Bank staff paper: LDI minimum resilience – recommendation and explainer

The Bank of England has published a bank staff paper entitled LDI minimum resilience – recommendation and explainer which was drawn up by the Financial Policy Committee (FPC) of the Bank. The paper follows last year’s market turmoil involving UK guilts, the subsequent effects on Liability Driven Investment (LDI) portfolios, and the imposition of temporary measures by the HM Treasury to counteract the dive of gilt prices and the imposition of additional (temporary) liquidity risk management requirements on LDI funds.
The paper now sets out recommendations primarily for The Pensions Regulator (TPR) as to a long-term approach for maintaining a minimum level of resilience among LDI portfolios which are particularly prevelant among defined benefit pension schemes. Specifically, the FPC recommends that
– LDI portfolios should be able to withstand yield shocks in the gilt market of „around“ 250 basis points;
– LDI portfolios should be able to „meet margin and collateral calls without engaging in asset sales“ that may trigger a further downward pressure on market prices of gilts and other assets, contributing even further to market stress;
– pension schemes may need to adjust their operational processes to „provide collateral to their LDI funds“ more quickly, if the situation so requires; and
– LDI portfolios need to take into consideration the „nature of their exposures, including on duration, leverage, and concentration of holdings, and the liquidity, duration, and convexity of collateral, in modelling their resilience to yield moves“.
The above noted 250 basis points were derived by the FPC by taking into consideration the idiosyncratic risk, that is the inherent, specific risks of securities held by LDI funds, and the systemic risk which may affect all securities alike. Additionally, LDI funds should incorporate some level of additional resilience for daily yield moves and to account for other risks such as operational risks. The following figure depicts the composition of the overall 250 basis points minimum resilience threshold:
Figure 1 – LDI resilience levels

To conclude, the FPC notes that most UK LDI funds would now meet this requirement without taking additional steps. Nevertheless, so the FPC, should managers of LDI funds take into account the assessment of additional risks such as „non-parallel shifts of the yield curve“ and should ensure that their assets are unencumbered and highly liquid – to ensure resilience of their portfolios.