Banks must apply a prudent approach when providing funding to LDIs, says BoE
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Banks must apply a prudent approach when providing funding to LDIs, says BoE 14 December 2022UK Reporter: Bob Currie
Image: AdobeStock/Alex Yeung
The major repricing of UK financial assets that took place in September, particularly the rise in bond yields, exposed vulnerabilities associated with liability-driven investment (LDI) funds.
This triggered a sharp increase in collateral calls, pushing some LDI funds into forced sales of their gilt holdings that threatened further market dysfunction and a threat to UK financial stability. To calm these fears, the Bank of England intervened through a temporary asset purchase programme, focused on long-dated UK government bonds, to restore normal market functioning and to enable LDI funds to improve their resilience to future sudden price movements in gilts markets.
From this experience, the Bank has concluded that LDI funds鈥� resilience to sharp and sizeable moves in gilt yields is inadequate and that liquidity buffers did not function as effectively as anticipated in offering protection.
By this fact, the Bank of England's Financial Policy Committee (FPC) recommends in its latest Financial Stability Report and Financial Policy Summary that LDIs must address these shortcomings and 鈥渕aintain financial and operational resilience to withstand severe but plausible market moves鈥�. This will include maintaining careful risk monitoring around any liquidity outside of the LDI fund, including in money market funds.
The FPC advises that financial regulators should lay down appropriate steady-state minimum levels of resilience for LDI funds, particularly relating to operational and governance procedures and the risks deriving from different fund structures and levels of market concentration.
The Bank of England鈥檚 focus extends beyond LDI funds themselves, also advising that banks must apply a prudent approach when providing funding to LDI funds, factoring in the resilience standards specified by financial supervisors and how the market is likely to be affected under stress conditions.
In drawing lessons from the September crisis, the FPC flags up analysis already ongoing through the Prudential Regulatory Authority and the Financial Conduct Authority to develop a clearer understanding of the roles played by different firms during the recent period of stress, including their risk management practices. The Pensions Regulator has also issued recent guidance designed to improve LDI resilience.
More broadly, the FPC concludes that the UK banking system is resilient to the current economic outlook and is well placed to meet the credit needs of businesses and households even if economic conditions deteriorate. Capital and liquidity positions are strong for the major UK banks and profitability has increased.
It does note, however, that major UK banks have tightened the lending policy, reducing their appetite for lending to 鈥榬iskier鈥� lenders in response to the deteriorating macroeconomic outlook. The FPC indicates that it will continue to monitor for signs of unwarranted tightening and encourages banks not to apply excessive restrictions which would limit the ability of creditworthy borrowers, whether businesses or households, to access liquidity.
In these circumstances, the FPC will maintain at two per cent the UK countercyclical capital buffer (CCyB) that is due to take effect on 5 July 2023. 鈥淢aintaining a neutral setting of the UK CCyB in the region of two per cent helps to ensure that banks continue to have sufficient capacity to absorb further unexpected shocks without restricting lending in a counterproductive way,鈥� concludes the FPC.
In line with ongoing work by the Financial Stability Board, the FPC recognises that tightening financing conditions and high volatility have contributed to long-standing vulnerabilities in market-based finance and that further steps are needed to improve resilience in this area.
The FSB work programme has focused on improving the resilience of money-market funds and open-ended funds, developing a better understanding of liquidity constraints in core funding markets, and on improving margin and collateral management practices.
As part of this programme, the FSB recommends wider stress testing to assess the resilience of non-bank financial institutions (NBFIs) to financial shocks and how these are interconnected with banks and core markets.
The Bank of England will provide further details in H1 2023 of its plans to introduce an exploratory scenario exercise that will focus on risks and resilience in the NBFI sector.
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Image: AdobeStock/Alex Yeung 