The latest version of the International Monetary Fund’s Global Financial Stability Report includes a chapter on “The Asset Management Industry and Financial Stability.” The report acknowledges changes in the banking industry that have increasingly pushed credit intermediation to the asset management industry, specifically highlighting the role of fixed-income funds. This shift provides the economy a “spare tire” for financing when banks are distressed, according to the report. Other advantages to this model include the fact that high leverage is limited to a small percentage of the investment fund industry and that investment fund shareholders bear investment risk in contrast to the solvency and liquidity risks faced by banks as a result of financing with short-term debt. However, the report notes that the changes have “given rise to concerns about potential risks,” citing the Office of Financial Research report on the asset management industry that “spurred an active discussion among academics, supervisors, and the industry.”
The chapter notes “known” risks regarding the size and concentration of the largest asset managers, the behavior of fund flows in emerging markets, and risks related to hedge funds and money market funds. The report focuses on the financial stability risks posed by “plain-vanilla funds,” finding that mutual funds affect asset price dynamics in less liquid markets and assets held in high concentration perform worse in periods of market stress. For example, the report points to higher increases in credit spreads during the 2008 crisis for bonds with higher levels and concentration of fund ownership and suggests that fund share pricing rules can create run risk. The report acknowledges, however, that portfolio managers may be able to mitigate this risk though the use of liquidity management. The report finds that herding has been increasing in mutual funds, and that patterns of inflows encourage portfolio managers to take excessive risks.
The report suggests that “[t]he delegation of day-to-day portfolio management introduces incentive problems between end investors and portfolio managers, which can encourage destabilizing behavior and amplify shocks.” The inability of investors to directly observe manager’s abilities and actions leads the investor to evaluate the manager based on performance in relation to peers and to benchmarks. It argues that this, in turn, may push the manager to take excessive risks, or to “retrench to the benchmark in response to losses,” which in turn can transmit shocks across assets. The manager may also be incented to mimic the behavior of peers which can cause herding, or to trade simply to give the impression that they are taking action in response to market changes. Lastly, the report notes that evaluating performance relative to a benchmark may increase volatility in the securities underlying that benchmark.
By looking at differences in a fund’s value at risk, the report found evidence that increased systemic risk appears to be more related to the focus of the fund, rather than the size of the fund or fund manager. The results showed that emerging market equity funds yielded the greatest contribution to systemic risk.
The report offers several suggestions to improve regulatory oversight. It suggests that regulators should clarify the definition of liquid assets and give additional guidance “to match the liquidity profile of each fund category to its redemption policy.” The IMF argues that regulators should also reassess funds’ risk management frameworks regularly in light of changing market conditions and should develop analytical and stress-testing capacities. The report recommends that regulators should monitor leverage levels related to the use of derivatives and seek to collect better data on the topic. The IMF suggests that focusing on activities and products in addition to size is “appropriate” and that “[i]nternational standards and guidelines for better supervision should be significantly expanded and enhanced.”