Special Report: 10 years since Lehman
The evidence of systemic risk in the asset management sector is limited but is kept under close scrutiny
• Regulators are wary of the systemic risk posed by the asset management sector
• Recommendations have been made to minimise systemic risk
• Policymakers want to ensure adequate levels of liquidity and leverage in funds
• There is some evidence of asset managers being a source of systemic risk
The global financial crisis of 2008 prompted a global regulatory effort on an unprecedented scale. Global regulators have strived to implement rules that minimise the risk that the financial system will collapse owing to its inherent weaknesses. This focus on macroprudential, rather than microprudential, policy has led regulators to look beyond the banking sector to find unidentified sources of systemic risk.
As a result, after implementing far-reaching regulation for the banking sector, they have turned the spotlight on the asset management industry. Regulators have serious concerns that asset managers could play a pivotal role in precipitating the next crisis, in contrast to the last one, where they had a small role.
Asset management lobby groups have rejected the idea that asset management brings systemic risk. However, it is not clear to what extent the industry overall shares regulators’ concerns. Lobby groups emphasise that the evidence that asset managers pose any systemic risk to global financial markets is not conclusive. However, regulators are taking steps to identify and reduce systemic risk in asset management. The debate on the matter is far from settled.
Assets grow as well as risk
Despite the industry’s criticism, the reason why regulators are watching both retail and institutional asset management closely are perhaps obvious. The sector has grown significantly in the years after the crisis. The European Systemic Risk Board (ESRB), the European Union’s macroprudential oversight body, reports that since 2008 total net assets of EU-domicled investment funds have more than doubled, growing from €6.2trn to €15.3trn in the third quarter of 2017.
The ESRB notes that alternative investment funds (AIFs) have more than tripled in size, growing from €1.6trn to €5.8trn over the same period. “As the investment funds sector becomes a larger part of the total financial market, so managing systemic risk in that sector becomes more pertinent”, says the organisation. The findings are detailed in a December 2017 document that outlines the ESRB’s recommendations on liquidity and leverage risks in investment funds.
Growth of the investment fund sector, however, does not prove the existence of a systemic threat to financial markets. But regulators and other observers have also noted increased risk taking within the sector. The latest issue of the European Central Bank’s (ECB) Financial Stability Review, published in May, says that euro-zone non-banks have raised exposure to lower quality credit assets. The ‘non-bank’ category includes investment funds and their clients, including insurance companies and pension funds.
The ECB says: “Shifts in the composition of the corporate bond portfolios of euro area non-banks suggest that risk-taking has gone up. […] The overall shifts in portfolio composition have largely been driven by an actual reduction in the holdings of higher-rated securities and an increase in lower-rated securities holdings […]. These developments expose insurance companies, pension funds and investment funds to greater credit and market risk against the backdrop of potentially stretched valuations in high-yield corporate bond markets.”
The ECB found, among other things, that by increasing the duration of portfolios, bond funds have exacerbated their maturity mismatch. Bond funds have experienced net outflows this year owing to lower returns, but this has not stopped the overall growth of the investment fund sector. At the same time, says the bank, euro-zone bond funds have eaten into their cash buffers and reduced exposure to the most liquid assets.
The implication is that a shock in bond prices could trigger panic. “From a systemic risk perspective, losses could propagate through the financial system if negative returns trigger investor outflows, eventually resulting in forced sales of less liquid securities”, concludes the bank, adding that an initial shock to bond prices would be amplified by fire sales, with wider implications for financial stability and “possible spillovers to the real economy”.
‘Interconnectedness’ of non-banks also worries the ECB. The FSR warns that owing to asset class and geographical diversification, the portfolios of insurance companies, pension funds and investment funds have become increasingly similar. This could cause problems, says the report: “In general, cross-border investments of euro area non-banks have the benefit of international portfolio diversification, but they may also become a channel for inward spillovers originating from shocks in global financial markets.”
In short, there are reasons to be wary of the growth of asset management, according to the ECB. That is why regulators, following the lead of the Financial Stability Board (FSB), have begun to design rules to minimise systemic risk. The rules have to do with separating institutions that pose a systemic threat to those that do not. But the focus has been mainly on making sure liquidity and leverage within funds are kept to acceptable levels.
Laying down the law
In early 2017, the Basel-based FSB set out 14 recommendations for addressing systemic risk in asset management. Lobby groups such as the US-based Investment Company Institute (ICI) and the UK’s Investment Association (IA) were broadly happy with the final recommendations. However, they made no secret of their disappointment with the FSB’s proposal to classify asset management as Global Systemically Important Financial Institutions (G-SIFIs) alongside banks and insurers. The FSB is yet to make a final decision on the designation.
ICI Global, which carries out the international work of the ICI, the association representing regulated funds globally, has been at the forefront of the discussion with regulators. Frances Stadler, senior counsel for securities regulation at the institute, says: “We have seen progress in some areas, where initially regulators were looking at asset management through a banking lens, which led to problems. For example, the FSB had proposed some methodologies for identifying G-SIFIs in the asset management sector that were based on size of funds or assets under management.”
“Since then, we have seen a positive shift in focus, away from looking at individual entities and towards looking at activities in which funds and managers engage. We think that is more sensible”, she says.
The debate has centered mainly around the actual rules, but a lot of attention has been given to methodology and terminology. Lobby groups have been particularly upset with the frequent use of the term ‘shadow banking’ by regulators. The FSB publishes a yearly ‘Shadow Banking Monitoring Report’ where the term is used to describe all non-bank financing, including regulated investment funds. However, the FSB has a broad and a narrow measure of shadow bank. The latter focuses on a stricter definition of entities that are involved in credit intermediation. In the latest report, published in May 2018, the FSB described how it had made its narrow measure definition even stricter.
Throughout the report, the organisation suggested that the growth of shadow banking should is not alarming. It also tried to quell fears that its continued scrutiny of the sector will bring further regulation.
The report said: “The inclusion of non-bank financial entities or activities in the narrow measure does not constitute a judgement that policy measures applied to address the financial stability risks of these entities and activities are inadequate or ineffective, nor necessarily reflect a judgement that regulatory arbitrage is a relevant factor.”
“It is based on a conservative assessment of the potential risks they may pose, especially during stressed events […] As a result, the narrow measure may overestimate the degree to which non-bank credit intermediation currently gives rise to post-mitigant financial stability risks.”
Shadow banking aside, the ESRB has put out five recommendations on leverage and liquidity in regulated funds that should apply to entities domiciled in Europe. In February, the International Organization of Securities Commissions (IOSCO) published 17 recommendations on liquidity risk management, building on the FSB’s work. Some of these recommendations simply reflect practices that are already common in the fund industry, therefore the effects may not be felt by asset managers and investors.
The industry is generally still undergoing a phase of debate and partial implementation of new rules. It may take some time to assess the impact of these rules on systemic risk levels.
The nature of the challenge
The starting point, however, is that no-one can be certain that asset managers pose a systemic threat. In its December 2017 document, the ESRB identified four sources of systemic risk from funds:
• Unexpected high level of redemption demand during a market shock, which would lead to forced selling in falling markets;
• Incentives to trade liquidity off against yield or increase leverage to deliver higher yield;
• ‘First-mover advantage’, whereby investors redeeming early bear lower costs;
• The redemption mechanism depending on market liquidity, which can be low in times of stress.
The idea is that if these risks materialise, there would be spillovers to other areas of the financial markets which could eventually lead to greater distress, or even a collapse of the system. But the ESRB’s premise is that “investment funds tend to maintain their investment strategy in the presence of market shocks. With the exception of some AIFs, investment funds typically use low levels of leverage. In this case, funds which are not experiencing redemptions pressure tend to keep their assets and may even opportunistically seek to purchase assets as prices fall, thereby producing a countercyclical impact.”
The ESRB recognises that while at times investment funds have experienced high redemption demand during times of market stress, there is no historical pattern of aggressive selling behaviour during those times.
Speaking to industry experts, opinions on the matter can vary somewhat. Sean Collins, chief economist at ICI, says: “Since the crisis, there has been a lot of speculation on whether asset managers or funds could pose systemic risk, and despite 10 years of evidence, it still remains complete speculation. There is no evidence post-crisis, just in the same way that there was no evidence before the crisis, that regulated funds pose any kind of systemic risk.
“It’s worth pointing out that these stories about funds posing systemic risk go way back, to at least the 1940s, and they pop up every five or 10 years depending on the topic du jour, predicting there will be massive redemptions from funds that could create instability in the financial markets. The real question we would like to see regulators and academics focus on and academics is why even in the face of very severe shocks fund investors tend to be really stable,” he says.
Others have reached similar conclusions, but have added some important caveats. An expert from an international consultancy who has researched the subject extensively, but does not want to be named, says: “it’s important to ask what are the aspects of the way asset managers behave that do not directly reflect end-investor behaviour. For the most part, changes in investment behaviour by asset managers are just straightforward pass-through of end investors decisions.”
It is difficult to find episodes of market stress that are not a result of end-investor behaviour but rather a consequence of how asset managers work. But what if asset managers could, because of the way they are built, accelerate crises and therefore amplify systemic risk? The expert says: “I think it’s probably true that asset managers tend to chase the latest fad. This is probably the most indirect systemic risk, but theoretically asset managers could accelerate the tendency for the market to move in one direction or the others by pushing certain products.”
“Then there’s liquidity issues,” he adds. “Do certain fund structures, such as UCITS or ETFs, create a false sense than there is more liquidity than actually exists? One of the conceptual worries about ETFs is that, in theory, they can trade at any moment. Does that lead the average investor to assume that there must be the kind of liquidity that will support frequent trading even in bad times? I do think there is a real risk that the some retail investors may be somewhat deluded by the perceived liquidity.”
In short, an incorrect perception of liquidity could accelerate value destruction. Similarly, issues with fund structures, such as first-mover advantage, may accelerate selling, says the expert. “To the extent that there’s something about the fund structure that is likely to accelerate selling, as compared to how end investors would behave, then there might be an issue. But it is difficult to show why end investors would react differently to liquidity issues.”
Another factor potentially creating systemic risk is the widespread use of benchmarks within mutual funds, he argues: “The existence of asset managers adds complexity from a behavioural finance perspective. I think there are reasons to think that when asset managers fall behind their target benchmark, a collective shift back to the benchmark may have knock-on implications and accelerate selling in distressed markets.”
Are fund vulnerable?
However, if the ESRB’s argument is examined further, we could ask another important question could be asked. What if there was a market shock so large that it could expose inherent weaknesses in the asset management sector? Christian Weistroffer, senior expert at the ECB says: “We try to identify vulnerabilities in the financial system and potential triggers, which could come, for instance, from political risk or a reassessment of global growth prospects, and how these vulnerabilities and triggers could interact. The question is, what are the mechanisms that can amplify shocks?
“When we think about investment funds, and systemic risk, we are not typically concerned with smaller idiosyncratic events in the sector,” he says. “It’s rather, how would a larger shock originating elsewhere in the financial system, such as coming from a repricing of global risk premia, affect the investment fund sector more broadly. Secondly, how would the sector respond to the shock, and are there potentially amplifying effects from this response?”
A large enough shock, argues Weistroffer, could expose liquidity mismatches that do not seem relevant in normal conditions.
Weistroffert points out that the asset management sector is currently not the main risk worrying central bankers. However, he says: “As a potential amplifier to any system-wide shock, I would still keep it on the list of key risks and monitor it closely.”
To recap, regulators may well be overestimating the risk that the asset management sector poses to the wider financial system. But if they cannot be proven wrong about their concerns with systemic risk in this sector, which may well be the case, then it falls to them to improve or enhance current regulation.