Global regulator has fund liquidity concerns

By Janice Roberts

Last week, the Financial Stability Board (FSB), (of which SA is a member), chaired by Bank of England governor Mark Carney, published policy recommendations intended to address “liquidity mismatches across investment funds”.

Will this make the asset management sector safer and less vulnerable to crises?  Governor Carney thinks so – but not everyone agrees.

The document entitled Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities is the latest from the Financial Stability Board (FSB) on how to address what it calls “structural vulnerabilities from asset management activities that could become financial stability risks.”

The risks centre around:

  1. A liquidity mismatch between fund investments and redemption terms and conditions for open-ended fund units;
  2. leverage within investment funds;
  3. operational risk and challenges at asset managers in stressed conditions; and
  4. securities lending activities of asset managers and funds.

“Asset management activities have increased significantly over the past decade, including through open-ended funds that offer daily redemptions to their investors,” the FSB says.

Such growth has been accompanied by increased investment in particular asset classes, which encompass some less actively traded markets.

“The trend towards greater market-based intermediation through asset management entities should enhance the efficiency, and contribute to the overall resilience, of the financial system. While historical evidence suggests that open-ended funds generally have not created financial stability concerns in recent periods of stress, growth in the sector and increasing holdings of less liquid assets by investment funds suggest that risks may have increased in recent years.”

The FSB adds that in the area of liquidity mismatch, the recommendations are designed to increase information and transparency to both authorities and investors with respect to open-ended funds as well as to strengthen liquidity risk management frameworks and practices of those funds.

“They also address the potential use of system-wide stress testing by authorities. Leverage recommendations focus on the measurement and monitoring of leverage within investment funds. The recommendation on operational risk would help ensure that risk management frameworks and practices are commensurate with the level of risks that an asset manager’s activities pose to the financial system. The securities lending recommendation focuses on situations where indemnifications are provided by asset managers to their clients in relation to securities lending activities.”

In June 2016, the FSB published proposed policy recommendations for public consultation.

The final recommendations published last week show a number of changes to the proposed recommendations to incorporate the responses to the consultation.

“Among other things, the recommendations on liquidity have been revised to encourage authorities to develop consistent reporting requirements, to better distinguish the information that is useful to authorities and investors, and to emphasise the exploratory nature of system-wide stress testing at this time. The purposes and uses of leverage measures also have been clarified,” the FSB adds.

It quotes its Chair, Mark Carney, as saying: “The growth in asset management activities provides new sources of credit and investment, and adds diversity to our financial system. The policy recommendations will enhance the resilience of asset management activities so that this form of market-based finance can help underpin strong, sustainable and balanced economic growth. This will be of lasting benefit to our collective economies.”

Daniel Tarullo, Chair of the FSB Standing Committee on Supervisory and Regulatory Cooperation, states: “The policy recommendations will better prepare asset managers and funds for future stress events. The recommendations should also significantly enhance the information available to authorities for understanding potential risks from the asset management sector within and across jurisdictions.”

Ashley Alder, Chair of the IOSCO Board and a member of the FSB Steering Committee, adds: “The policy recommendations are an important step towards addressing potential financial stability issues in the asset management sector from a market-wide, activities-based perspective.”

Not everyone is happy though. Following the publication of the FSB’s document, Amin Rajan, chief executive of Create Research, a consultancy that works with asset managers   told the Financial Times: “These tools have their uses — at least on paper. How effective they will be in a crisis‎ is another matter. Devices that aim to avoid mass sell-offs can also be self-defeating by reinforcing the sense of panic.”

Meanwhile, Paul Stevens, president of the Investment Company Institute, which represents asset managers, commented to the same newspaper: “The FSB has made some helpful changes to its recommendations. Nevertheless, we remain troubled that this report continues to perpetuate the FSB’s flawed assumptions about liquidity risk management by open-end funds, despite detailed economic analysis from the Investment Company Institute in the comment record that calls into question these assumptions.”

The FSB has good intentions: Funds should be able to sell assets with ease to meet investors’ requests to pull money out during periods of market volatility.  Perhaps the $77 trillion asset management industry does need stricter rules.

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