Open-ended investment funds face up to the shadow banking dragnet

The debate over the systemic risk of non-bank financial institutions (NBFIs) – sometimes called shadow banks – is a recurrent theme but it has recently moved to the forefront thanks to tighter monetary policies, geopolitical risks and factors such as the UK’s LDI crisis. While regulators are assessing the threats posed, most market participants believe changes will not happen for years. For some, there are fears that largely unleveraged segments like open-ended investment funds could be unfairly targeted.

“There is a high level of constructive paranoia in the financial services industry, including on the part of many regulatory supervisory bodies because things had been going so well for so long,” says Rich Nuzum, executive director, investments and global chief investment strategist at Mercer. “It is in my opinion a good thing that regulators are creative and proactive in their anxiety, and NBFIs are part of their concerns.”

In many ways, a false sense of complacency had enveloped the financial service community over the past decade due to the prolonged benign interest and inflation rate environment. 

However, over the past three years, a rapid succession of events – a pandemic, the war in Ukraine and escalating prices – have served as a wakeup call. The situation was further exacerbated by a meltdown in crypto markets, the collapse of hedge fund Archegos, the US regional banking crisis and the UK’s liability driven investment (LDI) debacle triggered by Liz Truss’s mini budget.

Financial institutions across the board were impacted, but the spotlight shone brightly on, insurers, pension funds, investment funds and other financial intermediaries – due to their broad reach. 

Overall, the IMF Financial Stability Report 2023 report shows that these organisations account for slightly less than half or 49.2% share of total global financial assets, surpassing banks with 37.6%. Central banks and public financial institutions account for the rest. Their significance has grown since the financial crisis (figure 1).

Investments funds represent 12% followed by insurers and pension funds at 9% each. They have not only usurped banks’ position as key lenders, but they also moved steadily into alternative assets such as hedge funds, private equity and private debt to boost returns during the low-interest-rate era (figure 2).

As Marine Leleux, sector strategist, financials at ING, points out, after a decade of bank regulation that curtailed banks’ risk profiles and lowered the vulnerability of the sector, financial risks in other parts of the system have grown, posing an indirect risk to the banking sector and a possible reason for central banks to step in. 

“70% of funds follow simple investment strategies that rely on little-to-no leverage.” Marin Capelle

She says: “It’s an ironic situation, both for banks that have seen this sector grow much faster than the banking sector itself, as well as for regulators who were hoping to have dealt with financial stability.

“In trying to minimise risk, the risk has been significantly compounded.” 

Regulators focus on liquidity

However, dealing with these changes is not straightforward. Virginie O’Shea, founder of UK-based Firebrand Research, notes regulators have long struggled with how to deal with the various perceived risks stemming from the non-deposit taking side of the industry.

She says: “I think the steadily growing influence of hedge funds and alternative asset classes over the last decade makes regulators nervous because of the increased volatility of the sector, but they don’t want to be seen to be preventing asset growth, so they focus on liquidity management instead,” she adds.

This puts into context the Financial Stability Board’s recent edicts. Over the past year, it has been busy assessing the vulnerabilities associated with liquidity mismatches and leverage which are sensitive to tightening financial conditions and slowing economic activity. 

In a recent speech at the International Financial Banking Society, FSB Secretary General John Schindler outlined the various measures the FSB is undertaking. 

These include analysing activities that create liquidity mismatches, such as daily or frequent redemption possibilities and insufficient liquid assets. He noted that this is particularly prevalent in non-bank entities, such as some money market and open-ended funds as well as derivatives and securities trading that can give rise to unexpectedly large margin and collateral calls, currency mismatches associated with external funding, and the unwinding of levered positions which can exacerbate liquidity strains.

In July, the FSB also published a consultation report proposing amendments to its 2017 policy recommendations to address liquidity mismatches in open-ended funds and strengthen liquidity management practices by open-ended fund (OEF) managers. 

The proposals build on a December 2022 report, which called for greater clarity on the redemption terms that OEFs could offer to investors, based on the liquidity of their asset holdings. The consultation was set to close on 4 September.

EFAMA: key measure ‘too narrow’

However, some organisations contend that given the diversity of players, it is unfair to view all NBFIs with the same lens. In a recent white paper, Open-ended funds and resilient capital markets, the European Fund and Asset Management Association (EFAMA) argues that the European investment fund sector is not systematically important. 

It says there are certain subgroups of funds that may contribute to pockets of risk, but it believes that effective micro- and macro-supervision remains key to identify and supervise these subgroups.

One of the problems is that FSB’s NBFI methodology to identify “economic activities that may give rise to systemic risks”, also known as the NBFI narrow measure, is not appropriate, according to Marin Capelle, regulatory policy advisor at EFAMA. He notes that the methodology equates the credit intermediation provided by the banking sector with that of market-based finance. It underestimates the heterogeneous composition of the funds’ client base and overestimates the sensitivity of investors to market fluctuations.

He adds: “If you are looking at the European investment fund sector it is important to realise that 70% of funds follow simple investment strategies that rely on little-to-no leverage.”

Federico Cupelli, deputy director of regulatory policy at EFAMA believes European market supervisors have a good grasp of the realities of the fund market and are already addressing liquidity management appropriately within the existing national and regional regulation, as well as in the context of the now finalised AIFMD/UCITS review.

“We also do not see investments into less liquid assets as a problem because product manufacturers are required upon authorisation to have robust liquidity management frameworks and related governance already in place,” he adds.

Although regulators and NBFIs will have their own perspective about how to tackle these problems, they all agree that collecting the right information is and will continue to be one of the main obstacles. 

“Considering the sector as overall less regulated than banks, less data is available to assess exposures to risks,” says Leleux. 

“This creates a sort of known unknown, as researchers and international organisations are able to identify the main risks that the sector is facing such as financial leverage, liquidity and interconnectedness between NBFIs and with the banking sector, but quantifying it remains a challenge.”

It is also expensive and time consuming. “We’ve seen ongoing tweaks in Europe to the UCITS and AIFMD regimes focused on liquidity, and more are ahead,” says O’Shea. “In the US, we’ve had the back and forth over the money market reforms and the removal of the controversial swing pricing proposals from the latest version of the regulation.”

She notes that greater oversight and more reporting mean greater burdens on firms in terms of cost and time, which takes away from managing risks. 

“The net effect of all of these changes needs to be better assessed and regulators should be making the best use of the data they already receive from the industry,” O’Shea adds.

O’Shea believes that although there is “a real desire on the part of national and supranational regulators to influence the risk and liquidity management behaviours of the buy-side, the implementation of bank-like regulation is inappropriate.” 

Whatever the outcome, few expect to see meaningful changes in the near future. Barring a major unexpected crisis, Nuzum believes that there will not be any big moves by regulatory supervisory bodies, but they will recommend incremental improvements over the years.