The Central Bank of Ireland has moved with Luxembourg authorities to bolster the resilience of a type of UK fund that ran into trouble in September 2022 and threatened the state’s pensions sector.
The funds at the centre of the move are called liability-driven investment (LDI) funds. While they are typically managed from London, many of them are listed in Dublin and Luxembourg.
A UK tax giveaway budget under then prime minister Liz Truss that September prompted a spike in the country’s government borrowing costs, affecting defined pension benefit funds, which LDI strategies that were propped up by hidden leverage.
While plain-vanilla LDI strategies use bonds – which generate predictable interest income – to match their payout liabilities, a raft of UK pension funds had used high levels of leveraged financial derivatives through investments in LDI funds to increase their exposure to bonds they didn’t hold.
These funds faced demands from other sides of the derivative deals for more cash as collateral as the markets on bonds spiked and actual bond values, which move inversely, declined.
The potential collapse of some pension funds invested in LDI funds forced the Bank of England to step into the market to buy tens of billions of pounds of UK government bonds, or gilts.
Under the new rules, Irish authorised sterling-denominated LDI funds must maintain resilience to be able to cope with a minimum of 3 percentage points of an increase in UK bond market rates, or yields. Luxembourg has also on Monday introduced a similar requirement for such funds, following engagement with UK regulators and the European and Securities Markets Authority (ESMA).
“The macroprudential measures announced today aim to safeguard resilience of sterling LDI funds, and – in doing so – support financial stability at a global level,” said Central Bank of Ireland governor Gabriel Makhlouf.
“Given the cross-Border nature of capital markets, achieving that outcome requires effective international co-ordination. The Central Bank has worked closely with relevant authorities from across Europe to ensure consistency in the policy measures taken to safeguard resilience of sterling LDI funds.”
This is the second time that the Central Bank has introduced policy measures for nonbank financial intermediation sector, or what’s often called the shadow banking sector.
It follows the Central Bank’s decision in late 2022 to proceed with plan to limit leverage – or borrowings – of property funds to 60 per cent of the value of underlying assets. Still, it gave pre-existing funds five years to comply. The measures are designed to ensure that investment funds are better able to absorb, rather than amplify, downturns in the commercial property market.
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