Putting Out the NBFIRE: Lessons from the UK’s Liability-Driven Investment (LDI) Crisis
In September 2022, the UK gilt market experienced severe stress following the country’s “mini-budget”. At the center of this turmoil were Liability Driven Investment (LDI) funds, highlighting the vulnerabilities present in the non-bank financial institution (NBFI) sector. This crisis, coupled with previous stress episodes like the “Dash for Cash” and “Archegos”, raised concerns about the stability of the financial system.
Seeking a deeper understanding of the factors that amplified the gilt market turmoil, the Bank of England (BoE) intervened by temporarily purchasing gilts to restore market conditions and enable LDI funds to rebuild their capital positions. This intervention ultimately proved successful, as the stress in the gilt market subsided and the BoE’s purchases were unwound.
This paper aims to identify the key reasons behind the BoE’s successful intervention and draw insights from the 2022 UK Financial Sector Assessment Program (FSAP) to address gaps and policy issues related to monitoring financial stability risks in the wider NBFI sector, both at the national and international level.
The first step in understanding the crisis is to examine the underlying vulnerabilities that made the NBFI sector susceptible to stress. The diverse nature of the sector, combined with its significant size, created risks that were not easily identifiable or manageable. LDI funds, in particular, were at the heart of the problem, as their investment strategies were based on matching liabilities with assets. However, these strategies were exposed to market fluctuations, and when the gilt market experienced stress, LDI funds faced significant challenges in maintaining their capital positions.
The BoE’s temporary gilt purchases played a crucial role in restoring order to the market and allowing LDI funds to rebuild their capital. The success of this intervention can be attributed to several key factors. Firstly, the BoE’s credibility and market confidence reassured investors and reduced panic-driven selling. Secondly, the central bank’s ability to effectively communicate its actions and intentions helped stabilize market expectations. Lastly, the specific design of the intervention, which targeted LDI funds directly, ensured the desired impact on capital positions.
Drawing from the FSAP findings, this paper also explores gaps and policy issues related to monitoring financial stability risks in the broader NBFI sector. The crisis highlighted the need for improved monitoring and oversight of LDI funds, as well as other NBFI entities, to detect vulnerabilities and address potential risks. Additionally, it emphasized the importance of international cooperation and coordination in setting consistent standards for the NBFI sector.
In conclusion, the UK’s LDI crisis serves as a valuable lesson in understanding the vulnerabilities within the NBFI sector and the necessary interventions to address them. The success of the BoE’s temporary gilt purchases highlights the importance of central bank credibility, effective communication, and targeted interventions. Furthermore, the crisis calls for enhanced monitoring and oversight of the NBFI sector, both at the national and international level, to ensure financial stability and mitigate systemic risks.