Title: Unlocking the Publisher’s Digest: A Transformative Journey for UK Pension Schemes
Introduction:
In this article, we dive into the interesting and transformative journey of UK pension schemes, particularly their role in the long-term UK government bond market, popularly known as Linker market. We will explore the challenges faced by these schemes and how they have adapted to improve their overall funding picture. Additionally, we will discuss the impact of the Bank of England’s acceptance of supporting non-banking parts of the financial system and the potential implications of this shift.
1. The Crisis of Long Duration Investment (LDImageddon):
During the autumn of 2022, long-term UK government bonds (gilts) faced a volatile period due to falling returns, leading to a liquidity crisis for pension plans with Long Duration Investment (LDI) strategies. These plans relied on gilts for protection against falling returns and as liquidity support. As yields rose, the margin calls increased, forcing pension funds to sell gilts, which further drove yields higher and triggered more margin calls. This cycle created a crisis where assets couldn’t be used for liquidity purposes, leading to implications for financial stability.
2. Enhancing Resilience Through Liquidity Reserves:
In response to the liquidity crisis, the Bank of England recommended significant increases in liquidity reserves for pension schemes. These reserves are aimed at cushioning schemes against major movements in gilt yields. The systemic resilience buffer ensures schemes can withstand yield movements without selling assets, preventing negative feedback loops and systemic risks that could impact the broader economy.
3. Deleveraging and Improved Liquidity:
UK pension schemes have embarked on a deleveraging journey, reducing risk and shifting towards fixed income instruments amid a higher yield environment. After the rush for cash during the peak of the chaos, liquidity has normalized at a higher level. This restoration of leverage indicates that schemes have improved underlying liquidity, with access to liquidity being less constrained.
4. Shifting Landscape and the Role of Non-Banking Sector:
LDImageddon has brought about a crucial shift in the Bank of England’s perspective. It recognizes the importance of supporting non-banking parts of the financial system, acknowledging the non-banking sector as a key source of liquidity for the corporate sector. This acceptance indicates that the Bank is willing to provide loans to non-bank financial institutions, ensuring financial stability and reducing risk for the broader economy.
5. The Emergence of “Lombard Street 2.0”:
The Bank of England’s Executive Director of Markets, Andrew Hauser, has signaled the need for new instruments that offer loans to the non-banking sector. This would represent a notable policy shift, as traditional lending has primarily focused on the banking sector. However, the new reality highlights the non-bank sector’s critical role in providing liquidity and supporting the real economy. The Bank intends to have lending facilities that can be automatically triggered by its expanded set of market counterparties.
Conclusion:
The journey of UK pension schemes since the LDImageddon crisis has been transformative. Deleveraging, enhanced liquidity reserves, and the Bank of England’s acceptance of supporting non-banking parts of the financial system have played significant roles in shaping this landscape. The focus on resilience and improved funding pictures for defined benefit pension plans indicates a better alignment between asset duration and long-term liabilities. As the industry navigates through regulatory changes and potential shifts in asset allocations, the exploration of new lending mechanisms and collateral demands will be crucial for maintaining stability and supporting the broader economy.
Summary:
The Unlock the Publisher’s Digest article explores the journey of UK pension schemes following the LDImageddon crisis. It highlights the challenges faced by these schemes, such as margin calls and liquidity constraints due to falling gilt yields. The Bank of England’s recommendations for increased liquidity reserves and the need for new lending mechanisms signify a shift towards supporting the non-banking sector. The overall transformation aims to enhance stability and financial resilience while addressing potential risks in the future.
—————————————————-
| Article | Link |
|---|---|
| UK Artful Impressions | Premiere Etsy Store |
| Sponsored Content | View |
| 90’s Rock Band Review | View |
| Ted Lasso’s MacBook Guide | View |
| Nature’s Secret to More Energy | View |
| Ancient Recipe for Weight Loss | View |
| MacBook Air i3 vs i5 | View |
| You Need a VPN in 2023 – Liberty Shield | View |
Unlock the Publisher’s Digest for free
Roula Khalaf, editor of the FT, selects her favorite stories in this weekly newsletter.
About a year ago, a lettuce survived a British Prime Minister, after a… dark strategy in a boring industry, disrupted a boring market and nearly triggered a financial crisis. What a time it was to be alive.
Barclays gilt guru Moyeen Islam has a timely analysis of what UK pension schemes have done since inception near-implosion triggered by responsibility-driven investments of the long-term UK government bond market in autumn 2022.
Lo and behold, unsurprisingly, he found “a long period of downsizing” for LDI plans as they deleveraged and stockpiled cash. But they now appear to be in great shape thanks to a transformed financing situation.
The fundamental idea of LDI – a better match between the duration of assets and the long-term nature of defined benefit pension plan liabilities – remains valid. And while rising gilt yields tripped up some providers last year, the overall effect has been to radically improve their overall funding picture for the UK’s DB schemes.
The crux of LDImageddon was that pension plans with LDI strategies used long-term gilts both to protect against falling returns and as liquidity support. This meant that as yields rose, they were hit with margin calls that had to be met by dumping gilts, driving yields higher and triggering more margin calls.
As Moyeen says (emphasis below):
All financial crises eventually turn into liquidity crises, whatever their genesis. The LDI crisis was no different. Having used gilt repos to generate leverage, pension funds were left holding assets (corporate credit, illiquid, etc.) that could not be used to realize liquidity when margin calls increased due to the volatility observed in the gilt. A key lesson for systems is that assets used to cover liabilities cannot and should not be simultaneously used for liquidity purposes.
In response to the liquidity crisis, the Bank recommended significant increases in the liquidity reserves that systems are required to hold to be resilient to minimum movements in gilt yields of 250 basis points: this is divided into 170 basis points (called “systemic resilience”) and a further 80 basis points (“basic resilience ”). The systemic resilience buffer is designed so that schemes can withstand a strong movement in yields without having to sell assets, which could otherwise lead to a negative feedback loop of a sell-off that would increase the systemic risk of the sector affecting others parts of the financial universe and ultimately lead to an unwarranted tightening of financial conditions that would impact the broader economy. Bank staff estimate that this would be equivalent to the movements seen in the linker market in the fourth quarter of 2222 and would be equivalent to a 1-in-100-year 5-day event. The 80 basis point “baseline resilience” level reflects the idiosyncratic risks of LDI funds. The calculation is equivalent to the “lookback” that the clearing house would use in setting initial margins (IMs) for centrally cleared risk, in this case a 10-year look back window for the 99.8 percentile of moves to 5 days – for 30 year linkers this is estimated to be around 80 bps.
You can see the deleveraging in various data, such as repo volumes for UK pension schemes:
After the rush for cash at the height of the chaos last fall, liquidity has normalized to a higher level. Given that leverage has been restored, this means that “underlying liquidity of schemes has improved and that, from a macro perspective, access to liquidity is not a hard constraint on fund activity,” Barclays claims.
As you would expect in a higher yield environment, pension plans have continued to shift towards fixed income to reduce risk.
The discussed revisions of Solvency II could, however, increase the share of illiquid assets, which currently amounts to around 12%.
However, the most important and lasting consequence of LDImageddon may be that the Bank of England has reluctantly accepted that it will occasionally have to support the non-banking parts of the financial system: what Dan Davies last year dubbed “Lombard Street 2.0”.
Here is Islam, with Alphaville’s emphasis in bold:
In the medium term, perhaps the most important structural change was signaled by BOE Executive Director of Markets Andrew Hauser. In his most recent speechHauser underlined the need for new instruments from central banks that offer loans to non-bank financial institutions along the lines recommended by the IMF.
Central bank lending to investment vehicles in the non-banking sector would represent a significant policy shift as their traditional counterparts are found in the banking sector. However, this would reflect the new reality that the non-bank sector as a whole is now a key source of liquidity for the corporate sector and can therefore be a source of both financial stability and the real economy. risk. Any new mechanism would represent a backstop rather than a routine lending channel.
Given that the BOE does not regulate parts of the NBFI universe, it raises questions of adverse selection (i.e., how the Bank knows it is lending to a viable entity). But the key point is that the Bank likely intends to shy away from significant market interventions and would prefer to have lending facilities that can be triggered automatically by its (expanded) set of market counterparties.
In terms of demand for collateral, Hauser’s speech specifically mentions “gilts – at a minimum” which would support continued demand for gilt collateral from schemes. Important issues relating to maturity, haircuts and pricing compared to existing structures need to be resolved over time, but the direction of travel seems clear: the Bank has little appetite or desire to intervene directly in the gilt market as it has been forced to do in the fourth quarter of 22. anything but the most extreme circumstances
Further reading
— No, current gilt yields do not back Liz Truss, please don’t make us explain that again
— How much did Truss’ 49-day tenure actually cost UK pension funds?
—————————————————-