Bank of England calls for tighter rules on LDI market after mini-budget chaos

Tighter oversight of the pensions industry is needed to ensure it can “withstand severe but plausible market moves” similar in size to those seen in the aftermath of Liz Truss’s disastrous mini-budget in September, the Bank of England said today.

The recommendation from the Bank’s financial policy committee (FPC) has been sparked by concerns over the capacity of a small part of the pensions market being able to absorb sharp falls in UK debt prices.

In the weeks after former prime minister Liz Truss’s mini budget in which she slashed taxes £45bn despite inflation running at a four decade high, long-dated UK gilt prices tumbled to their lowest level in two decades due to investors demanding a higher rate of return to swallow a surge in government borrowing.

Those downward moves forced liability driven investment (LDI) funds – which pension fund managers use to maximise returns to pay scheme members – to rapidly ditch assets to repay creditors that had lent them money to invest in other assets, including UK bonds and stocks.

As LDI funds sold gilts, yields soared higher. The two move inversely.

The Bank was forced to step in with an up to £65bn emergency bond buying programme to prevent a “fire sale” infiltrating UK financial markets. Threadneedle Street did not end up using the entire package and is now selling bonds it hoovered up under the programme.

The fiasco threatened to destabilise UK markets, raise interest rates to unsustainable levels and intensify a looming recession. 

The FPC in today’s financial stability report judged that the “episode demonstrated that levels of resilience across LDI funds to the speed and scale of moves in gilt yields were insufficient”.

To ensure funds can cope with future bouts of gilt market volatility, the FPC suggested LDI funds should be required to increase the amount of money they set aside to dip into to pay off creditors, known as capital buffers.

A spokesperson for The Pensions Regulator (TPR) told Morning Wire: “We welcome the FPC’s recommendations. We will continue to work closely with the Bank of England and other regulators on a longer term plan to ensure trustees who use LDI maintain an appropriate level of resilience in leveraged arrangements.”

TPR last month issued guidance to pension fund trustees urging them to carry out tests to explore how they would “respond to stressed market events” to ensure they remain “resilient during these events”.

Millions of homeowners face £3,000 bill rise

Banks fund lending on international markets, meaning when yields rise, they tend to hike mortgage rates to protect margins. 

Financial markets have since calmed after now chancellor Jeremy Hunt ditched nearly all of Truss’s mini-budget and then raised taxes and cut spending £55bn last month to shore up the public finances.

However, mortgage costs are still running above five per cent, adding to a tight squeeze on household finances and likely prolonging the coming recession.

The Bank calculated those on fixed mortgages expiring at the end of next year will have to pay £3,000 more annually due to higher rates. 

Nearly seven million households have a fixed rate mortgage. Debt tenures will vary, meaning not all of these people will have to remortgage at the end of 2023.