The Treasury Select Committee are in the midst of an immediate inquiry into the impact of the “micro-budget” of September 23rd. You can read here the transcript of the first oral session featuring among others Torsten Bell and Paul Johnson.

The second oral hearing includes the appearance of Jon Cunliffe and his Bank of England team and makes for equally interesting viewing.

You can listen to the entire session here. 

John Cunliffe told us that the £65bn promise to pension schemes made by the Bank of England, was the first time the Bank had intervened to manage financial stability. This was not a paper exercise, it was and remains a massive undertaking. This was not a return to QE, the Bank made it very clear that this was quite different. The Bank would have preferred to use the Repo method but it could not because of the circumstances of the pension schemes. This intervention was new and risky and the Bank are clearly very relieved that so far it has worked.

These are my views of what was said and what we in pensions can draw from this “oral evidence” but they need to be put in this blog because there is a concerted effort in the pension market to make out that what has happened was no more than a blip, the last wag of the tail of the QE dog. That is definitely not the case.

Pension Scheme liquidity was putting public money at risk.

Those in denial that anything much happens in the dozy world of DB pensions will be surprised by Andrew Hauser’s comment that “on Friday schemes were whispering there might be a problem and on Monday they were shouting down the phone“.

John Cunliffe is now saying that “while I can’t guarantee it’s over, there’s a lot more resilience in these funds today”  We now know that the BOE were allowing BBB corporate bonds to be used as collateral and repossessing these bonds from the banks. Andrew Hauser makes it quite clear that “public money was at risk” and this was why the £65bn bail-out was time limited. It begs the question, who was trying to bounce the bank into extending that limit by leaking to the FT and BBC on October 11th that the bank were considering extending the limit?

This is a matter of personal interest to me as I had to answer the question from Fiona Bruce at the PLSA in front of 1100 delegates, “should the bail-out be extended?”. I am proud that I answered “no”.

How did this near calamity happen?

This blog is me getting my head round what appears to have happened to allow two thirds of our pension schemes to nearly bring the gilt market to a halt and cause grave damage to the UK financial system.

It’s me trying to understand why those pension funds were dithering through the end of September and well into October , demanding more time to get their act together when the fire was burning around them and the Bank of England was holding a safety net for their assets.

I’m going to tell you what I learned about the regulators , the funds and the schemes and their advisers. Please read this, even if you are telling yourself

“we may have lost our assets but it’s ok because pension scheme funding’s got better”

What Jon Cunliffe, Andrew Hauser and Sarah Breeden was saying was that had the BOE not acted, the unpreparedness of pension schemes and their LDI fund managers could have caused a crisis at the long-end of the gilts market which could have screwed things up for the country as a whole.

Listen to the video/audio from 16.44 and for the next five minutes if you are in doubt that we nearly had a catastrophy.

The reasons for this happening include the lack of liquidity for long dated gilts, the concentration of long dated gilts purchasers (the two are linked) and the doom spiral created by pension funds having to sell these gilts to meet collateral calls because they did not have sufficient liquid assets elsewhere in their portfolios.

Considering the very large amount of money paid to in house teams and external consultants to manage risk, the finger of blame points firstly to the trustees and executives of schemes. I made this point in Liverpool too, to zero applause.

So what of the regulators?

We are now getting the full story as to why LDI was not stress tested (or at least not tested for the right kind of stress).

1. LDI is what the Bank of England call “non-banking finance” which means schemes are financed to buy bonds through the derivatives market rather than directly from the banks. This is handy as it means the lending is not tested as it would be under  the Basle standards
2. Of course the banks market their swaps and repos through intermediaries who run funds – Insight, LGIM, Schroders and Black Rock are the ones we mostly know. All the intermediaries are keen to point out the risk is being born by the investors and the banks – not by them.
3.  These funds are not the standard insured pooled funds that we invest into in DC contracts.  I’m told that the primary reasons for larger schemes to use the Irish QIAIF  Funds (often single investor) was to circumvent the borrowing restrictions that make UK structures less easy . (LGIM use Lux SIVs for this reason too) .
4. Irish and Luxembourg funds are cheaper and easier to run for LDI (but harder for the FCA to regulate)
5. Although these funds are European, they fall under the reporting requirements of ESMA  which covers the alternative fund manager investment regulations (AIFMD UK) that the FCA has responsibility for 
6. In order to run these AIFMD funds, you need to produce a “Risk Management Process” documnet, that  is approved by the Regulator and includes inter alia, maximum and expected leverage levels.
7. So it looks like the FCA is – along with ESMA – responsible for oversight on these LDI Pooled AIFMDs.

All this, I learned from listening to Jon, Andrew and Sarah (except for the bit about Ireland and Luxembourg which I got from a Swedish friend who looked at setting up LDI through his bank in 2010 and a correspondent who has actually run LDI funds).

It seems that there was some talk between the Pensions Regulator and the Bank of England in 2017 and LDI was stress tested, but only to loads considerably less than the 160 bps surge in yields experienced at the end of September. Testing to 100bps was considered sufficient back in the day – clearly it wasn’t.

So we have a picture of the PRA and the BOE sidelined because this was fake banking

1. The PRA excluded because LDI was through offshore  funds and dressed up as insurance and banking derivatives  not banking.
2. The FCA marginalised because the funds were based overseas and not in their direct “perimeter”
3. TPR blind-sided because they’d done their diligence was “undue” and because this looked like the FCA’s problem
4. The Bank of England , concerned but unable to get one regulator to take charge of the situation.

It’s a story of “nearly regulation” which allowed two thirds of Britain’s DB schemes invest into a shadowy world of fake banking and offshore funds without proper testing of what could go wrong. If this had happened in the world of retail finance, this would be a scandal. Because it is happening in an institutional world, the inquest is behind closed doors.

So what of the funds?

We learned that not all funds behaved the same over the initial period of the crises. Some took as long as 10 days to respond , some – most especially the pooled funds – were on it from day one.

I hope I’m not seen as cynical, but when you are running a pooled fund, you look after your funds under management and the AMC which pays you a living. If you are simply the agent of the bank, collecting debts from your customers, urgency isn’t quite so well rewarded.

Jon Cunliffe referred to the insurers running segregated mandates as “agents” and that appears to have been their role, collecting and posting collateral and doing their best to make sure their clients didn’t lose their hedge (and thus the reason for having the fund).

We learned that the banks, as soon as they were getting gilts paid to them as collateral were selling them back into the market, presumably to the Bank of England. Let’s hope our bank picked up some cheap paper and can resell it soon, as they say they intend to – at a profit.

As for the regulators , let’s hope that we can learn from this that if we have separate regulators for pension schemes , pension funds and banking, that they can work a little better together

As for the funds, we should be asking big questions about whether they deliberately chose to operate in a regulatory vacuum and whether they were fulfilling their consumer duty – or at the very least – treating their institutional customers fairly.

As for pension schemes , it is once again an opportunity to remember that old adage “if it looks too good to be true, it probably is”.

The two letters from Jon Cunliffe to Mel Stride written on 10th and 18th October

Letter one (published 11/10/22)  ; is here

Letter two (published 18/10/22)   ; is here

The Treasury Select Committee