On 7 November 2022, Sara Breeden (Executive Director, Financial Stability Strategy and Risk, Bank of England) gave a speech at the ISDA and AIMA on ‘Risks from leverage: how did a small corner of the pensions industry threaten financial stability?’

In her speech, Ms Breeden sets out how leverage outside the banking sector can create risks to financial stability, starting with that small corner of the pensions market. Ms Breeden then goes on to set out what needs to be done, by participants, by their regulators and by financial stability authorities, in order to ensure those risks to financial stability are reduced.

Key points in the speech include:

• How did a small corner of the pensions industry threaten financial stability?
  • The rise in yields in late September -130 basis points in the 30-year nominal yield in just a few days – caused a significant fall in the net asset value of leveraged liability driven investment (LDI) funds, meaning their leverage increased significantly. This created an urgent need to deliver to prevent insolvency and to meet increasing margin calls.
  • The funds held liquidity buffers for this purpose but such buffers were exhausted, the funds needed either to sell gilts into an illiquid market or to ask their DB pension scheme investors to provide additional cash to rebalance the fund.
  • With the gilt market unable to absorb forced sales, yields would have been pushed even higher, making the scale of the selling need even larger still. This is the self-reinforcing spiral that the Bank of England (the Bank) intervened to prevent.
  • The Bank’s 13 day and £19.3 billion intervention was made on financial stability grounds. It was the first example of the Bank acting to deliver their financial stability objective through a temporary, targeted intervention in the gilt market.
• What does this episode remind us about the risk from non-bank leverage?
  • A common factor across all the uses of leverage is that it can increase the exposure of the leverage taker to underlying risk factors – whether that be house prices, earning, interest rates, currencies or asset prices. Therefore, leverage can amplify shocks to each of these risk factors.
  • These episodes highlight the need to take into account the potential amplifying effect of poorly managed leverage, and to pay attention to non-banks’ behaviours which, particularly when aggregated, could lead to the emergence of systemic risk.

• The market channel.
  • Collateralisation has increased the sensitivity of liquid-asset demand to market volatility. And, if market participants are not prepared for such calls, their actions to raise cash can squeeze liquidity in already stressed markets, further amplifying shocks.

• The counterparty channel.
  • Banks and central counterparties (CCPs) may need to have access to more information on the risk positions and balance sheets of their leveraged counterparties if they are to understand fully concentrated and hidden exposures.
  • A second lesson for banks’ and CCPs’ counterparty credit risk management from the recent extraordinary events is that the past is not always a good guide for the future. And so they need to be creative in identifying stress scenarios that best illustrate their counterparties’ credit risk and so the conditions under which margin calls might not be met.

• What is being dome to address risks from non-bank leverage, and where is there further progress to be made?
  • Regulators worked with LDI funds during the Bank’s operations to ensure greater resilience for future stresses. And in aggregate, intelligence suggests that LDI funds raised over £40 billion in funds and made over £30 billion of gilt sales during the operations, both of which have contributed to significantly lower leverage
  • Banks have an important role to play in reducing risks both to themselves and to the wider system from non-bank leverage. That starts with information. Imperfect information on overall positions leads to inadequate risk management.
  • A first step is for lenders to require greater transparency of hidden leverage taken by their counterparties. Prime brokers should have access to data on a fund’s overall leverage, not just the portion to which they have contributed, just as banks ask household borrowers about their student loan repayments and credit card debts when issuing a mortgage.