The impressive growth of the asset management industry since the 2008 financial crisis should cause anxiety. There are many reasons to believe that while banks have been made safer by tighter regulation post-crisis, the systemic risk embedded in the asset management sector has grown significantly. First, funds have engaged in riskier activities, particularly when it comes to credit. They have raised the share of lower-rated corporate debt, increased the duration of investments and moved toward the fringes of credit provision, with some engaging in private debt. As a result, asset managers have become lenders. Credit creation depends, in part, on them.
This is not a problem in itself, except that regulators have signalled that growing risk levels in investment funds could raise the risk of liquidity mismatches. When markets are distressed, redemption demands by investors could trigger aggressive selling by funds. But, if assets turn out to be less liquid than anticipated, fund managers could be forced to sell at a loss, so accelerating market falls. The risk is significant if investors are promised liquidity on their investments that does not match reality. The argument is valid for both pan-European UCITS funds and exchange-traded funds, which are increasingly being used to access illiquid credit investments such as high-yield bonds, emerging market debt and loans.
Critics of this argument contend that fund investors do not redeem aggressively in falling markets, as they are generally long-term investors. In addition, fund managers are clear on liquidity terms. Naturally, fund managers should be aware of these risks, and should have built sufficient liquidity buffers and stress-tested their investments.
It is hard to take a clear view because the evidence supporting the argument that systemic risk has risen is limited. At the same time, it is difficult to disprove the regulators’ contention.
That is why the efforts made by regulators to monitor and reduce systemic risk in the asset management sector should be welcomed. In fact, the industry should wish for the debate to continue. Further regulation to make investment funds and asset management activities rock-solid is essential. That is why the industry should adopt the recommendations on liquidity and leverage in funds that the Financial Stability Board (FSB) and the European Systemic Risk Board (ESRB) have proposed, and regulators should build on those. The industry can thrive despite regulation. But, if there are no rules preventing fund managers from making promises of liquidity to investors, the industry could suffer when markets crash.
Carlo Svaluto Moreolo, Senior Staff Writer