Meyrick Chapman is the principal of Hedge Analytics and a former portfolio manager at Elliott Management.
In a cruel way it is amusing that the recent LDI shambles rebounded so badly on now ex-prime minister Liz Truss and then-chancellor Kwasi Kwarteng.
After all, in the wake of 2008 the main aim of regulators was to ensure the political order would never again face the risk and responsibility of an overleveraged financial system. It seems this cunning plan has backfired. The LDI explosion shows the post-crisis financial architecture has important flaws.
But so far those flaws primarily appeared for pension funds. Why is that? And might this hold some lessons for the future?
First, some background. The simple regulatory response to the global financial crisis was to create a modern twist on the “risk transfer” business of finance; risk in banks would be reduced by shifting it to other financial actors.
In a reversal of Colbert’s famous maxim on taxation, the art of financial regulation consists in stuffing the right goose to obtain the largest possible amount of immediate political foie gras with the smallest possible amount of hissing. Perfect candidates for such stuffing are long-term investors — like pension funds and life insurers. Not all have managed the transition to the new regime well.
UK defined-benefit pension funds were the first to suffer because of bad decisions. For example, they generally accepted that the interest rate swaps they used should be backed by “clean” Credit Support Annexes (CSA). Clean CSAs only permit cash or government bonds to be posted as margin. This contrasts with a “dirty” CSA where collateral may be posted in a much wider range of instruments, including lower-rated corporate bonds.
Pension funds were persuaded by the argument that the new regulations were good for the system (including them), not just good for banks. Why? Because new regulations made it expensive for banks to continue with the old system. The regulators made sure that if you objected to their rules, it would cost you. Heterogeneity is not part of the regulatory lexicon.
It is not as if investors weren’t warned about the likely effect of reform. In April 2012, during discussions on central clearing of derivatives, the International Swaps and Derivatives Association (ISDA) said the new regulations would mean that:
. . . existing Credit Support Annexes would require renegotiation. Also being prescriptive as to eligible collateral threatens the bilateral negotiation principle of the OTC market, would reduce liquidity and reduce the ability to effectively mitigate credit risk.
In other words, the new regime would switch flexible arrangements for inflexible arrangements.
Some were not entirely happy with the new arrangements. It is said that Dutch pension funds, the largest pool of pension assets on the European mainland, were reluctant to switch to central clearing. They much preferred to maintain flexibility with their counterparties offered by the old system.
And it is striking that UK life insurers did not run into margin problems in anything like the same extent as pension funds. Life insurers suffer from the same predations of low interest rates and therefore run similar LDI strategies as pension funds. Perhaps life insurers have generally opted for a curmudgeonly adherence to “bad practice”.
More likely, perhaps UK life insurers are just better managed than pension funds, or more aware of unwitting risk transfers. It is not the imposition of clean CSAs per se which damaged cash flow. Instead, pension funds, unlike insurers, may have failed to establish repo lines with banks for corporate bonds in the event of large cash call. This crucial aspect of adaptation to the new system seems to have been missing.
Why the difference? Life insurers are (generally) integrated risk management businesses unencumbered by a trustee structure like pensions. Trustees are not famed for their financial sophistication. But this is a failure of pension oversight more than a failure at the fund level. The regulatory authorities created the potential problem, and it was their responsibility to ensure pension funds were aware of potential pitfalls in the new system. Regulators appear to have failed to identify the flaws or communicated these flaws to trustees sufficiently robustly.
A wider lesson for society might be to ask more searching questions about exactly who benefits from financial regulation and how ultimately risks are apportioned. The current system seems to be both literally and figuratively a matter of buck-passing, though in both senses end users invariably find they are charged a disproportionately high fee.
In the meantime, perhaps we should celebrate the LDI episode at least as evidence that regulatory reform is not always successful in its attempt to pass the buck.
A more lasting lesson might be that post-crisis reforms show a level of hubris that may lead the deities that oversee finance to find lots of other unexpected ways to embarrass the political class.