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Pension funds may hit financial stability - study

EUROPE – A prominent economist has said the growth of pension funds may lead to “unfamiliar types” of financial instability.

“Pension funds and other institutional investors which are vehicles for retirement saving may also give rise to unfamiliar types of financial instability from the point of view of regulators and market players, which would be accentuated as they grew during the expansion of precautionary saving and/or funding,” said E. Philip Davis, professor of economics and finance at Brunel University in the UK.

“These would pose challenges to central banks in terms of adoption of macro-prudential analysis and response to crises,” Davis writes in a 20-page paper prepared for a conference organised by the Austrian Central Bank later this month.

Davis, a former senior advisor at the Bank of England, said there are two types of “financial turbulence” that could be generated by pension funds.

The first involved “extreme market price stability after a shift in expectations and consequent changes in institutional asset allocations”. He said this problem was mainly focused on the “herding” of institutions.

“The challenge here is the appropriate monetary policy response to the preceding misalignment, as well as possible need for emergency liquidity assistance for institutions facing difficulty after the adjustment.”

The second area of turbulence would involve the collapse of market liquidity and issuance. “Again often involving one-way-selling by institutional investors as they seek to shift asset allocations simultaneously, the distinction is often largely one of whether markets are sufficiently resilient, and whether market-maker structures are suitably robust”.

But while pension funds and other institutional investors are both able to “sit out” crises than banks given their long-term liabilities, Davis argues, they may also focus more on debt claims as their members approach retirement.

And he says that competition amongst asset managers may lead investment mangers to take “heightened credit risks in order to maximise their return on assets”.

“Credit cycles, could, in other words, affect institutional investors as well as banks. Solvency could be threatened directly for life insurance companies and defined benefit pension funds if a significant proportion of their assets defaulted.”

Mitigating this was the fact that DB schemes are not easily subject to runs on suspicion of insolvency.

The study notes that in general, a financial system characterised by institutional investors and extensive capital market financing “may be more stable than a bank-based one, especially if there is mispriced safety net protection in the latter and low values of banking charters”.

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