The Bank of England's Response to the LDI Crisis
In September 2022, the UK experienced a financial crisis centred around liability-driven investment (LDI) funds used by defined benefit pension schemes. The crisis was triggered by the UK government's "mini-budget" announcement of unfunded tax cuts, which led to a sharp rise in gilt yields.
This caused severe stress for LDI funds, which use leverage to hedge interest rates and inflation risks for pension schemes. As yields rose, LDI funds faced urgent demands to post more collateral to cover the fall in bond prices. However, with limited liquidity, many were forced to sell gilts, creating a negative spiral as prices dropped further.
To stop this dynamic, the Bank of England (BoE) intervened in the gilt market, buying long-dated gilts to stabilize prices and restore orderly market functioning. While successfully halting the crisis, the episode highlighted the systemic risks LDI funds and the broader non-bank financial sector posed.
It demonstrated how vulnerabilities in one part of the system can rapidly spiral and require extraordinary central bank action. With LDI strategies now managing over £1.6 trillion in UK pension assets, the BoE is implementing reforms to reduce risks for the future.
Toughening Regulation of LDI Funds
A key priority is strengthening the regulation of LDI funds themselves. The BoE has criticized the "complete absence" of oversight and transparency in the sector. There are no reporting requirements on leverage, liquidity, or exposures.
From April 2023, new rules will force LDI funds to hold larger liquidity buffers, maintain lower leverage, and meet stricter collateral standards. Stress testing will also be expanded to cover more extreme scenarios.
Funds must prove they can quickly generate liquidity and reduce leverage, even under severe market moves. According to the BoE, more minor, less sophisticated schemes may find it challenging to meet the new standards, meaning LDI strategies are no longer suitable for them.
Enhancing Resilience of Pension Schemes
As key clients of LDI funds, pension schemes must also improve resilience. Those with LDI saw collateral demands jump five-fold during the crisis.
The new guidance will require schemes to set limits on leverage and exposure to gilts. Buffer assets must be stress-tested and set aside to meet margin calls in a crisis. Schemes will need contingency plans to generate liquidity, even selling less liquid assets at a loss.
The Pensions Regulator pushes schemes towards more prudent "flight to safety" investment strategies. While this may result in lower returns, it would reduce risks that schemes cannot meet obligations to pensioners.
Extending Regulation to the Wider Non-Bank Sector
Beyond LDI, the BoE and Financial Conduct Authority are reviewing risks from the rapid growth of non-bank finance. Funds across the investment industry chain reacted to the LDI turmoil by hoarding liquidity.
This suggests fragility requiring enhanced oversight1. Regulators plan to introduce reporting requirements to improve visibility across the sector. There will also be reviews of liquidity risk management and leverage.
Though more intensive regulation may impact profitability, the goal is to reduce systemic vulnerabilities to ensure financial stability. The LDI crisis forced the BoE to take unprecedented action to protect the broader economy.
With reforms across the industry, regulators hope to minimize this "reliance on the public sector" in the future. Though the costs may be high, increased oversight should allow liability-driven investing to continue while avoiding another destabilizing crisis.
1: Lessons from the United Kingdom's Liability-Driven Investment (LDI) Crisis in - IMF eLibrary. (2023). Retrieved from https://www.elibrary.imf.org/view/journals/002/2023/253/article-A002-en.xml
2: Defined benefit pensions with Liability Driven Investments - Parliament (publications). (2023). Retrieved from https://publications.parliament.uk/pa/cm5803/cmselect/cmworpen/826/report.html
3: Risks from leverage: how did a small corner of the pensions industry threaten financial stability? − speech by Sarah Breeden - Bank of England. (2022). Retrieved from https://www.bankofengland.co.uk/-/media/boe/files/speech/2022/november/sarah-breeden-speech-at-isda-aima.pdf
4: Bank staff paper: LDI minimum resilience - recommendation and explainer. (2023). Retrieved from https://www.bankofengland.co.uk/financial-policy-summary-and-record/2023/bank-staff-paper-ldi-minimum-resilience