GLOBAL - Pension funds could damage the global financial system if they switch asset allocations in response to pressures to manage their risks, according to the Bank for International Settlements (BIS).

A BIS working group on the global financial system pointed to "systemic implications" as pressure to focus on liability-driven investment strategies reduce pension funds and insurers' provision of long-term risk capital.

The committee, set up in November last year and chaired by European Central Bank board member Peter Praet, expressed doubts over pension funds' ability to maintain a long-term investor perspective given prospective volatility of financial statements under international accounting rules, and regulatory mandates on scheme risks.

The report said: "This could alter the traditional role of life insurance companies and pension funds as global providers of long-term risk capital.

"A partial retreat of institutional investors from the long-term and/or illiquid segment of the credit market could reduce the private and social benefits this sector generates through long-term investing and the extent to which it mitigates the pro-cyclicality of the financial system."

The committee pointed out that low interest rates would make it difficult for pension schemes to meet future liabilities from fixed income yields.

Yet volatility-inducing changes to pension fund IAS19 accounting standards, combined with business models and balance sheets that remain exposed to low interest rates, could encourage pension funds to strengthen their existing appetite for high-quality, long-term bonds at the expense of other asset classes.

Increased demand for risk-free long-term assets, notably government bonds, could in turn damage the medium-term prospects for corporates as institutional investors continued to reduce their exposure to financial institutions. 

Meanwhile, Solvency II's requirement that insurers stockpile capital against losses in both assets and liabilities will make it more expensive to hold equity-like instruments, structured products and long-term corporate bonds compared with government and covered bonds.

In the meantime, the need to mitigate risk will increase the appetite for derivatives as hedging instruments, including interest-rate swaps, futures and equity options, the report said.