The Bank of England governor, Andrew Bailey, allegedly once fell asleep during a 2019 meeting about a pensions scandal, when he headed Britain’s markets watchdog. Now there are questions whether the BoE and other regulators were asleep at the wheel when it came to pension funds’ near-crash, following Kwasi Kwarteng’s “mini” Budget.
Last week’s incident — prompted by a huge surge in gilt yields, which sparked margin calls for defined-benefit pension funds using derivatives to hedge risk — has illuminated a dark corner of finance. Like other crisis-hit areas, it is one little understood despite its influence on people’s lifetime savings. It is one rife with power imbalances, conflicts and activities that fall between regulators. Despite warnings, failings have gone unaddressed for years.
The episode ought also to be studied amid wider markets turbulence. High inflation and interest-rate increases, particularly by the US Federal Reserve, have exposed strategies based on rates staying low for a long time. There will undoubtedly be other eruptions.
The near-implosion of what should be one of the safest markets leaves awkward questions about its oversight. In the UK, the BoE protects overall financial stability. The Pensions Regulator supervises workplace retirement schemes, and the Financial Conduct Authority regulates asset managers such as BlackRock and Legal & General Investment Management. These firms pool pension funds’ investments, including via so-called liability driven investment strategies at the heart of the crunch. This strategy to help pension schemes meet their obligations was not only endorsed by their regulator, it was actively encouraged. It worked well for 20 years — until it did not.
The boss of Next previously warned the central bank about the financial stability “time bomb” in the LDI market. The BoE itself flagged systemic risks of the strategy in 2018 but little was done to mitigate them.
Although the Pensions Regulator monitors schemes’ funding and risk management, it does not regularly collect market-wide data on the scale of collateral and leverage. It is for LDI managers to agree with individual clients — often small and non-expert — their level of leverage (for some, it was as high as seven times), and collateral. Broad EU-originated principles, rather than hard rules, frame LDI funds’ liquidity management. Asset managers are effectively setting the rules of the game, yet are its dominant players. This needs to be reviewed by regulators.
Another lesson from the financial crisis is the importance of rigorous, obligatory stress tests that have consequences for failure. While many pension funds do stress test their models, the tests are not set by the regulator and are not tough enough.
The tests are often provided by investment consultants, who act as gatekeepers to hundreds of billions of pounds of pension fund money, yet whose services remain unregulated in the UK. They advise trustees — whose competence the watchdog has questioned — where to allocate funds, and which asset manager to pick. Their role last came to the fore during a market rout following the Brexit referendum. The Treasury promised to consider giving the FCA oversight of investment consultants’ services. It should now do more than ponder.
The original sin lies with a prime minister and chancellor who poured petrol on volatile markets with an unfunded fiscal statement promising huge tax cuts. Regulation could never insulate funds completely from the turbulence unleashed. Alas, with a government prioritising growth at all costs and a slashing of red tape, the near-term chances of even sensible guardrails seem slim.