letter include a review by the government and the UK Endorsement Board of whether the current system of accounting for pension scheme finances in company accounts is appropriate - and whether to introduce a system “that does not drive short-termism in pensions investment”.
It also recommends that investment consultants are brought “within the regulatory perimeter as a matter of urgency”, and that the The Pensions Regulator be given a duty to consider the impacts of the pensions sector on the wider financial system.
Asked who, if anyone, had been to blame for the crisis in UK financial markets last autumn, Hollick told IPE:
“There’s a collective villain, and the collective villain is that things were going along jolly nicely and interest rates were flat and no one really tested that - there was no requirement to look long and hard at what could happen in the event of a 300 basis point change.”
It had been an industry-wide thing, he said.
“Nobody asked the awkward questions.
“And the pension fund trustees, who had the legal responsibility to look after these things of course relied on the advice they received,” said Hollick.
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