The building blocks of
resilience - speech by Sarah
Breeden
Given at Westminster Business Forum policy conference
Published on 16 June 2023
Following the Financial Policy Committee's recommendations, Sarah Breeden sets
out the steps being taken to build resilience within Liability Driven Investment funds.
She then looks at other vulnerabilities within non-bank financial institutions and
how the LDI framework could be applied to build resilience within these firms.
Speech
Pension funds have an enormous responsibility in ensuring that pension obligations are honoured
while also playing a vital role in facilitating the flow of savings into investment, including funding
productive finance[1] and climate resilience.[2] And they are key players in the gilt market which is
vital to the functioning of sterling financial markets more broadly. On all these grounds, pension
fund resilience is a key financial stability issue, which will be the topic of my speech today.
I suspect I don't need to remind this audience of what happened last autumn. You will all remember
how poorly managed leverage[3] at some liability-driven investment (LDI) funds[4] amplified a
sudden repricing of assets following the Government's growth plan, creating a self-reinforcing
price spiral in the long-end of the gilt market. The Bank of England (Bank) then undertook a
targeted intervention in the gilt market in order to deliver our financial stability objective, buying
time for LDI funds to build their resilience.[5]
Even that brief reminder may have been enough to send hearts racing. I won't use any more of this
speech today to look backwards. For those that do want to dig deeper, I'd like to briefly plug a
speech by my colleague Jon Hall, which will cover the risks of leverage including in LDIs next
week.
What I'd like to do instead is explain what the Financial Policy Committee (FPC) is doing to build
steady state resilience in LDI funds and what needs to be done by pension funds to ensure risks
to financial stability are reduced.
Then I'll look forwards to how the FPC might use this framework for steady state resilience in LDI
funds to build resilience throughout the system of market-based finance[6] in the future.
How are we building resilience in LDI funds?
As this audience will know, the FPC does not have specific regulatory responsibility for pension
schemes or LDI funds. However, the FPC has recommended a framework for steady-state
resilience within LDI funds.[7] The FPC recommended that The Pensions Regulator (TPR) specify
and enforce minimum levels of resilience for LDI funds, continuing its collaboration with other
relevant regulators where necessary. TPR took a first step towards this in April.[8]
What should LDI funds be resilient to? And what form will this resilience take?
The FPC wants to ensure that in the future, core markets such as gilt markets can continue
operating even while suddenly repricing.
That requires LDI funds to be resilient enough to prevent forced deleveraging and gilt sales in the
event of severe but plausible stresses in gilt yields. Funds should hold enough assets, which can
meet collateral demands, to be able to absorb such a shock without having to sell assets. This will
avoid feedback loops that threaten financial stability. Importantly, the FPC intends for LDI fund's
resilience to be usable.[9] And after withstanding a stress, LDI funds should be able to continue
operating during a period of recapitalisation by pension schemes.
This is not just a financial stability issue. It is not in the interests of pension schemes or their
corporate sponsors for LDI funds to unwind their hedges in periods of market turbulence, when
they are most needed. And neither is it in their interests for LDI funds to sell assets at temporarily
depressed prices. So pension schemes have no reason not to invest in LDI funds if they use their
resilience to meet margin and collateral calls.
To what level should LDI funds self-insure against stresses?
The FPC judged that LDI funds should be resilient to a yield shock of, at a minimum, around 250
basis points. And that funds should also hold additional resilience over and above this, based on
their own individual risks.
How did we arrive at that judgement?
We split up LDI funds' steady state resilience according to three building blocks:[10]
Firstly, a baseline resilience component that captures the idiosyncratic risks of assets
held by LDI funds.
This component was calibrated similarly to the baseline price volatility that central counterparty
style initial margin models intend to absorb, by looking at the tail of the ten-year distribution of
30year index-linked gilt yields,[11] Currently, this is around 80 basis points.
Secondly, a systemic resilience component aimed at ensuring that all LDI funds can
absorb a severe but plausible historical stress, over the period of time needed to
recapitalise the fund, without the need for forced asset sales.
This was calibrated by looking further into the tail of a longer distribution of 30-year index-linked
gilt yields,[12] and is currently around 170 basis points. You might think of it as funds being able to
absorb a shock like that seen in September 2022 without that leading to forced sales with
systemwide consequences.
These two components make up the 250 basis points of minimum resilience. In calculating this
minimum resilience, the FPC expected pension schemes to be able to deliver collateral to their
LDI vehicles within five days. LDI funds unable to receive collateral within five days should be
resilient to a larger shock, calibrated to their own timelines.
Third, an additional resilience component, that captures risks specific to the individual
fund.
This component should be calibrated by funds according to assessments of their own exposures
and operational capabilities, as well as interest rate trends and levels of market volatility.
The result of resilience levels being proportionate to individual risks will be some variation
between different LDI funds' resilience levels. But it is worth reiterating that the Bank's intervention
last autumn was to focus on the resilience of the gilt market, rather than to protect the funds and
schemes themselves. So LDI funds should carefully consider their individual risk profile. And
pension schemes should not mistake naturally occurring variation in resilience, which reflects
variation in risks, for a race to the bottom.
These proposed resilience levels are broadly consistent with those firms have been maintaining
since the co-ordinated regulatory action last autumn. And indeed they have been put to the test
recently.
Between end March and late May, the benchmark 30-year index-linked gilt yield rose by 82 basis
points. During that time, the largest five-day move stood at 27 basis points. These changes in
yields mechanically reduced the resilience of LDI funds and led to a number of LDI funds
recapitalising in order to replenish their resilience.
This recent volatility shows that the resilience framework recommended by the FPC is functioning
broadly as intended, with funds holding significantly larger buffers than last year on average and
initiating recapitalisation at far higher levels of resilience than they did previously. It means they
have managed to absorb rather than amplify this shock. So far so good.
We will though assess whether there are any lessons to be learned from this recent experience for
the implementation of the FPC recommendations and TPR guidance.
Of course, LDI funds are not expected to self-insure against all possible shocks. But we do need
to ensure there is the right balance between private self-insurance and a public back-stop.
Central banks cannot be a substitute for the primary obligation of LDI funds to manage their own
risk. The FPC's recommendations for building resilience in LDI funds - a form of private
insurance - are aimed at ensuring there is the right balance between public backstop and private
insurance and are an important step to removing the moral hazard that could be introduced by a
public backstop.
But in situations where tail risks to financial stability materialise, the Bank remains ready to act.
Providing backstop liquidity insurance when tail risks to financial stability crystallise is a core part
of central banks' job. My colleagues in our Markets area have been considering these issues[13]
including with colleagues internationally.
What more should LDI funds and pension schemes do to build their
resilience?
The FPC's recommendation is necessary for building resilience within LDI funds. However, this is
just one piece of the puzzle in terms of ensuring LDI funds do not pose future risks to financial
stability.
There were other vulnerabilities within LDI funds that were identified during September 2022's
volatility that contributed to the market dysfunction. LDI fund managers should also look to make
improvements beyond their balance sheets, ensuring lessons are learned and fully embedded
across their business. The Financial Conduct Authority (FCA), as the relevant regulator for LDI
fund managers, has published guidance on this.[14] The guidance covers risk management,
operational processes, and stress testing capabilities.
The responsibility of ensuring the resilience of LDI funds lies not just with LDI managers. Pension
schemes which invest in LDI products must also contribute to resilience. I've already spoken about
pension schemes' role in ensuring LDI managers can use their resilience as collateral by
remaining invested in LDI funds as they do so. Beyond this, TPR has published guidance on the
responsibilities of pension scheme trustees in ensuring LDI resilience.[15] Fred Berry, from TPR,
will speak about this later this morning.
Pension schemes should also have regard to the Government's broader strategy[16] to ensure that
defined benefit schemes (DB) schemes in the UK are sustainable, well-governed, and that
scheme members achieve better outcomes. The government is in the process of encouraging DB
scheme trustee boards to more actively detect and respond to risks. Given the potential risks to
financial stability from DB pension schemes, this work is essential.
How can this framework enhance resilience in non-banks more
widely?
Now I would like briefly to change tack and think about whether our approach to LDI funds'
resilience might also be relevant when considering the appropriate resilience of other non-banks
whose activities can impact UK financial stability.
As non-banks play a greater role in the financial system[17] as well as the real economy[18] we will
continue to ask questions on the resilience of non-banks[19] so that they absorb rather than amplify
shocks.
What vulnerabilities have we identified?
I've spent this morning talking about measures to tackle the root cause of the stress last autumn,
poorly managed leverage. But LDI funds aren't the only non-bank to use leverage.[20]
And leverage is also not the only vulnerability in the non-bank system. Forced selling that can
follow from leverage can also arise from liquidity mismatches[21] or from a lack of preparedness
for margin calls.[22]
Identifying vulnerabilities is only half the battle. We also need to understand how market
participants will behave when a stress hits.
To this end, the Bank is very shortly launching its exploratory exercise to enhance understanding of
the risks to and from non-banks, their behaviours, and how these behaviours can amplify shocks.
As part of this exercise the Bank may reach out to some of you attending this conference. Shining
a light on how market participants may behave collectively in a stress will help both the Bank and
yourselves better prepare for such events. You'll hear plenty from us once the exercise is launched.
In particular, my colleague Lee Foulger will be giving a speech next week outlining how this
exercise will helps us to better understand system-wide resilience.
But what should we do about these vulnerabilities? We should seek to contain them and to
mitigate their financial stability impact. This is what I've laid out today with respect to LDI funds'
leverage.
Further frameworks may need to be built up. Such frameworks would allow market participants to
be better prepared for shocks while allowing regulators and financial stability authorities to be
more transparent about our expectations.
Whether these frameworks address vulnerabilities from leverage, liquidity mismatch, or liquidity
demands from margin calls, they can draw on the building blocks we have used to calibrate LDI
resilience.
Non-bank frameworks should capture both systemic and idiosyncratic risks. They should account
for risks specific to individual participants. In calibration they should draw on the tails of
distributions, which include system wide stresses, to calibrate resilience. The timeframes the
calibrations are drawn from should consider the options and incentives for raising additional
liquidity that are in place, and operational processes should be improved to ensure this additional
liquidity can be supplied. Non-banks should not have any impediments to drawing down on their
liquidity during stress.
Given a suitable framework for addressing non-bank vulnerabilities, the question for financial
stability authorities, regulators, and participants, is where should these frameworks be applied?
Phrased another way, what activities and which markets are systemic?
Some non-bank regulatory frameworks are already being built. UK authorities issued a discussion
paper on Money Market Funds (MMFs) last year.[23] And ahead of a consultation paper to be
released later this year, the FPC judged that MMFs should be able to withstand severe but
plausible levels of investor outflows without amplifying stress and increasing risks to financial
stability by holding more liquid assets.
It is for staff at the UK authorities to calibrate a range of holdings of liquid assets maturing within a
week that would address financial stability risks from MMFs. However, it is easy to see how the
illustrative scenario I talked you through earlier could be used to calibrate the appropriate
resilience of MMFs.
MMFs could have a range of holdings to reflect idiosyncratic and systemic risks. These holdings
could be calibrated according to observed historical outflows, as seen in the dash for cash and
LDI stress events. And as discussed in the discussion paper, the usability of these holdings will
also be a key consideration for the UK authorities.
Conclusion
The FPC have recommended a framework for the steady-state resilience of LDI funds, built over
three building blocks: baseline resilience, systemic resilience, and fund specific additional
resilience. The first two building blocks amount to a 250 basis point minimum. And the framework
also requires pension schemes to put in place operational processes enabling them to deliver
collateral within five days and to support LDI funds in drawing down during stress.
This framework provides us with a suitable framework for addressing non-bank vulnerabilities
more generally. We can use this framework to contain non-bank vulnerabilities and so to mitigate
their financial stability impacts.
But this is a conference for pension funds, so I will leave on a message to the experts at this
conference. Ensuring financial stability is not only a job for financial stability authorities and
regulators such as TPR, but also for participants.
The FPC has set out a steady-state resilience framework to promote financial stability. But let me
leave you with an encouragement to each play your role. LDI fund managers and pension
schemes must ensure lessons from the crisis are learned and fully embedded into their operations
and onto their balance sheets. I look forward to your support in building the operational and
financial resilience that will help ensure we deliver financial stability.
I'd like to thank Alex Briers and Natan Misak for their assistance in drafting these remarks. I would
also like to thank Renée Horrell, David Baumslag, Leo Fernandes, Pierre Ortlieb, Steven
Page 8
Dodkins, Stephane Amoyel, Lee Foulger, Gian Valentini, Clare Macallan, Thomas Wise, Danny
Walker, Ali Moussavi, Andrew Bailey, and Georgia Waddington for their helpful input and
comments. The views expressed here are not necessarily those of the Financial Policy
Committee.
1. See A roadmap for increasing productive finance investment
2. The responsibility for supporting and enabling an orderly transition to net zero is wider than the pension sector. It is for
the entire finance sector to support and enable that transition. See Climate action: approaching a tipping point? -
speech by Sarah Breeden
3. See Risks from leverage: how did a small corner of the pensions industry threaten financial stability? - speech by
Sarah Breeden
4. In this speech, I will use 'LDI funds' to refer to leveraged LDI funds and LDI mandates in which many pension schemes
invest.
5. See Thirteen days in October: how central bank balance sheets can support monetary and financial stability -
speech by Andrew Hauser
6. Market-based finance refers to the system of markets (eg equity and debt markets), non-bank financial institutions
(including investment funds, hedge funds, pension funds and insurers) and infrastructure (such as central
counterparties and payments providers) which, alongside banks, provide financial services to support the economy.
See Assessing the resilience of market-based finance
7. See Financial Policy Summary and Record - March 2023
8. See Using leveraged liability-driven investment
9. A regulatory buffer is said to be usable if institutions are permitted to operate normally even if their regulatory ratios
decline below it. See Emerging prudential lessons from the Covid stress - speech by Victoria Saporta
10. See Bank staff paper: LDI minimum resilience - recommendation and explainer
11. The 99.8th percentile of a 10-year look-back window of rolling five-day shocks.
12. This might be expressed as a 1-in-100 year (or 99.998th percentile) five-day shock.
13. See Looking through a glass onion: lessons from the 2022 LDI intervention - speech by Andrew Hauser
14. See Further guidance on enhancing resilience in Liability Driven Investment
15. See Using leveraged liability-driven investment
16. See Pension Schemes Act 2021 and Pension Schemes Act 2021
17. See Building financial market resilience: From diagnosis to prescription - speech by Jonathan Hall
18. See Investing in financial stability - speech by Sarah Breeden
19. Including, but not limited to, investment funds, hedge funds, pension funds and insurers. See Assessing the
resilience of market-based finance
20. In the non-bank financial system, leverage is used: to facilitate trading; to invest in companies and infrastructure; and to
arbitrage price discrepancies and so improve the efficiency of financial markets. See The impact of leveraged
investors on market liquidity and financial stability - speech by Jon Cunliffe
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21. During the dash for cash we saw liquidity mismatch driving run dynamics in money market funds (MMFs) and
openended funds (OEFs). See Taking our second chance to make MMFs more resilient - speech by Andrew Bailey
22. The collection of margin reduces and mitigates risks that the failure of one firm could have a severe impact on the rest
of the financial system. By design, margin requirements are procyclical in that they rise in stressed market conditions,
to match the increase in expected losses and risks. This ensures that counterparty risk is properly mitigated. During
the dash-for-cash, some non-bank financial institutions redeemed MMF shares, borrowed in the gilt repo market, and
sold gilts and corporate bonds in order to raise cash to meet redemption pressures and margin calls, replenish their
liquid asset holdings, or in anticipation of further calls. These actions contributed to selling pressures in those markets
and the large withdrawals from MMFs. See The role of non-bank financial intermediaries in the 'dash for cash' in
sterling markets
23. See DP22/1: Resilience of Money Market Funds
Sarah Breeden
Executive Director, Financial Stability Strategy
and Risk
©2023 Bank of England