Liability driven investment funds (LDIs) have maintained “high levels of resilience” despite recent volatility in the gilt market, the Bank of England’s Jonathan Hall said today.
Hall, an external member of the Bank’s Financial Policy Committee (FPC) said that recent moves in gilt yields had been “significant” as investors reassessed the likelihood of further rate hikes.
This movement in gilt yields “mechanically reduced the resilience of LDI funds”, Hall said. Yields and prices are inversely linked, meaning a spike in yields trims the value of LDI funds’ assets.
Hall noted many funds have recapitalised in order to restore their buffers, limiting the impact of the spike in yields.
This came after recommendations from the Bank’s FPC earlier this year which required LDI funds to maintain capital buffers sufficient to withstand a “severe but plausible stress”.
“This first test of the resilience standard demonstrated that the FPC’s recommendations are functioning broadly as intended, with funds holding significantly larger buffers on average and firms initiating recapitalisation at far higher levels of resilience,” Hall said.
Hall’s comments came in a speech discussing the dynamics shaping deleveraging and the risks it poses to financial stability.
He argued that raising funds to deleverage was a preferable solution to selling assets, which can lead to a fire-sale as occurred in LDI funds last Autumn.
He argued it was vital to ensure “critical sources of liquidity, such as Money Market Funds, are able to supply that liquidity, even in times of stress.”
His speech came a day after the Bank launched its first system-wide stress test which attempts to better understand the impact of shadow banks on financial stability.
Shadow banks, or non-bank financial institutions, have rapidly climbed up the agenda for regulators as their influence on the global economy has increased. Shadow banks perform many of the same functions as banks but do not have the same regulation.
Andrea Enria, supervisor at the European Central Bank, also pointed to risks in the shadow banking sector today.
According to Reuters, he argued risks in the sector had grown “profoundly” and “could intensify in coming months as monetary policy continues its efforts to bring inflation back to its target.”