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Addressing systemic risks associated with market-based finance activities - Resilience of the EU financial sector in the global context
Asset management, market liquidity, and financial stability
By Gelos Gaston - Division Chief, Global Financial Stability Analysis Division, International Monetary Fund (IMF)
In recent years, credit intermediation has been shifting from the banking to the nonbank sector, including the asset management industry. Tighter regulations on banks, rising compliance costs, and continued bank balance sheet deleveraging following the global financial crisis have contributed to this shift. In advanced economies, the asset management industry has been playing an increasingly important role in the financial system, especially through increased credit intermediation by bond funds. The larger role of the asset management industry in intermediation has many benefits from a financial stability point of view. But it also entails risks, some of which we are only beginning to understand better.
In the IMF’s April 2015 Global Financial Stability Report, we pointed to incentive problems induced by the delegation of day-to-day portfolio management, which can encourage destabilizing behavior (such as herding) and amplify shocks. Moreover, we examined how easy redemption options and the presence of a “first-mover” advantage can create risks of runs, and the resulting price dynamics can spread to other parts of the financial system through funding markets, and balance-sheet- and collateral channels.
In our October Report, we took a closer look at two issues: the relationship between the open-end mutual funds and market liquidity, and the role of hidden leverage among mutual funds.
The presence of a “first-mover” advantage can create risks of runs.
Many people have been worried about market liquidity. In our analysis, we found that although the levels of market liquidity are not low, liquidity has become more fragile, partly due to changes in market structure, and the growth of a more homogeneous buy side. Empirically, larger holdings by mutual funds, in particular, open-end mutual funds, are associated with more severe liquidity declines during stress periods. When bonds were more heavily held by mutual funds before the financial crisis or the 2013 taper tantrum, liquidity (imputed round-trip costs) tended to decline more during the event. This underscores the need to find ways to reduce both liquidity mismatches and the first-mover advantage at mutual funds.
On hidden leverage, although regulations in Europe and the U.S. foresee limits on cash borrowing by mutual funds, leverage levels that can be achieved through derivatives are large. And current regulations only require bond mutual funds to disclose a limited amount of information about derivatives. At the same time, the assets of large bond mutual funds that use derivatives have increased significantly in recent years, and many have embedded leverage exceeding 100 percent of their asset value. This hidden leverage creates the potential for cross-asset contagion. Therefore, implementing enhanced and globally consistent reporting standards would be important to facilitate a proper analysis of risks across the financial sector.