EUROPE – Institutional investors using benchmarks in managing their portfolios may lead to herd behaviour – and problems for monetary policy - says the European Central Bank.
“If benchmarks play a key role in portfolio management, a natural tendency to herd may emerge among institutional investors,” said Lorenzo Bini Smaghi, ECB executive board member.
“As is well known, herding can be a recipe for asset misalignments, in particular over the short term, and for the emergence of self-fulfilling price setting.” He was speaking at a conference in Geneva on the topic of the increasing role of pension funds in the financial markets.
Bini Smaghi also pointed to the risk of market concentration. He said: “It is striking to note, in this context, that already now 40% of outstanding government bonds are held by pension funds. Concentration may reduce the efficiency of the market and increase its fragility, in particular in the face of contagion.”
He continued: “If the fixed income market is dominated by few institutional investors seeking to beat a benchmark, there is a risk that asset prices might reveal little about fundamentals. Asset prices might tend to be determined mainly on the basis of other investors’ expectations and on the anticipation of central bank policy over the short term.”
There was a question of interest for central banks about whether the emergence of large pension funds “affects the transmission of monetary policy on output and inflation”.
If asset prices were set on the basis of short-term benchmarking then “the relationship between the policy rate and households’ and firms’ behaviour may become non-linear and unpredictable”.
He told delegates: “The emergence of pension funds may in fact itself contribute to an environment of low interest rates, especially at the long end of the curve, reflecting the increasing demand for fixed income assets.
“This may create phenomenon like “conundrum”, in which long term rates behave in a way not fully consistent with movements in short term rates. Such conundrum may impact directly on the transmission mechanism of monetary policy.”
He suggested institutions may have to supply more data on their investments.
“Going forward, the information provided by monetary financial institutions might have to be complemented with timely balance sheet information on institutional investors, to properly take into account the triangular relationship between banks, institutional investors and households and the possible substitution between bank-based and institutional investors’ financial transactions.”
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