Financial Markets: Stability

Baroness Bowles of Berkhamsted Excerpts

Thursday 3rd November 2022 Lords Chamber

[Baroness Bowles of Berkhamsted (LD)]

My Lords, the mini-Budget caused sharp falls in the value of sterling, gilts and confidence in the UK’s rating. Despite policy reversals, there is substantial residual damage in people’s pockets and pension funds.

But this was not just an economic event. It triggered a systemic financial stability event, leaving question marks over regulators. The devil was liability-driven investment funds—LDI—and, as if we learned nothing from the great financial crisis, financial engineering that hides behind three-letter acronyms eventually leads to four-letter expletives when it blows up. So what was lurking, and why? The Pensions Regulator—TPR—has overly favoured investment in gilts, which steered funds away from higher-yielding productive investments. The accounting practice also developed of requiring net present value of liabilities, based on gilt interest rates, to be used in both pension scheme valuations and sponsor company accounts. That transferred artificial volatility to both scheme and company balance sheets.

Ways to smooth that volatility were therefore sought. LDI emerged and, with it, borrowing and leverage using repo and derivatives. Gilts were subject to repo—that is, sold but with retention of interest, a buy-back agreement and margining—and the cash used to buy further investments. Along with interest rate swaps, this quashes the accounting volatility and the pension fund gets to hold equities that regulatory edicts had inhibited. This sounds a bit like regulation-dodging, but the practice was actively encouraged by TPR. Alas, it also exposed pension schemes to cash margin calls. They were borrowing short against long liabilities—maturity transformation, just like Northern Rock, with shades of the great financial crisis again.

Then excess set in and, instead of buying equities with the borrowed money, more gilts were bought and underwent repo and so on. They were often leveraged four times, or seven times, as admitted in a TPR survey, or, anecdotally, 13 times. In 2018, the Bank of England Financial Stability Report noted that leverage and exposure to derivatives in pension funds was far greater than in hedge funds. It advised liquidity buffers and stress-tested market moves to 100 basis points based on historical review. My thoughts were that it did not think widely enough, not even to taper tantrums. The Bank pointed to international concern about systemic risk in non-banks but, despite the known UK-specific circumstances of DB schemes and a systemic feedback loop on gilts should there be a falling market, direct action was not—maybe could not—be taken. So the systemic trigger event happened. There was a spiral of margin calls and, although the Bank intervened to purchase gilts, the fire sale of assets within pension schemes cost many of them around 25% of asset value.

Now we come to the funny money accounting illusion where the TPR, FCA and BoE all say that, due to the recent rise in gilt yields, the net present value of liabilities has dropped, deficits have narrowed and pension schemes are in a better position for buyout. Rejoice they may, but assets—out of which pensions will actually be paid, both now and in the future—have dropped by 25%. That hole will be felt.

Was LDI, at least in its simplest embodiment, a smart move? Possibly, but there is the issue that pension scheme borrowing is not legal. TPR hides behind the sophistry that repo is a sale and repurchase, though the BoE and FCA more honestly call it borrowing. Thus, in pursuit of buyout or accounting niceties, employers, trustees and regulators have embraced the contrivance of dubious legality to evade primary principles in legislation, with the Pensions Regulator, the FCA and the BoE seemingly oblivious to those primary principles. It is an accident waiting to happen again.

--- Later in debate ---

[Baroness Penn (Con)]

No, it is correct. The noble Lord seems to know how it is composed, so we are transparent in how that number is reached. I would like to make a little progress.

[Baroness Bowles of Berkhamsted (LD)]

I am sorry, I know that the Minister keeps being interrupted, but maybe it should all come at once. She mentioned that the Bank of England had powers to intervene. I would be very interested to know what preventive powers she thinks the Bank of England could have used to intervene on LDI and leverage. It put it in its Financial Stability Report, but genuinely, I do not know what powers it has to intervene over something that is not covered by FiSMA. It is DWP and there is another regulator, yet it is causing a systemic glitch that could happen again.

[Baroness Penn (Con)]

The noble Baroness is right that there is more than one regulator at play in this space. That point was also made by the noble Lord, Lord Davies of Brixton. If the noble Baroness will forgive me, I will come on to some actions taken after the 2018 stress test shortly.

The noble Lord, Lord Tunnicliffe, asked what the forthcoming Bill will do to promote financial stability. Allowing us to tailor our financial services regulation to the UK’s situation and needs will mean that we can create the best regulation for our circumstances. In a world where financial services are evolving all the time, with new developments and technologies requiring regular changes, the measures in the Bill will mean that UK regulations can remain up to date and effective.

It is also the role of the Government to ensure that their own decisions lead to trust and confidence in our national finances. Our responsible approach to managing the economy meant that we went into Covid and the current economic crisis with strong public finances, allowing us to intervene to support people’s lives and livelihoods. In that context it is important to acknowledge that, while well intended, the recent growth plan had unintended consequences for economic volatility.

Mistakes were made, and we have taken steps to fix them. Most of the tax measures in the growth plan have been reversed and the associated volatility dissipated. However, we are still faced with a profound economic crisis, with global inflationary pressures driven by increased demand post Covid, elevated energy prices after Putin’s invasion, widespread labour shortages and, in response, central banks across many major economies raising interest rates.

My right honourable friend the Chancellor of the Exchequer has been clear that we will take the measures needed to restore confidence and trust in the UK’s public finances and to deal effectively with the economic shocks that are being felt across the globe. In doing so there will be difficult decisions to take, but I hope that I can reassure the noble Lord, Lord Tunnicliffe, and others, that in taking them, this Government will protect the needs of the most vulnerable.

Specifically on recent events, the FPC noted in its July Financial Stability Report that the worsening global economic outlook had caused markets to be volatile in recent months. Since July, global inflationary pressures have intensified further. Specifically on the intervention by the Bank of England, all noble Lords will be aware that in late September there was elevated uncertainty in the UK bond market that resulted in gilt yields rising rapidly and significantly. LDI funds, many of which held leveraged positions in the gilt market, faced significant margin calls as a result. In some cases, these calls exceeded the cash buffers that they held, forcing them to raise cash by selling gilts into a falling market. Large sales of gilts into an already illiquid market led to yields increasing even further, in turn triggering further margin calls and forcing further gilt sales to try to maintain solvency.

This would have led to a spiral of falling prices but increasing pressure to sell gilts, so, within its remit, on Wednesday 28 September, the Bank of England started temporary purchases of long-dated UK government bonds, with the aim of restoring orderly market conditions. In line with the Bank’s statutory financial stability objective, the purpose of these operations was to act as a backstop to restore orderly market conditions and reduce any risks from contagion to credit conditions for UK households and businesses while the appropriate adjustment takes place. This operation was fully indemnified by the Treasury.

It is worth remembering that the Bank’s intervention served to keep the gilt market stable so that funds had time to adjust their positions in line with the changed market conditions. The speed and scale of repricing far exceeded historical moves, and therefore fell outside the expectations of risk management plans or regulatory stress tests. Throughout the intervention, the Bank worked with LDI funds and pension schemes as they built their financial resilience ahead of it coming to an end. Market conditions have since improved. The Bank’s usage of the scheme, at under £20 billion, was significantly below the maximum size permitted under its maximum daily auction size and below the increase in the indemnity provided by the Treasury. This stress in the LDI sector highlights the necessity of ensuring that the appropriate risk oversight and mitigation systems are in place for market-based finance.

I shall try to address the question asked by the noble Baroness, Lady Bowles, and the noble Lord, Lord Tunnicliffe, about what has happened since the 2018 exercise that looked at this. Since then, the Bank of England has worked with other domestic regulators, including the Pensions Regulator and the FCA, on enhancing monitoring of the risks. That included working with the Pensions Regulator on a survey of DB pension schemes in 2019 and prompting work to improve pension liquidity risk management. As the FCA noted in its letter to the noble Lord, Lord Hollick, and my noble friend Lord Bridges in March this year, the FCA contacted the largest LDI fund managers to ask them what plans they had in place to deal with increased volatility. It also probed large managers on the speed with which they could call money from underlying pension funds in the event of stress.

In response to many noble Lords, including the noble Lords, Lord Sharkey, Lord Sikka and Lord Davies of Brixton, and the right reverend Prelate, the Government recognise that there will be lessons that need to be learned from the market volatility seen in recent weeks. The regulators are working with the industry to improve their resilience to market shocks, and it remains a focus of the Government and regulators to ensure that we have a robust regulatory system.

In addition to the ongoing monitoring of systemic risks by the FPC, His Majesty’s Treasury and UK financial regulators have been working internationally as part of the Financial Stability Board, as I previously noted, to develop global approaches to identify and address vulnerabilities in market-based finance. The noble Lord, Lord Sikka, asked why we take a different approach to the regulation of banks versus non-banks in the financial system. Part of that is the international nature of the non-banking part of our financial system.

The Bank of England has also committed to working with the Pensions Regulator and the Financial Conduct Authority to ensure that appropriate levels of resilience are in place to mitigate risks to UK financial stability. As the Pensions Regulator chief executive emphasised earlier this month, DB pension schemes were not and are not at risk of collapse due to rapid movements in the price of gilts, and savers should not make any hasty decisions about their pension pots.

I turn to pensions. As I have just stressed, defined-benefit pensions remain strong, and members of those schemes that were invested in LDI funds are not at risk of losing out as a result of either the aforementioned volatility or interventions made by the Bank. Indeed, the independent Pensions Regulator issued a statement on 12 October for trustees of defined-benefit and defined-contribution schemes and their advisers, which communicated its expectations on matters for trustees to consider in relation to managing schemes and supporting savers.

The noble Lords, Lord Sharkey, Lord Best and Lord Campbell-Savours, and my noble friend Lord Young of Cookham, rightly mentioned the housing market, and I want to respond directly. The fact is that interest and mortgage rates have been rising since last autumn in response to global trends. This is not a UK phenomenon, with the US Federal Reserve having raised its base rate since March 2022 and the ECB taking similar steps. In the UK, around 75% of residential mortgages are on a fixed rate and therefore, in the short term, shielded from rate rises. However, I know that, for those on variable rights and those who are seeing their own fixed-rate deals coming to an end in forthcoming months, there will be significant concern. Where mortgage holders fall into financial difficulty, FCA guidance requires firms to offer tailored forbearance options. While it is important to note that the pricing of mortgages is a commercial decision for lenders in which the Government do not intervene, the Government do offer support through Support for Mortgage Interest loans for those in receipt of income-related benefits and protection in court through the pre-action protocol.

Similarly, the setting of rates is a commercial decision for private landlords in which the Government do not intervene. However, we understand that many people will be worried about the impact of rising prices. My noble friend Lord Young of Cookham spoke more broadly about the reform needed in the private rented sector in order to provide more security to tenants in that sector. I agreed with much of what he had to say. Indeed, the Government’s programme of work to reform the private rented sector continues through, for example, our commitment to ban Section 21 no-fault evictions. We heard ideas from my noble friend Lord Young and the noble Lords, Lord Best and Lord Campbell-Savours, for other changes that we could potentially make in housing. I will take those back to the department and ensure that they are looked at carefully.

The noble Lord, Lord Sharkey, asked whether the local housing allowance would be uprated. He will know that, as part of our response to Covid, the rates of local housing allowance were increased significantly to the 30th percentile of the market, with 1.5 million households gaining just over £600 a year. We have maintained those rates at an elevated level last year and this year in order to ensure that claimants can continue to benefit from this. This is reviewed annually, and I will not comment further on the uprating of benefits.

More specifically, many noble Lords spoke about the difficulties that vulnerable people are facing this year with the rising cost of living. The Government absolutely recognise that and are focusing our support most heavily on those households. People are facing a difficult time. We have put in place an energy price guarantee and further support for those on income-related benefits, pensioners and those with disabilities. There is also discretionary support for local authorities to provide help in their local areas.

I am conscious of the time so I will begin to wrap up. Many noble Lords used this debate as an opportunity to look ahead to the Chancellor’s Autumn Statement. I welcomed the constructive efforts by the noble Lord, Lord Liddle, to make suggestions not just about areas of spending that should be prioritised but about ideas for tax reform to help to fund them, which always needs to come alongside. I will only say to him, on his suggestion for equalised pension tax reform, that we have heard in this Chamber in recent weeks about the challenges of keeping GPs and others in their roles because of the tax treatment of their public sector pensions, and the idea might perhaps be a bit more complicated than it may look at first sight.