There is an "urgent need" for increased resilience among non-bank financial institutions and activities, including liability-driven investment programs and money market funds, the Bank of England's financial policy committee recommended.
The FPC said in a quarterly market update on Wednesday that LDI programs should be able to absorb gilt market shocks of 250 basis points at a minimum, "in addition to the resilience required to manage other risks and day-to-day movements in yields."
LDI programs hit headlines last fall as gilt yields soared and prices plummeted amid announcements of unfunded tax cuts. The price drop resulted in huge collateral calls for some pension funds on their LDI programs, with some forced to sell assets to raise necessary cash to keep hedges in place.
In December, the FPC said regulatory action should be taken to ensure LDI programs could withstand shocks, resulting in the setting of a 300 basis points to 400 basis points buffer for moves in gilt yields. The FPC also said regulators should set appropriate steady-state minimum levels of resilience for these programs.
A separate document detailing the FPC's recommendations said the minimum 250 basis points recommendation comprises two components — that LDI resilience "should capture both systemic and idiosyncratic risks." The FPC set a "systemic resilience component" of 170 basis points, designed 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." That figure was calculated on the basis of a "1-in-100 year five-day shock to 30-year index-linked gilt yields," the document said.
On top of that, the FPC added a baseline resilience level of 80 basis points, allowing LDI programs to "stay resilient to idiosyncratic risks while continuing to operate."
LDI strategies "should be able to: withstand severe but plausible stresses in the gilt market; meet margin and collateral calls without engaging in asset sales that could trigger feedback loops; and improve their operational processes to meet margin and collateral calls swiftly when needed," the update said.
As such, the FPC wants The Pensions Regulator to take action as soon as possible to mitigate risks to financial stability "by specifying the minimum levels of resilience for the LDI funds and LDI mandates in which pension scheme trustees may invest." The FPC wants TPR to continue to work with other domestic and overseas regulators.
In order to implement and enforce its recommendations on LDI resilience over the long term, the FPC said TPR "should have the remit to take into account financial stability considerations on a continuing basis." The regulator "would need appropriate capacity and capability" in order to achieve this, the FPC said.
The FPC update also said that while U.K. banks are resilient — although it is monitoring events in the banking system closely following the failure of Silicon Valley Bank and "severe stress" for other overseas banks such as Credit Suisse — "there is an urgent need to increase resilience" in non-bank financial institutions.
As well as the need for immediate action regarding LDI programs, the FPC said money market funds — which help institutions to manage their cash in part due to the short notice required for redemptions — "are vulnerable to rapid and large investor withdrawals and could be a source of risk to the financial system and the wider economy. That is why the Bank of England is working with other authorities to improve their resilience," the update said. U.K. authorities will consult on these issues soon, the update added.
The BOE will also conduct a system-wide exploratory scenario to look into behaviors of bank and non-bank institutions "following a severe but plausible stress to financial markets." The exercise will consider what drives behaviors and their consequences, focusing on their potential to amplify shocks in ways that might threaten U.K. financial markets and stability.
"This will be an exploratory exercise focused on market resilience and its importance for financial stability; it will not be a test of individual firms' resilience," the update said. Certain institutions will be asked to participate in the exercise, with more information on the work set to be released in the second quarter of this year.
