The Bank Of England May Endanger The Most Important (Free) Market In The UK

Monday, 03 October 2022
By Con Keating

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An article in Friday’s Financial Times, entitled “UK watchdogs hold crisis talks to avert gilts cliff-edge”, informed us that “Pension sector regulators [are] concerned about end of BoE support”. The entire article should be read. It reports, albeit sourced from an unnamed ‘former policy maker’, that “One option might be for the BoE to formalise its gilt-buying operation into a permanent facility that could be triggered in similar circumstances, without the need for emergency intervention or the backstop of taxpayer funds, a former policymaker said.”

This is an appalling idea. No matter how it is structured, such a facility could only impair the price mechanism of the most important (free) market in the UK financial system – permanently It would raise the cost of finance to the Treasury. It would also hold the prospect of deleterious ‘spill-over’ effects on many other important financial sectors, such as insurance and banking, which would also ripple through into the corporate sector via higher costs, all of which would be inflationary in anything but a benign environment.

For many years, we have written on the potential problems arising from UK DB pension funds employing the strategy known as ‘Liability Driven Investment’ (LDI). We wrote about this earlier this year (see Index Linked Gilts & Liability Driven Investment). Since this crisis emerged, we have published, on several websites, a blog (An Anatomy of a Crisis), which examines the root causes of the market instability we have been experiencing in recent days.

It is true that the market reaction to fiscal policy and political developments provided the trigger for this bout of turmoil; that was an exogenous shock and would, in the absence of an endogenous unstable arrangement (LDI) within the pensions system, have produced no more than a simple fall in prices, and markets would have continued functioning in a relatively smooth way.

The problem is the endogenous feedback loop operating within the gilt market arising from the investment strategies employed by many pension schemes. This strategy, known variously as LDI or ‘de-risking’, is mistakenly described as such and believed to be a sound risk management strategy for pension funds. In fact, it is no such thing; it actually introduces an interest rate risk into these funds where no interest rate risk exists – pension liabilities are a function of the extent of the pension promise, future price and wage inflation, and life expectancy.

Over the past decade and more, the Pensions Regulator (TPR) has zealously promoted the use of these strategies by pension funds. To quote a senior pension scheme trustee, the extensive use by schemes came about “…because TPR was actively telling schemes to use leverage, which, along with threats to Trustees about their independence and suitability if they did not, created an unenviable place for Trustees.

There is a natural experiment which indicates that the Pensions Regulator has, unfortunately, been very successful in ensuring the widespread embedding of LDI strategies in UK Defined Benefit pensions (and the associated value destruction on a grand scale). In the UK, there are two classes of defined benefit (DB) pension schemes which are functionally identical: private sector DB and local authority DB. Only the DB pension schemes in the private sector are regulated by the Pensions Regulator, those in local authorities are not. LDI is used extensively within the private sector - £1.5 trillion by some estimates. It is not used by local authorities. They follow investment strategies which seek to maximise returns consistent with their risk tolerance. Interestingly, they have far higher allocations to untraded, illiquid private investments, such as infrastructure, than the private sector does – and that of course has been an objective of government for a very long time.

In our blog, ‘An Anatomy of a Crisis’ we indicate that these strategies may in fact be ‘ultra vires’ for scheme trustees. We also point out that the transposition of a restriction on the use of derivatives from European law to UK law is incorrect. Under IORP Directive I Directive Article 18 (now the IORP II Directive Article 19) pension funds can only use derivatives for investment purposes, for example, hedging exchange rate risk on foreign listed stocks, but not for hedging discount rates used for valuing the current amount of future pension payments. It is instructive to quote the exact wording:

investment in derivative instruments shall be possible insofar as such instruments contribute to a reduction in investment risks or facilitate efficient portfolio management. They must be valued on a prudent basis, taking into account the underlying asset, and included in the valuation of an IORP's assets. IORPs shall also avoid excessive risk exposure to a single counterparty and to other derivative operations;

We also point out that by not understanding the restriction (or its purpose) and where it came from, we have a Pensions Regulator who does not understand what it is regulating (and promoting) despite having commissioned a survey in December 2019 entitled “DB Pension Scheme Leverage and Liquidity Survey” showing extensive repo and derivatives exposure- Table 4.4.3.1 of this survey records £64.64 billion of gilts funded by repos. The survey reports total notional exposure of leveraged instruments as £498.5 billion and total assets for the sample of £697 billion. There are also related issues with corporate accounting and scheme regulatory financial reporting which contribute to the use of these techniques.

The solution to the endogenous problem of LDI does not lie with interventions in the gilt market. It lies in correcting the comprehension and behaviour of the Pensions Regulator, who has clearly not taken a macro prudential view of the pensions system and the risks that were being embedded, and in the elimination of these strategies from defined benefit schemes’ management techniques. Systemic problems are not managed with a microscope.