The Bank of England’s (BoE) latest Financial Stability Paper highlights that the actions of funds and assets managers can amplify stresses in the broader financial system.
While a source called the July paper an ‘incomplete exercise, focusing on only one type of stress scenario, one market and simple models of important parts of the system,’ others in the market say that it doesn’t go far enough.
The research outlines how the existence of possible spillover effects can damage both the prices of assets as well as the functioning of funds and the market more generally. It bases the analysis on an evaluation of the fire sale risk – a scenario where assets are sold at heavily discounted prices and owners of liquidity all rush to sell at the same time – and the so-called feedback loop it can create. The financial crisis of 2007/8 saw interest rates on corporate bonds spiral upwards in the UK, with the US facing a similar situation.
“The main concept here is the negative feedback loop, or pro-cyclicality,” said Jerôme Legras, managing partner and head of the research department at Axiom Alternative Investments. “Autocorrelations tend to change during extreme market events.”
Why it’s important
The BoE’s research is one of the latest studies to analyse how economic shocks can be amplified by the market itself, and is the next step in assessing how systemic risk can move across the market.
While the stability of banks worldwide has been the subject of regular and extensive stress tests, both in theory and in practice, the exercise is newer for the funds sector which is still dominated by academic research.
Sector-wide policy frameworks have been introduced globally since the financial crisis – in the UK, the BoE’s Financial Policy Committee was established in 2013 – with the aim of ensuring that financial shocks are absorbed rather than amplified. But the report notes that banks account for only half of the UK’s financial system and that the core principle behind bank stress testing should be applied more widely, including to the funds sector.
This comes as the amount of debt securities issued by EU funds has risen from 15% of their entire assets to 25% since 2009. From that perspective, large-scale redemptions from open-ended investment funds could result in mass asset sales which would jeopardise market stability and the ability of funds to absorb excess liquidity.
"The main concept here is the negative feedback loop, or pro-cyclicality"
The research found that ‘weekly redemptions from investment-grade corporate bond funds equal to one percent of total net assets (similar to those seen in October 2008 at the peak of the global financial crisis) would result in an increase in European investment-grade corporate bond spreads’.
According to Legras, it’s these reactions that actually reinforce market stress.
“But if regulators decide to introduce specific stress tests for funds, with redemption assumptions for example, and with precise consequences related to these stress tests (what would be a fail or pass, and what would be the impact of a failure?), this could contribute to further uncertainty,” he said.
What still needs to be done
The BoE’s report acknowledges that it still needs to explore other stress scenarios, and modelling the behaviour of institutional investors is left as further work. The approach stands in contrast with the direction taken in the US, where recent reports pointed that the Financial Choice Act will spell the end of stress testing for asset managers.
Ropes & Gray counsel David Tittsworth told IFLR in April that stress testing for asset managers is “somewhat of a square peg in a round hole” because there was no evidence to show that asset management activity poses a systemic risk to global financial stability.
This is a thought echoed by Legras. “Investments funds already do their liquidity stress scenarios, taking into account redemptions etc, so nothing new there,” he said.
A director of market practice and regulatory policy at the International Capital Markets Association, Patrik Karlsson, highlights the fact that liquidity risk management tools, which have been used at times of stress, were omitted from the BoE’s research. These include measures designed to disincentivise the first mover advantage such as swing pricing or dilution levies, and more extreme measures such as the suspension of redemptions.
“The report acknowledges it makes certain assumptions about funds’ behaviour,” said Karlsson. “Its results aren’t strong enough because it has left out some mitigating tools.”
The Financial Stability Board has recommended that national regulators carry out stress tests of asset managers to assess issues arising from liquidity mismatches. In the UK, however, while it has reviewed funds liquidity risk management, the Financial Conduct Authority has yet to introduce any binding rules.
Market welcomes end to asset management stress tests
PRIMER: the European Bank Recovery and Resolution Directive