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Categorized | Financial

Protect asset managers from doom-mongers

Posted on June 30, 2015

Bond Certificates©Dreamstime

Do asset managers pose a growing systemic risk to the economy? This month the Reserve Bank of Australia and the Basel committee on banking supervision joined a growing list of regulators who think so.

Among the scenarios the authorities worry about is a bank-style run in which investors, fearful that redemptions by others will cause the value of their funds to fall, rush to pull their money out ahead of the crowd. That, the argument goes, would damage those on the other side of the trade, and cause large price swings in financial markets.

    The Financial Stability Board, set up by the Group of 20 leading nations to help oversee the financial system, is among the international bodies to propose labelling the largest asset managers global systemically important financial institutions, which would lumber them with stringent regulations and capital requirements hitherto visited only on the biggest insurers and banks.

    But the risks are overstated. True, mutual funds own a hefty 20-30 per cent of corporate bonds traded on global markets, and investors can pull out at short notice. It would be hard to find buyers for a big portion all at once. But the likelihood of a fire sale is lower than armchair thinkers seem to believe.

    Mutual funds investors have never been especially flighty, even in times of market stress. Our recent study with the Oliver Wyman consultancy shows that bond mutual funds experienced outflows of just 5 per cent after the 1994 bond rout — which was the worst period for redemptions in the past 35 years.

    Things were no worse after 1987, the Asian crisis, the technology meltdown at the turn of the millennium, or even in the most recent crisis. Since bond mutual funds in Europe and the US on average have cash holdings of between 4 and 7 per cent of total assets, the likelihood of unmanageable outflows seems slim. The industry, it seems, is already managing the risk of a dislocation that is within the range of historical precedent.

    Still, there is no doubt that quantitative easing and financial reform have shifted liquidity risk from banks to investors, and regulators might wish to do more than simply take comfort in the past 35 years worth of benign experience. Here, then, is a better idea: instead of applying restrictive rules that will indiscriminately inflict pain on mutual funds without doing much to make the financial system less fragile, regulators should use stress tests of the largest funds to calibrate their response.

    Predictive models could help quantify the risk, taking into account the differences between investors. Mutual funds held in retirement savings plans have been far stickier than other investors, and yet some regulators have assumed the opposite.

    Bouts of illiquidity are inevitable, so funds and regulators should prepare for them. How, for example, should the cost of meeting redemption requests be allocated between investors? Under what circumstances should it be permissible to bar redemptions? Such questions are best considered before a crisis, when answers will be needed urgently.

    In contrast, labelling the largest fund managers “systemic” does not seem to capture many of the risks policy makers fear. The International Monetary Fund, for example, says it is worried about the disruption that asset managers might wreak in emerging markets. Yet only one of the 10 largest emerging market debt mutual fund managers would be captured by the proposed rules.

    Market structure reforms could also help. Moving more business on to central clearing houses could reduce channels of contagion — so long as the clearing houses are resilient. The benefits of electronic trading networks, which normally seize up in panics, are overstated.

    The corporate bond market and mutual funds were a source of enormous strength throughout the crisis to fund companies. We should tread carefully. Stress testing is probably the best place to start.

    The writer is a managing director at Morgan Stanley. Betsy Graseck, also at Morgan Stanley, contributed to this article