risks from leverage : how did a small corner of the pensions industry threaten financial stability? − speech by sarah breeden given at isda & aima published on 07 november 2022 sarah breeden explains how leverage in non - banks can pose risks to financial stability and so to the economy as a whole. she sets what needs to be done by participants, by regulators and by financial stability authorities - to ensure those risks to financial stability are reduced. speech on the afternoon of 28 september, i found myself in a rather unusual position : having to explain to journalists why a part of the pensions industry, unheard of to most of their readers, had posed such a large threat to financial stability that it warranted intervention in the gilt market from the bank of england. financial markets globally had been volatile for months. but in the days leading up to that fateful wednesday and following the announcement of the government ’ s growth plan on 23 september, long - dated gilt yields in particular had moved with extraordinary and unprecedented scale and speed. now volatility itself does not warrant bank of england intervention. indeed, it ’ s essential that market prices are allowed to adjust to changes in their fundamental determinants efficiently and without distortion. however, some liability - driven investment ( ldi ) funds were creating an amplification mechanism in the long - end of the gilt market through which price falls had the potential to trigger forced selling and thereby become self - reinforcing. such a self - reinforcing price spiral would have resulted in even more severely disrupted gilt market functioning. and that would in turn have led to an excessive and sudden tightening of financing conditions for households and businesses. in response to this threat, the bank of england intervened on financial stability grounds. but what led to that intervention? the root cause is simple – and indeed is one we have seen in other contexts too – poorly managed leverage. so today i ’ ll set out how leverage outside the banking sector can create risks to financial stability, starting with that small corner of the pensions market. and then i ’ ll set out what needs to be done - by participants, by their regulators and by financial stability authorities - if we are to ensure those risks to financial stability are reduced. how did a small corner of the pensions industry threaten financial stability? many uk db pension schemes have been in deficit, meaning their liabilities – their commitments to pay out to pensioners in the future – exceed the assets they hold. db pension schemes invest

and so the conditions under which margin calls might not be met. [ 12 ] as i will explain, that could relate to wrong way, risk, market dynamics, the behaviour of other market players, even operational details. i think further progress on both these fronts is needed if we are to be confident the counterparty channel is fully managed. are these risks unique to non - banks? i think it ’ s helpful at this stage to ask whether these issues are unique, or if we ’ ve tackled them before in other contexts. and with that in mind, i ’ ll draw a very brief comparison to a market which has already been widely studied and embedded in the macroprudential toolkit : the mortgage market. banks manage their exposures to mortgagors, through affordability testing, leverage limits and collateral. and that ’ s important from a financial stability perspective, given the feedback and amplification mechanisms that have been seen during stresses in the past. for example, stress test scenarios cover house prices falling and borrowers defaulting, and so can capture the potential for amplified price moves and a self - reinforcing price dynamic, as a result of forced sales by bank lenders into a falling housing market. perhaps correlated falls in asset prices and leverage can create amplifying price dynamics in non - bank financial institutions as well as with households. in addition, in our financial stability analysis of the mortgage market, we recognise that reductions in spending by highly indebted mortgage borrowers as they keep up with debt repayments can create negative spillover effects to the rest of the economy. and perhaps in the same way, too, might forced asset sales into stressed financial markets have negative spillovers for all other users of that market. in the case of the core government bond market that could be significant. what is being done to address risks from non - bank leverage, and where is there further progress to be made? having set out how leverage in non - bank financial institutions might create risks to financial stability, i ’ ll turn now to what needs to be done if we are to ensure those risks are reduced. let me be clear. the onus for building resilience in the non - bank system sits first and foremost with the firms themselves. if firms use leverage, they must be able to manage the liquidity consequences of their risk exposures. as part of this, they need to learn from the decades of experience that show how leverage and liquidity risk creates rollover