International financial regulators, considering lessons learned from defusing systemic risks in the banking sector, have set their sights on similar risk tools to reduce the systemic risks associated with open-ended bond funds. An industry representative claims that such macroprudential tools won’t work as regulators don’t fully understand how fund management works. The markets, meanwhile, have little faith that regulators can effectively resolve this daunting conundrum.
Just before Christmas, the Basel-based Bank for International Settlements (BIS), which brings together financial regulators and central banks from around the globe, issued a report in which it said tools currently used to manage systemic risks in open-ended bond funds fail to deliver. The problem came to light during the March 2020 market turmoil at the onset of the Covid-19 pandemic, when investors worldwide collectively sold their investments in a global dash for cash.
At that time, bond, money market and investment funds, including ETFs, suffered heavily from these large withdrawals and found it hard to maintain liquidity. The moves amplified market swings and threatened to undermine financial stability. Markets only calmed down after the European Central Bank intervened by launching its 750 billion euro pandemic rescue package. Regulators now want to address these systemic risks by taking on non-bank financial institutions, or NBFIs, formerly known as “shadow banks”.
Macroprudential tools
Basel’s specialists see a need for a more effective use of macroprudential tools, preventing liquidity mismatches through more stringent application of regulation. They also urge improved identification of systemic risks in open-ended bond funds, better use of liquidity tools, and boosting the gatekeeper role of regulators so that the tools are usable at times of stress in the market. Their BIS review is based on a data set of 77 billion euro in open-ended bond funds registered in Luxembourg.
The CSSF, Luxembourg’s financial regulator, said that such issues “are definitely relevant topics for future research”. Its own analysis shows that small bond funds with relatively few investors are “more likely than others to have large net redemptions”, and even more when their past performance was poor. “A lack of uniformity in reporting requirements and underlying definitions gives rise to discrepancies,” the CSSF report said in October.
Too early to take position
CSSF spokesman Paul Wilwertz confirmed that it “contributes actively to these discussions”, but that it “seems too early to take definitive positions” on the specific macroprudential measures that might eventually be taken since “additional analytical work is needed to enhance the understanding of the interaction and propagation of risks.”
“The challenge for the authorities is to manage those risks effectively while allowing the financial system to perform basic functions in the interest of society,” said Agustin Carstens, BIS General Manager, when presenting the study. “Policymakers cannot afford to fall behind the curve.”
Industry representatives question the BIS conclusions. They call on regulators to carefully consider specific aspects of the asset management business. Some new regulatory measures, they claim, may even have adverse effects and disrupt markets.
Industry heterogenous, diversified
“Macro-prudential tools won’t work as our industry is far more heterogenous and diversified than the BIS believes,” said Federico Cupelli, Deputy Director of EFAMA, the European trade body for asset and fund management, in emailed comments.
“Imposing a one-size-fits-all approach fails to have regard to the investment strategy, underlying assets and investor profile of the fund in question,” said Cupelli. “The management of liquidity risks is a function of, and is directly related to, the characteristics of the fund being managed.”
On the road to Bali
The BIS report is but one marker on a road towards new regulation on which several international bodies, including the ECB’s European Systemic Risk Board (ESRB) and the Financial Stability Board (FSB), are travelling together. The FSB will host a conference in June on systemic risks in NBFIs and recently published a call for papers. This will lead to a report for the G20 Bali Summit in October of this year, said an FSB spokesperson.
The European Securities and Markets Authority (ESMA), which also coordinates the work of national EU supervisors such as CSSF in Luxembourg, is already preparing tools. Risks relating to leverage, liquidity and interconnectedness have been “on our radar for several years,” the spokesman said.
ESMA’s actions include a push for more convergence among national regulators in the EU on liquidity management and guidelines for leverage limits. ESMA points out that in the upcoming revision of EU investment fund directives, management companies can suspend redemptions while supervisors can be granted powers to activate and manage liquidity management tools. The EU will debate these proposals the coming months.
Stepped up supervision
Since the 2007-8 crisis, financial regulators worldwide have stepped up their supervision. In the EU this led to increased powers for European supervisory agencies such as ESMA in fund management and EBA in banking. In the banking sector, the overhaul has managed to significantly reduce the systemic impact of banks. Taxpayers now are off the hook, largely.
Some regulators argue it is time to apply a similar approach to NBFIs as for banks. After all, a mass redemption of funds is similar to a bank run on banks. Generating more clarity through stronger monitoring and more stringent regulatory reporting is one option. Building a war chest during good times in order to mitigate the effects of collective withdrawals at times of trouble is a second.
The costs and complexity for the non-bank financial system could be significant, possibly even more so than with banks. This also is the case for investors, many of whom are not aware of the potential impact of mass redemptions.
Next financial crisis
The March 2020 events might have provided a glimpse of a next financial crisis. Sławomir Soroczyński, Head of Fixed Income at Crown Agents Investment Management in London, argued current market conditions, encouraged by low interest rates and a surge in asset values, reflect an increase in risk appetite and possibly made funds vulnerable to a correction.
“The market has been in a buying mode for months but many seem to forget how it dropped last March,” Soroczyński said, speaking in a personal capacity. “I have been around since 1994 and honestly never have seen anything like this. The market in ETF bonds makes too many assumptions. Money is flowing in – yes, it is true. After last year everyone assumes that if bad things happen central banks will run to the rescue.”
Doubt about regulatory success
Crown Agent’s Soroczyński does not believe regulators will be able to effectively solve the problem easily. “The bedrocks of the market are broken so it is impossible to discuss fixing through regulatory channels,” he said.
Regulators recognize the complexity of the challenge.
“The policy challenges are daunting,” said Carstens, as chief global regulator at BIS. “The task does not have a clear beginning and a clear end. This will be a continuing endeavour.”