On Saturday October 8, top UK bank executives were summoned to an emergency video call with Sam Woods, head of the Bank of England’s regulatory arm.
Ten days earlier, the BoE had intervened in the bond market, pledging to buy up to £65bn of long-term gilts to stabilize prices after the turmoil triggered by Kwasi Kwarteng’s ‘mini’ budget and amplified by the huge British pension funds.
The unprecedented fall in prices and soaring yields had taken banks and officials by surprise.
“Before you get a big earthquake, you normally get a few tremors,” a managing director said on the call with the BoE. “It wasn’t a tremor, it was a total explosion.”
Although the BoE’s intervention calmed the markets, officials were still worried about the fragility of the situation during their weekend meetings with leaders of banks such as Barclays, Lloyds and NatWest, as well as executives British companies from JPMorgan Chase, Morgan Stanley, Goldman Sachs and Deutsche Banque. The BoE and the banks declined to comment.
For several days, banks had been providing the BoE with daily reports on their exposure to faltering pension funds, including information on whether schemes were failing to respond to margin calls.
UK defined benefit pension funds invest heavily in gilts and also use derivatives as part of so-called liability-driven investment strategies. As gilt prices fell after the government announced unfunded tax cuts, schemes were forced to sell assets – including gilts – to raise funds for banks’ margin calls on drifts. These sales would further depress gilt prices, fueling a price spiral.
Until the intervention of the BoE, there was a risk of failure of individual pension schemes and pooled LDI funds, managed by asset managers such as Legal and General Investment Management.
This left banks exposed, but the BoE also looked at other potential routes of contagion, including banks’ use of reverse repurchase agreements or repurchase agreements, where they lend money pension funds through their corporate treasuries and take government bonds as collateral.
This was not the preserve of racy investment banks, but the more routine parts of regular banks.
Among UK lenders, Lloyds Banking Group had the most exposure to the repo market, with £52bn, or 8.5% of assets on its corporate balance sheet. In the £400bn gilt repo market, according to BoE estimates, Lloyds accounted for around 13% of assets.
By comparison, NatWest had £25.8bn of repo exposure, or 6% of its on-balance sheet assets; Britain’s Santander Bank had £12.6 billion (4.4%); British bank HSBC had £8 billion (2.3%) and Barclays £3.2 billion (0.4%).
“Lloyds certainly has one of the biggest repo books, so they would have been one of the biggest counterparties involved,” said a trader at a rival bank.
As the BoE monitored the potential repercussions for banks, it focused on pension funds themselves and their efforts to reshuffle their portfolios in the face of multi-billion pound margin calls.
On October 4, a week after the BoE’s intervention, it became clear that although the central bank was willing to buy up to £5 billion worth of gilts per day, the facility was not widely used. In the first six days of the program, the BoE had bought just £3.7bn in total.
LDI managers were telling the BoE that they were preparing to make most of their sales the following week because their pension fund clients would then have more clarity on the amount of collateral they would have to post and on the assets that could be sold.
The bank believed that LDI’s managers ultimately wanted to hold on to their sterling government bonds, which matched their long-term needs, and were therefore trying to sell whatever other assets they could first.
Several banks were also reporting to the BoE that they were making very large guarantee calls to dissatisfied customers.
Market volatility added to operational challenges. Banks typically sent their margin calls to customers first thing in the morning, with collateral due by 1 p.m. But at that time, market movements sometimes moved in the opposite direction, which meant that funds had to sell assets at distressed prices to provide collateral which would then be returned directly to them the next day.
Northern Trust – a large Chicago-based custodial bank that provided back office services to two of LDI’s largest managers, Legal & General Investment Management and Insight Investment – was overwhelmed by the sheer volume of margin calls and was forced to recruit American personnel. to help with its largely manual processing systems, according to those involved in the trades.
“Most of the attention was on the operational pressure on custodians, whose manual processes were delaying the delivery of collateral,” said a person involved in discussions with the BoE.
At 7 a.m. on Monday October 10 – after its weekend of calls with banking bosses – the BoE announced that it would significantly expand its support for the pensions market, increasing its capacity to buy gilts and accepting a wider range of assets as collateral for loans. A day later, he extended his bond purchases to index-linked gilts, the value of which is linked to inflation.
“The really violent swings are probably behind us after the bank’s reaction,” said a chief executive who was on the calls over the weekend. “But we are in the middle of that. Things are still moving. »
Additional reporting by Emma Dunkley, Siddharth Venkataramakrishnan, Harriet Agnew, Stephen Morris and Joshua Franklin