Britain’s financial regulator has admitted that it was not prepared for the threat to pension funds posed by sharp rise in bond yields in the wake of Liz Truss’s “mini” Budget, saying the issue had not been “right at the top of the radar”.
Nikhil Rathi, chief of the Financial Conduct Authority, made the admission during a hearing of the House of Lords’ industry and regulators committee, which was examining how turmoil in the bond market led the Bank of England to pledge an emergency intervention worth up to £65bn.
The central bank was forced to intervene after the bungled “mini” Budget on September 23 sent UK bond yields soaring, with the 30-year gilt surging from 3.7 per cent to a peak of 5.1 per cent.
The spike triggered cash calls on thousands of pension funds which used hedging contracts, or liability-driven investing strategies (LDIs), which are sensitive to movements in bond prices. This forced the plans to rapidly sell liquid assets, including gilts, putting more upward pressure on yields.
Giving evidence to the committee, Rathi said that at the height of the bond market storm, banks which were counterparties to the LDI contracts faced potential losses of tens of billions of pounds if demand for gilts collapsed.
Asked why the FCA had not been more alert to this systemic risk, Rathi said: “I don’t think that the particular scenario of a 250 basis point move in a space of five days in index-linked gilts, which has just never happened at any major [time] in our history, that particular risk wasn’t tested for.”
He added: “This didn’t come up, ultimately, as right at the top of the radar. There were many others [risks] . . . where we were really focusing our energy. Clearly, that’s something for us to think about.”
Pressed on its record of supervising schemes, Charles Counsell, chief executive of The Pensions Regulator, told the committee that “on reflection, we didn’t have as much data” on the use of LDI strategies, leverage and collateral, as “perhaps we would like to have”.
“This is clearly an area where we will be having a real, a real focus,” he said.
Rathi said the FCA was now considering stronger safeguards — including leverage caps and higher capital buffers — on LDI strategies, which have been used by up to 60 per cent of the UK’s 5,200 defined-benefit pension plans to mitigate interest rate and inflation risks.
“I think it is correct for us now to be thinking about whether there should be greater safeguards against leverage,” he said, adding that intervention would be “most effective” if there was cross-border agreement and implementation, given most LDI funds used by UK pension plans are domiciled offshore.
The FCA added it was now getting information from LDI managers on a “fairly intense and frequent” basis.
Asked by the committee whether LDI strategies still had a role to play in pension strategies, Counsell said “the hedges serve a purpose” and that if the ability to hedge was removed it would be “not without cost”.