LDI sector stress caused dysfunction in UK government bond markets

The Bank of England's Financial Policy Committee (FPC) said that rapid and large moves in the interest rates on UK government debt exposed weaknesses in liability-driven investment (LDI) funds, in its Financial Stability Report published on 12 July 2023¹. The report states that in September 2022 the impact of a shock in the LDI sector led to further market dysfunction in UK government bonds, and that episodes like this can push up the cost of borrowing¹.

The FPC made recommendations in March 2023 to increase the resilience of these funds to interest rate shocks, and said the authorities responsible for regulating them have since published new guidance¹. In March 2023 the FPC recommended that The Pensions Regulator (TPR) take action as soon as possible to mitigate financial stability risks by specifying the minimum levels of resilience for the LDI funds and LDI mandates in which pension scheme trustees may invest¹.

The report also sets out the wider interest rate backdrop. Since December 2021, Bank Rate has increased from 0.1% to 5%¹. The market-implied near-term path for UK Bank Rate has increased further since the December 2022 report, and is now expected to peak at around 6.2% in early 2024, with market expectations for Bank Rate to average around 5.5% over the next three years¹. The FPC agreed to maintain the UK countercyclical capital buffer (CCyB) rate at 2%¹.

The Bank has launched a system-wide exploratory scenario (SWES) exercise, described as the first exercise of its kind, to consider how banks and non-banks act in stressed financial conditions¹. The report notes that many firms involved in market-based finance are not regulated by the Bank of England, and that it is working with other regulatory authorities on resilience¹.

Why it matters for households

The report links disruption in government bond markets to the cost of borrowing for households and businesses more generally, stating that disruption to these markets can increase borrowing costs¹. On mortgages, it estimates that around half of mortgage accounts, around 4.5 million, have seen increases in repayments since mortgage rates started to rise in late 2021, and that higher rates are expected to affect the vast majority of the remainder by the end of 2026, around 4 million accounts¹. It states that monthly interest payments would increase by around £220 if a mortgage rate rises by the 325 basis points implied by current quoted mortgage rates¹. Rates on a 75% loan to value mortgage fixed for five years stood at around 5% in June, and for an equivalent two-year fixed-rate mortgage rates were around 5.5%¹.

The report says UK banks remain strong enough to support households and businesses even if future economic conditions are worse than expected, and that they have not seen a big rise in borrowers unable to make loan payments¹. It adds that increases in interest rates feed through to the economy gradually, so the full impact is yet to be felt¹. The FPC's mortgage market measures introduced in 2014 include a flow limit on lending to borrowers with loan to income ratios at or above 4.5¹.

What happens next

The report states that in March 2023 the FPC recommended TPR act as soon as possible on minimum resilience levels for LDI funds and mandates, and that regulators have since published new guidance¹. The Bank's system-wide exploratory scenario exercise has been launched, with the report saying it will provide insights to help understand and address vulnerabilities in market-based finance¹. No further dated steps are set out in the report.