The Bank for International Settlements said policymakers should encourage regular liquidity stress tests for asset managers to ensure they can withstand shifts in market sentiment.
The latest BIS annual report said that as banks have scaled back their market making operations, particularly in fixed income, other players such as asset managers are playing an increasingly important role.
In fixed income, market makers are focussing on the most liquid bonds, reducing the the average size of relatively large trades US investment grade corporate bonds and become more selective in offering services to core clients and markets. As a result, liquidity has become concentrated in the most actively traded securities, such as the government bonds of advanced economies, at the expense of less liquid corporate and emerging market bonds.
As a result regulators are looking at the role asset managers play in maintaining financial stability.
The BIS said: “Here the concern is not so much the failure of individual firms, but the impact of their collective behaviour on systemic stability through asset prices, market liquidity and funding conditions. Even when unleveraged, these investors are quite capable of generating leverage-like behaviour.”
As market makers have reduce their provision of liquidity, investors are increasingly turning to fixed income mutual funds and exchange-traded funds.
Bond funds have received $3 trillion of investor inflows globally since 2009, while the size of their total net assets reached $7.4 trillion at the end of April 2015. In US bond funds more than 60% of inflows were into corporate bonds. “ETFs have gained importance in both advanced economy and emerging bond funds,” said the report.
The BIS said the growing size of the asset management industry may have increased the risk of liquidity illusion - where liquidity appears ample in normal market conditions but vanishes quickly in times of stress. Asset managers and institutional investors may not have the resources to actively make markets at times of large order imbalances and have little incentive to increase their liquidity buffers during good times. As a result, when market sentiment shifts, investors may find it more difficult than in the past to liquidate bond holdings, particularly in relatively illiquid corporate or emerging market bonds.
The BIS said: “Policymakers can provide them with incentives to maintain robust liquidity during normal times to weather liquidity strains in bad times – for example, by encouraging regular liquidity stress tests.
The report said risks taken by asset managers have become more important as individual companies have grown bigger and the decisions taken by a single large asset manager could potentially trigger fund flows with significant systemic repercussions. As a result regulators have been focussing on the incentive structures of asset management companies.
“Restrictions on investment portfolio shifts could limit incentive-driven swings and, by effectively lengthening asset managers’ investment horizons, could stabilise their behaviour in the face of temporary adverse shocks,” added the BIS. “Similarly, caps on leverage could contain the amplification of shocks.”
The report also suggested that redemption risk can be addressed by liquidity buffers and restrictions on rapid redemptions from managed funds.
Featured image via milo827/Dollar Photo Club
