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Categorized | Capital Markets

Investors amplify boom and bust cycles

Posted on July 31, 2014

Market boom and bust cycles are exaggerated by life assurance companies and pension funds, increasing risks to the stability of financial systems, warns a research paper published by the Bank of England.

Evidence of “pro-cyclical” behaviour was apparent during the post-2007 financial crisis and during the “dotcom boom” at the start of the century, according to the study published on Thursday. The performance of economies could have been hit as a result.

    The report’s conclusions are the latest example of policy makers shining the spotlight on fund managers and large owners of financial assets, and their potential for creating financial market disruption.

    Earlier this year, Andy Haldane, a member of the BoE’s Financial Policy Committee, warned that the world’s asset management sector posed mounting risks to financial stability and urged regulators to develop new tools to deal with the challenge.

    The Bank of England said the views expressed in the discussion paper, based on work by academics and industry experts as well as bank staff, including Mr Haldane, did not necessarily reflect its views.

    Life assurance companies and pension funds manage more than $50tn of assets globally. Because of their long-term liabilities, they should provide finance to real economies on a similarly long-term basis and help spread risks in the financial system. By investing “counter-cyclically” – essentially, buying assets when prices are falling and selling when they are rising – they could help stabilise markets.

    However, the BoE report found there was “some evidence of pro-cyclical shifts in asset allocation following the dotcom crash of the early 2000s, and to a lesser extent during the recent financial crisis”.

    Evidence of “procyclicality” by pension funds was mixed. While pension funds in some countries appeared to have behaved counter cyclically during 2008-09, others had been net sellers of equities. “This arguably reflected structural shifts in these countries towards more conservative asset allocations, rather than being a reaction to market conditions, but nonetheless may have been destabilising in the context of market developments at that time.”

    Global equity markets fell sharply after the collapse of Lehman Brothers investment bank in late 2008. But those fund managers that invested counter-cyclically saw handsome returns. Since the trough in March 2009, the US S&P index has risen 190 per cent, and the FTSE All-World index by 150 per cent, on the back of aggressive policy actions by the world’s central banks.

    Possible causes of procyclicality are regulation, herding behaviour by fund managers, industry practices and accounting rules – including “mark-to-market” valuations. Pension fund regulators have “introduced elements of regulatory flexibility in periods of stress”, the report notes, but its conclusions could encourage measures that constrain funds from pushing prices higher in upswings.

    Pro-cyclicality is potentially damaging because it increases price volatility, the report warns. “Although asset price volatility does not necessarily equate to financial instability, it can decrease the resilience of the financial system, and thereby potentially contribute to serious interruptions in the vital functions which the financial system as a whole performs in our economy.”