The Bank of England (BofE) has shared the results of its system-wide exploratory scenario (SWES) exercise, revealing that UK pension funds have "significantly" improved their resilience with respect to liability-driven investment (LDI) over the past two years.

The BofE initially launched the SWES in June 2023, in an effort to better understand the behaviours of banks and non-bank financial institutions (NBFI) in stressed financial market conditions, and how these behaviours and market dynamics can amplify shocks and potentially pose risks to UK financial stability.

The SWES was the first system-wide exploratory scenario exercise that included NBFIs, with The Pensions Regulator (TPR) also playing a key role in analysing the results of the exercise, particularly in relation to the impact on LDI and the collateralisation processes of such investments.

It was launched after the 2022 gilts crisis, which required BofE intervention, showed that market-based finance has been increasingly prone to sudden liquidity stresses during periods of market volatility.

The BofE acknowledged that the use of leveraged LDI strategies by pension schemes was a "key source of pressure" in corporate bond markets in the SWES.

However, it found that, compared with 2022, LDI funds are now much more resilient and can meet the margin calls they face following the SWES rates shock by running down buffers.

In the SWES exercise, however, LDI funds were recapitalised by their pension fund investors, and would have opted to sell gilts had this been unsuccessful.

Although these recapitalisation calls were smaller than estimates of those issued during the 2022 LDI episode, the BofE stressed that pension schemes still need to meet them rapidly.

The BofE therefore highlighted this as demonstration of the importance of the Financial Policy Committee’s (FPC’s) recommendation and the Financial Conduct Authority and TPR’s 2023 guidance to increase the financial and operational resilience of pension schemes’ LDI positions.

It also stressed the importance of maintaining it, explaining that the functioning of the gilt market depends on the resilience of the financial sector and the markets that support it – particularly gilt repo, and the derivatives markets that banks use for hedging.

In addition to this, the SWES identified how the sterling corporate bond market may ‘jump to illiquidity’ after a shock due to sales pressure by firms in several sectors that need to access liquidity or de risk.

According to BofE, banks’ willingness to warehouse risk is limited, and potential countercyclical investors only enter the market relatively slowly.

It also found that some rapid sales arise from pension schemes meeting recapitalisation calls from LDI funds seeking to rebuild headroom over regulatory buffers, underscoring the important role of pension funds to UK financial stability.

The BofE also found that the sterling corporate bond market becoming illiquid in stress risks reducing its effectiveness as a source of financing for the real economy, particularly if poor conditions persist or repeated periods of illiquidity reduce longer-term confidence in that market.

In light of this, the BofE suggested that greater transparency through improved data collection and disclosures could help to mitigate these risks by raising awareness of potential correlated asset sales.

TPR will therefore explore with industry potential improvements to existing data collections to improve contingency planning by pension schemes and reduce risks to corporate bond market functioning.

TPR also said that it plans to engage with pension schemes to better understand their behaviour in stressed markets, and explore options to reduce behaviour that amplifies market shocks.

Commenting on the report, TPR chief executive, Nausicaa Delfas, said: “This report shows that pension schemes are now more resilient to extreme market movements.

“We recognise the important role pensions play in the wider financial ecosystem and continue to guard against systemic risks by understanding how schemes act during stressed market conditions, as well as exploring improvements to our data collection to make sure we keep savers safe."

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