The central bank liquidity toolkit

On 28 September Andrew Hauser of the BoE gave a speech covering the bank’s role in the resilience of non-bank financial institutions (NBFIs), including LDI funds (our focus here) and insurers. In particular, this covered the unveiling of a new facility, which, once designed, would allow the bank to lend to insurance companies and pension funds:

A journey of 1000 miles begins with a single step: filling gaps in the central bank liquidity toolkit - speech by Andrew Hauser | Bank of England

We’ve outlined some initial thoughts on what he said below in bold, alongside some extracted quotes from his speech and the BoE’s website where this is shared:

“Andrew Hauser sets out the bank’s ambitious plans for tackling systemic risks in market-based finance by developing a new lending tool for non-bank financial institutions, starting with UK insurance companies and pension funds, including newly-resilient LDI funds.”

We believe that resilience among LDI funds has improved with self-insurance from higher collateral headroom and enhanced governance, described in more detail by the TPR in their guidance: Using leveraged LDI.

“Current levels of resilience range widely across NBFIs. In the UK, insurance companies are at the stronger end of the spectrum. LDI funds are also now required to maintain strong levels of liquidity resilience consistent with their systemic role, under standards put in place following the Autumn 2022 crisis. These LDI standards have significantly bolstered the resilience of the wider defined benefit pension scheme sector.”

The BoE notes that there is only so far that self-insurance can go. We would agree with this summation as, for example, pension funds are still faced with balancing risk and return in their asset allocation. Complete self-insurance would therefore likely prevent other objectives from being satisfied.

“But, just as for banks, it is unrealistic for the private sector to self-insure against the most severe system-wide liquidity shocks: in such cases, safeguarding financial stability requires an effective public backstop.”

Central banks have tools in their toolkit to tackle market dysfunction. Asset purchases and sales can never be totally ruled out (as noted in the speech). But lending and temporary liquidity facilities may be preferable in the first instance. In our view, a direct lending facility against gilts is most likely to be a backstop against repo stress.

“There are many hypothetical stress scenarios in which NBFIs may be simply seeking temporary liquidity – e.g. to manage a temporary surge in fund investor redemptions; margin calls on derivatives; or temporary drying up in dealer funding. In such circumstances, it is preferable to backstop market functioning by lending directly to NBFIs against high quality collateral.”

Lending against gilt collateral seems a given, but the BoE appears also to be considering a wider pool of collateral.

“It might also suggest lending against collateral from all ‘core’ markets whose functioning was judged to be critical to households and businesses: presumptively at least gilts, but quite possibly ranging more broadly.”

Operational challenges will have to be overcome in due course. Most obviously, the sheer number of defined benefit pension schemes, which the BoE notes exceeds 5,000 compared with fewer than 230 banks.

“How we can make a practical reality of the new tool, working with NBFIs and their regulators to tackle the many operational challenges involved – starting with UK insurance companies and pension funds, and their newly-resilient LDI funds.”

Most importantly there is a willingness from the BoE to implement a facility which could lend to pension funds, with the design stage beginning straight away.

“The first step is we will be embarking, with immediate effect, on the design of a facility allowing us to lend to insurance company and pension funds (ICPFs) – including newly-resilient LDI funds.”

We look forward to feeding into this process and working with the BoE as part of our continued engagement in LDI and the wider market.

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