How banks and regulators reacted to the collapse of the UK bond market

On Saturday, October 8, the UK’s top bankers were called for 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 £65 billion in long-term government bonds to stabilize prices after the turmoil started by Kwasi Kwarteng’s ‘mini’ budget and bolstered by massive pension funds. from the UK.

The unprecedented fall in prices and the increase in revenues had surprised the banks and officials.

“Usually before you get a big earthquake, you get a few quakes,” a top executive said during the conversation with the BoE. “This was not an earthquake, it was a full-blown explosion.”

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While the BoE’s intervention had calmed markets, officials were still concerned that the situation was fragile during their weekend meetings with senior executives from banks including Barclays, Lloyds and NatWest, along with British heads of JPMorgan Chase, Morgan Stanley, Goldman. Sachs and Deutsche Bank. The BoE and the banks declined to comment.

The banks had been providing the BoE with daily reports for several days about their exposure to the shaky pension funds, including information on whether the schemes were failing to meet margin calls.

UK defined benefit funds invest heavily in gilts and also use derivatives as part of so-called liability-driven investment strategies. As gold prices plummeted following the government’s announcement of unfunded tax cuts, the schemes were forced to sell assets — including gilts — to raise money for banks’ margin calls on the derivatives. Those sales would push gold prices down further, fueling a price spiral.

Until the BoE’s intervention, there was a risk of default of individual pension plans and pooled LDI funds, managed by asset managers such as Legal and General Investment Management.

That exposed the banks, but the BoE was also interested in other routes of potential contagion, including banks’ use of reverse repos or repurchase agreements, where they lend money to pension funds through their corporate treasuries and take government bonds as collateral.

This was not reserved for spunky investment banks, but the more typically mundane parts of ordinary banks.

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Of the UK lenders, Lloyds Banking Group had the largest exposure to the repo market, with £52 billion, or 8.5 percent of assets on the company’s balance sheet. Of the £400 billion repo market, as estimated by the BoE, Lloyds accounted for about 13 percent of assets.

In comparison, NatWest had £25.8 billion in repo exposure, or 6 percent of its balance sheet assets; Santander’s UK bank had £12.6 billion (4.4 percent); HSBC’s British bank had £8 billion (2.3 percent) and Barclays had £3.2 billion (0.4 percent).

“Lloyds definitely has one of the bigger repo books, so they would have been one of the bigger counterparties affected,” said a trader at a rival bank.

While the BoE monitored the potential knock-on effects for the banks, the focus was on the pension funds themselves and their efforts to review 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 while the central bank was willing to buy up to £5 billion in government bonds per day, the facility was not being heavily used. In the first six days of the program, the BoE had bought a total of just £3.7 billion.

LDI executives told the BoE they were preparing to make the bulk of their sale next week because that would give their pension fund clients greater clarity about the amount of collateral they would have to deposit and what assets could be sold.

The bank believed that LDI executives ultimately wanted to keep their sterling government bonds to meet their long-term needs, so they first tried to sell every other asset they could.

Several banks also reported to the BoE that they were making very large collateral calls to defaulting customers.

The volatility in the market contributed to the operational challenges. Banks typically send their margin calls to customers early in the morning, with collateral to be paid no later than 1 p.m. But by then, market movements sometimes swung in the opposite direction, meaning funds had to sell assets at distressed prices to provide collateral that would be returned directly to them the next day.

Northern Trust – a major Chicago custodian bank that provided administrative services to two of the largest LDI executives, Legal & General Investment Management and Insight Investment – ​​was overwhelmed by the sheer volume of margin calls and was forced to recruit staff from the US to to help with its largely manual processing systems, according to people involved in the trade.

“Most of the focus has been on the operational burden on the custodians, whose manual processes were holding back the delivery of collateral,” said one person involved in discussions with the BoE.

Monday, October 10 at 7 a.m. — after a weekend of phone calls with bank bosses — the BoE announced it would dramatically expand its support for the pension market, increase its capacity to buy government bonds, and use a wider range of assets as collateral for loans. accept. A day later, it expanded its bond purchases with index-linked government bonds, the value of which is linked to inflation.

“The really violent swings are probably behind us after the bank’s response,” said a top executive on the phone over the weekend. “But we are in the middle of it. Things are still moving.”

Additional reporting by Emma Dunkley, Siddharth Venkataramakrishnan, Harriet Agnew, Stephen Morris and Joshua Franklin

Jacky

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