Covid-19 has impacted us all, in one way or another. Apart from the very real and ongoing human tragedy, the pandemic has had major economic and financial repercussions. And among the myriad consequences for the financial industry is the renewed focus on an issue from previous crises – after the coronavirus-related selloff in February and March, we find regulators reflecting on systemic risk.
Unlike the global financial crisis (GFC), the market dislocation Covid-19 unleashed was felt less in the banking world. This time around, the effects were more acutely felt in certain short-term securities, with knock-on impacts on a small number of funds that held those securities.
We have been here before
This is not, of course, a new issue. In fact, it is partly the recurrence that captures regulators’ attention. The reflex response is to consider tighter regulation – a path that regulators seem intent on pursuing. But is this what the investors truly need? Is there an alternative that can address these concerns without doing unintentional damage to the ecosystem around them? More specifically, without upending the real benefits these instruments and funds provide?
Asset management is a large and growing business, with many interwoven and communal risks that have evolved alongside the increasing complexities of the industry. It is already tightly controlled and well regulated. But the question of top-down regulation has been around for a while, intensifying during, and after, the GFC. The specific impact on short-term securities initiated by Covid-19 has re-ignited the regulators’ scrutiny of liquidity and leverage.
It pays to look back at exactly what happened in the early stages of the pandemic. As markets fell in February and March, there was a temporary but severe dislocation, centred on liquidity in short-term securities. Certain funds suffered a shortage of liquidity as investors headed for the doors. The greatest concentration of selling appeared in money market funds (MMFs) and corporate bond funds, especially high yield. Indeed, in the eurozone high-yield bond market, net selling as a percentage of overall funds invested in the asset class was the highest since the GFC.
The increased level of redemptions that MMFs faced in mid-March had an immediate and tangible impact on short-term financing for non-financial enterprises, which typically use these instruments for their financial needs. This pushed up the cost of borrowing and reduced the availability of funding sources – thereby having a direct impact on the real economy. Some highly leveraged funds were also forced sellers of certain assets, contributing to reduced liquidity and drops in the valuation of those assets. Having become forced sellers, those leveraged funds offloaded these assets at much reduced prices, in some cases locking in substantial losses.
At the same time, it became clear that liquidity in the secondary market, provided primarily by banks, had evaporated. In Europe, in particular, there was severe upheaval. Central bank action, in providing large-scale asset purchase programmes and other measures to markets, was important in stabilising the system.
The fund management industry showed resilience in its reaction to Covid-19.
For instance, during the peak of the crisis in March, despite the turmoil, all MMFs in Europe met their redemption obligations as they made use of available buffers, or cash from expiring certificates of deposit or commercial paper. Where there were liquidity related issues, they tended to be in the minority and not illustrative of any systemic weakness or vulnerability.
Where were the banks?
Because of regulation introduced after the GFC, banks were already in a better capital position than before, holding higher levels of liquidity. This helped them to cope with the damage done by the market rout. When the pandemic struck, banks were naturally inclined to protect their own balance sheets and manage their capital requirements, effectively passing the problems down the chain by withdrawing their support to secondary markets, which impacted market counterparties including some funds. One could call this an unintended consequence of the strict regulations imposed by the regulators on banks. Whatever the label, it had a direct and severe impact on secondary markets. A reversal of this situation only occurred once central banks had stepped in, or indicated support to secondary markets. The crisis passed without much damage to the financial system but with questions again being asked about its resilience.
An examination of the broad issues
What is at stake here? There are regulators across numerous jurisdictions who are calling for tighter regulation of liquidity and leverage. Their banner is ‘macro-prudential’ – protecting the wider financial system. While the problems in March were relatively specific, the proposed solution could be top-down and all-encompassing.
There are regulators across numerous jurisdictions who are calling for tighter regulation of liquidity and leverage.
Governments and regulators look at the increased banking regulation that followed the GFC and – rightly – call it successful, in terms of the reduction in leverage and banks’ greater resilience to withstand future shocks. Systemic risks from banks have been reduced. And regulators appear to be eyeing up asset management for similar treatment.
Many market participants, including asset managers, counter that there was no systemic risk in March, that the industry held steady during the selloff, and that the issues were limited in scope and impact. What happened to short-term securities in March was a markets-based issue, rather than an investment-funds-based issue. The irony was that the absence of bank liquidity in secondary markets was the main cause of the problem – a situation that came about because of tighter regulation of banks. Further, the available evidence suggests that asset managers, bar some specific and limited disturbances, actually held up well in the face of a massive and correlated market downturn – and certainly didn’t place the entire financial system in jeopardy.
The industry argues that systemic risks from banking are not at all commensurate with those posed by asset management. Similar centralised regulation would be a blunt tool. Banks’ business models are more homogenous, with their scope generally operating along distinct business areas and national lines, and therefore easier to control. Asset management is increasingly diverse, international and more nuanced, requiring more sensitivity in regulation and oversight. The fear is that sweeping, top-down regulation would potentially stifle the benefits to investors and the delivery of capital to the economy. Although the direction of travel towards more centralised control since the GFC seems set, the liquidity and leverage issues around Covid-19 did not uniformly bolster the case for it.
Asset management’s place in the financial system
It is hard to contest that the funds industry provides an essential allocation of capital to the financial system. Asset managers provide a wide range of vehicles for investment and advisory services, with the intention of creating wealth for their customers, be they institutional – such as pension funds and charities – or retail savers. Indeed, the importance of generating returns for retail savers – who have faced the shift from defined benefit to defined contribution pension plans and a consequent rise in DIY investing (such as self-administered pension schemes) – cannot be overemphasised.
Disintermediation is another growing benefit, as the industry provides a diverse source of funding to the wider system. The EU has been moving towards diversifying the economy away from bank-based financing towards market- based financing, through alternative lenders and capital markets (a key tenet of the European Commission’s Capital Markets Union). Asset management is a crucial part of this solution.
Asset managers provide a wide range of vehicles for investment and advisory services, with the intention of creating wealth for their customers
For instance, although Europe is behind the curve of other regions, market-based financing has risen to around 40% of the total. European authorities are keen to raise that number still further, given the tangible benefits of market- based financing – namely the diversification of funding sources and the relative ease of access. In Ireland, where asset management has grown significantly over the past several years, the ratio is higher still, particularly when compared to GDP. The chart below shows the growing dominance of market-based financing of non-financial corporations in the euro area (€ billions).
So, there is an element of carrot and stick. Governments and economies need the asset management industry to fulfil this mandate of diversified funding but, at the same time, regulators also want more centralised control, so that risks to the wider financial system are limited. It is clear to see a fine line must be tread, so that regulators do not impinge on the huge benefits that market-based funding and diverse fund offerings bring.
A more resilient industry
Resilience has improved over the years, with liquidity risks being reduced through the introduction of detailed liquidity stress testing (LST). EU MMF regulations already force fund management companies to carry out regular LST, based on varying financial and economic scenarios, as now do the European Securities and Markets Authority’s (ESMA) LST guidelines for all European funds. Internal monitoring of liquidity and leverage is increasingly sophisticated and already subject to new regulatory requirements, which are in the process of being rolled out.
The case for regulation
Regulators would argue that this is not about restricting or killing off enterprise and innovation in the industry – it’s about providing proper oversight, so that the risks to the entire financial system can be identified and managed. An early warning system would benefit everyone.
Central Bank of Ireland Governor Gabriel Makhlouf calls for “resilience” in the system, so that it functions properly through good times and bad.1 The Governor pinpoints the risks of excessive leverage and illiquidity, identifying them as the historic and recurring catalysts of systemic shock. He states that the type of panicked selloff seen in March introduces more pronounced cyclicality. Reassuringly, however, he does recognise the sensitivities and different ingredients of the fund industry relative to banking, while understanding that imposing bank-style regulation may not work. He puts forward some interesting suggestions, such as limits on leverage and the alignment of redemption profiles with the underlying liquidity of their funds to avoid liquidity mismatches.
The International Organization of Securities Commissions (IOSCO) has also made recommendations to address liquidity risk management, particularly regarding the mismatches in certain high-profile funds – and some consequent suspensions. Additionally, ESMA announced early this year that it would be closely analysing the liquidity and redemption profiles of all UCITS funds. IOSCO and ESMA, among other regulatory bodies, are monitoring the situation but admit more work is needed, alongside proper consultation with all stakeholders.
This follows the 2018 publication of the European Systemic Risk Board’s recommendations regarding liquidity and leverage in UCITS funds, which, in turn, followed recommendations from the Financial Stability Board on the same topics. The thrust of the recommendations is to widen the range of tools available to fund managers to cope with large redemptions in times of market dislocation, as well as to increase disclosure from those funds investing in less liquid assets or using leverage.
Given the increasingly interconnected financial network that crosses borders and jurisdictions, different authorities need to work together to ensure greater harmonisation of these regulations
It is early days, but the different authorities are piecing together a framework that they hope can better monitor and regulate the fund industry. Given the increasingly interconnected financial network that crosses borders and jurisdictions, different authorities need to work together to ensure greater harmonisation of these regulations.
The endgame appears to be greater scrutiny and visibility around funds where there is risk, through better disclosure of those risks, and a broadening in scope of the tools available to prevent these risks damaging the wider financial system
A sledgehammer to crack a nut?
There are genuine concerns, however, which the industry highlights. Most investors are quite happy owning funds with some less liquid assets, as they may not be interested in short-term movements but more in long-term returns. Additionally, leverage, if managed carefully, can be part of a legitimate investment tool kit.
There are other high-profile bodies that have questioned the need for centralised regulation. The CFA Institute, for instance, suggests that systemic risks to the financial system are “misplaced”.3 The Institute believes that the industry has shown great resilience in times of crisis and does not require the burden of extra regulation, even in relation to the highlighted liquidity issues in open-ended funds. It questions the effectiveness of certain proposals from regulators, stating that some risks are “inherent” to markets and should be tolerated as part of the system.
Further, Andrew Bailey, the Governor of the Bank of England, stated in a 2018 speech to the London Business School’s annual asset management conference that the fund industry is part of the solution to the inevitable shocks in the financial system: “Asset management and other investment funds can act as a shock absorber, with losses being distributed across the system, and with many investors being in for the long term and able to ride the shock”.
Recent industry publications have also made several suggestions regarding short-term money markets and MMFs. With banks hamstrung in March by the laws regulating their capital ratios, it has been proposed that high-quality commercial paper be considered as a high-quality asset. This would mean that banks can freely support commercial paper markets in times of crisis without compromising their capital ratios. Other suggestions have included the use of MMFs as bank collateral or a relaxation of some of the guidelines around MMFs, namely mark-to-market and liquidity buffer requirements, which can create unintended consequences in times of market turmoil.