It’s estimated that the “leverage” or borrowing within LDI inflated the exposure of UK pensions to long dated and index linked gilts by £1tr (£500bn became £1.5 trillion through the use of shadow banking).

These numbers are so huge that they seem to make the £65bn offered by the Bank of England to create a liquid market for gilts being sold to create loan collateral, small beer.

But £65bn is not small beer, it was a promise – made for a short time – that equates to the (yes fake) advert.

This “big news” from Britain’s funded pension sector, becoming big news for the wider financial community.

O Leverage, Where Art Thou?

— by @HarrietAgnew and @JosephineCumbo https://t.co/DBiAABDxIY

— Philippe Maupas (@philmop) October 25, 2022

The FT’s team has found deep disquiet at the heart of the European funds industry

Europe’s largest asset manager has warned that the tremors in the UK pensions market should be a “wake-up call” to investors and regulators about the dangers of hidden leverage in the financial system.

Vincent Mortier, the CIO of Amundi repeats eloquently what we have been discovering over the past few weeks

I don’t believe that anyone before the crisis had any idea of the magnitude of this shadow banking in the pension fund industry.

That cannot be true, there were only a small number of players . A few investment houses issuing the contracts through a few fund managers, selling them on with the help of a handful of consultants and “fiduciary managers”.  The local market knew, but no-one seemed to notice that pension schemes were being financed this way.

Mortier’s analysis is intuitively right

Increased capital requirements imposed on banks to make them safer following the financial crisis have moved risk off their balance sheets to less heavily regulated parts of the financial system, namely asset managers, insurance companies and pension funds.

We know , through the highly publicised sales campaigns of Merrill Lynch in the early years of the century, that investment banks capitalised on the opportunity offered by the 2004 Pensions Act and the mark to market accounting standard that it introduced. Even before the banking crisis, investment banks could see an opportunity to finance pension schemes into solvency using the derivatives market and fund managers.

The events of 2007-8 made lending to pension funds a much easier prospect – as Mortier points out.

Investors have fuelled the shift by pouring money into alternative strategies such as private credit as they searched for yield in a low interest rate environment.

Cumbo and Agnew have found some numbers that show just how profound the shift has been

In 2000, non-banks held $51tn of financial assets, compared with banks’ $58tn, according to the Financial Stability Board. Its latest data showed non-banks hold $227tn in financial assets at the end of 2020, outstripping banks at $180tn.

Small wonder that the Regulators have been blindsided. TPR is not a banking regulator nor the PRA a pensions regulator. The FCA finds itself piggy in the middle of Gog and Magog.

The use of LDI, over-the-counter derivatives and parts of the private credit market including leveraged loans, has been an  area of growth for fund managers. But we ought to be questioning whether this is the right kind of growth, or just another example of financial engineering , creating the impression that all is ok, when really it’s not.