Mutual funds and other non-bank financial institutions will face their first “stress test” next year to learn lessons from the near-meltdown in Britain’s pension fund industry, the Bank of England (BoE) said on Tuesday.
The BoE had to step in from September to buy £19.3 billion ($23.75 billion) worth of government bonds to stabilize markets after the turmoil caused by the fiscal plans of Liz Truss’s short-lived government.
Liability-driven Investment (LDI) funds, used by pension funds to secure their long-term payouts, struggled to meet the demand for collateral as bond prices plummeted.
The BoE’s Financial Policy Committee (FPC), which monitors the financial system for risk, said Tuesday that the LDI crisis highlighted the need to test how nonbank financial institutions (NBFI) deal with stress.
“The Bank will for the first time conduct an exploratory scenario exercise, focusing on NBFI risks, to understand these risks and future policy approaches,” the FPC said in its semi-annual Financial Stability Report.
Further details will be determined in the first half of 2023.
“There is also a need to develop stress testing approaches to better understand the resilience of NBFIs to shocks and their interconnections with banks and core markets,” the FPC said.
Neil Birrell, chief investment officer at asset manager Premier Miton Group, said the industry is likely to respond with a “massive sigh” to news of the stress test.
“Another layer of regulation only creates more work. But on the other hand, as fund managers, we don’t have to fear any of this because we’re probably doing it all already,” said Birrell.
The test will focus on the UK government and corporate bond market and key participants, such as banks, that play a central role in financing the UK economy.
Such market-based funding accounted for £776bn, or 55%, of all loans to UK businesses by the end of 2021 and nearly all of the nearly £390bn increase in loans to the sector between the end of 2007 and the end of 2021.
LDI funds are often listed in Ireland and Luxembourg, where regulators – along with their UK counterparts – have introduced quick fixes that have forced funds to hold much more cash.
They can now handle a rate move of 300 to 400 basis points, well above the 150 basis point level held before the September turmoil.
The FPC said it would work with counterparts in the European Union to come up with longer-term “steady state” minimum cash buffer guidelines, which could potentially push up fees to absorb costs or increase the use of LDI funds could make it unattractive.
Jonathan Lipkin, director for policy, strategy and innovation at the Investment Association, said the industry would work with regulators to ensure that any risk measures taken are proportionate.
The UK pension regulator will update its guidance for the industry, including the new steady-state cash buffer levels, data reporting and requirements for fund managers to accelerate decision-making in a crisis.
The regulator said on Tuesday it would likely update its guidance for trustees using LDI in April to ensure arrangements are sufficiently resilient.
The FPC also said it supported a call by the Financial Conduct Authority to regulate advisers who advise pension funds.
After regulators introduced stricter rules for banks more than a decade ago in the aftermath of the global financial crisis, attention has returned to non-banks, such as funds and insurers, which account for about half of the global financial system.
Regulators are concerned that there is too little data on hidden leverage in the system, as evidenced by LDI.
“The episode also exposed shortcomings in how banks monitor and manage risk related to LDI funds,” the FPC said.
The FPC said a consultation paper would be forthcoming in 2023 on likely moves to require money market funds — which struggled as economies went into COVID-19 lockdowns in March 2020 — to hold more cash.
($1 = 0.8127 pounds)
(Reporting by Huw Jones and David Milliken; additional reporting by Carolyn Cohn and Naomi Rovnick; editing by David Goodman and Mark Potter)