Reacting to financial turbulence in September 2022 that menaced the UK’s pension industry, the Central Bank of Ireland and Luxembourg regulatory bodies have acted together to strengthen the robustness of liability-driven investment (LDI) funds. Frequently managed from London, many of these funds are registered in Dublin and Luxembourg.
In September, a massive tax cut budget established by then-Prime Minister Liz Truss triggered a surge in the UK’s government borrowing costs, disturbing defined pension benefit funds which were supported by hidden leverage within LDI strategies. Conventional LDI strategies utilise bonds to balance their payout obligations, thanks to the steady interest income from bonds. Yet, numerous UK pension funds opted to employ leveraged financial derivatives in their LDI funds investments to expand their bond exposure, even those they didn’t possess.
These funds were pressured for additional money as collateral from counterparts in the derivative transactions when bond markets surged, and actual bond values- which move inversely- plummeted. This scenario endangered some pension funds invested in LDI funds, leading the Bank of England to intervene by purchasing many billions in UK government bonds (gilts).
Amid these new regulations, LDI funds approved by Ireland that are denominated in sterling must maintain the capacity to withstand at least a minor increase of 3 percentage points in UK bond market rates. A parallel condition was set out by Luxembourg on Monday, following consultations with UK regulators and the European and Securities Markets Authority (ESMA).
The Central Bank of Ireland Governor, Gabriel Makhlouf, noted that the steps initiated were intended to fortify the robustness of sterling LDI funds and therefore, support global financial stability. He highlighted that the application of these measures necessitated copious international collaboration, owing to the cross-border feature of capital markets.
Notably, this is the second instance of the Central Bank implementing policy measures for the non-bank financial intermediation sector, also known as the shadow banking sector.
The Central Bank’s decision in the latter part of 2022 to go ahead with its plan to restrict the leverage – or loans – of property funds to 60% of the underpinning assets’ worth has been implemented. Nevertheless, extant funds have been granted a five-year period to adhere. These actions are strategised to reinforce the capacity of investment funds to counteract, rather than exacerbate, dips in the commercial property market.