Financial basis

UK pension funds shouldn’t be so exciting

Pension funds are supposed to be among the least attractive financial institutions. Their job is to make long-term investments to meet the foreseeable needs of future retirees. They should be immune to short-term shocks. Yet last week in the UK they were at the center of an incipient financial crisis.

What led to this was a new twist on a well-known theme: leverage meets unforeseen events. The danger when these two collisions are not confined to a particular country or market, so regulators around the world should take note. Banks are somewhat safer than they were before the crash of 2008, but risks originating outside the traditional financial system still require greater attention.

The embarrassment of UK pension funds shows how subtle these risks can be. Funds used derivatives, they believed, to hedge their positions, that is, to make their portfolios safer. Using a popular technique called “liability-driven investing”, they hedged against the risk that lower interest rates would increase their liabilities (the present value of future pension payments) more than they would increase their assets (government bonds, stocks and other investments). They did this, in effect, by borrowing to increase their exposure to government bonds.

Unfortunately, the reduction in risk from falling interest rates did not take into account the possibility that rates could rise sharply and dramatically – which happened after the UK government announced a new policy reckless budget on September 23. Higher rates (lower bond prices) reduced the long-term liabilities of pension funds, but also caused the funds’ derivatives counterparties to demand more collateral up front. That meant selling bonds, driving their prices even lower, which required more collateral, and so on — a vicious cycle that, for many, evoked the Lehman Brothers moment of 2008.

The Bank of England interrupted this downward spiral by promising to buy bonds on “any scale necessary” to restore order to the markets. It is too early to tell how the story ends. The debacle has made investors everywhere more anxious, and the central bank’s intervention, to put it mildly, is complicating its efforts to tighten monetary policy and rein in inflation.

For regulators, the lesson is this: the details of last week’s breakdown are new, but the core dynamics are not. Virtually every case of financial contagion and crisis, from the mortgage meltdown in 2008 to the implosion of Archegos Capital Management last year, shares the same basic characteristics.

The greater the leverage held by non-banks such as pension funds, hedge funds and insurers, the more dislocations are likely to proliferate and threaten the entire system. Regulators limit banks’ leverage by imposing capital requirements. In the world of so-called shadow banking, it largely depends on the counterparties. In good times, they often set collateral requirements too low, resulting in huge calls for additional collateral in bad times, when markets are most stressed and least able to deliver them.

In 2018, the Bank of England knew that pension funds would be hit by margin calls when interest rates rose, but concluded that all was well. Its worst-case scenario called for an interest rate hike of 100 basis points. At the time, that seemed like a lot. Already rising, they rose more than that in the space of a few days – and would have risen much more had the bank not intervened.

Regulators must remember that low-probability events are not zero-probability events: they eventually happen, and when they do happen, the damage can be enormous. Beyond banks in the ever-widening landscape of non-banking finance, they need to take a closer look at leverage in all its forms – and set margin requirements and other rules that reflect the extent to which markets can move when things go wrong.

One day, if regulators do their job, pension funds will be boring again.

More from Bloomberg Opinion:

• UK repos got margin calls: Matt Levine

• The problems facing the gilt market are not unique to the UK: Richard Cookson

• Corporate bond doomsayers are a bit premature: Jonathan Levin

The editors are members of the Bloomberg Opinion Editorial Board.

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