In the first of its bi-yearly Global Financial Stability Report, the IMF flagged concerns over the risks to global financial stability posed by the asset management industry.
The organisation called for greater regulation to be put on the industry.
In the 146-page report, the IMF said that the asset management industry has under management $76trn (£51.6trn) – equal to global GPD and 40 per cent of global financial assets.
Matthew Harris, director at Dalbeath Financial Planning based in Fife, said: “The capital strength of asset management companies is a very important factor for us. They are the custodian of our clients’ assets and their ability to withstand a downturn should be tested. If necessary they should take steps to improve their balance sheets.”
Tighter regulation, rising compliance costs and continued balance sheet deleveraging following the global financial crisis has resulted in a shift by banks away from credit intermediation.
The resulting void is being filled by the non-banking sector, including asset management, according to the report.
Open-ended funds in particular are exposed to redemption risk because investors have the option to cash in their sharesThe IMF said asset managers could help investors diversify their assets more easily and provide financing to the real economy as a “spare tyre” when banks were distressed.
Nevertheless, the growth of the AMC industry has given rise to concerns about potential risks.
Commenting on recommendations to implement stress tests, Richard Metcalfe, director of regulatory affairs at The Investment Association, said: “It is an interesting idea. It is not 100 per cent clear to us what the IMF wants to achieve, but stress testing is not something that we will rule out.
“We know that the market will overshoot on occasions, but whether that is down to investment funds and fund managers is debatable. It depends on the type of fund it is and exposure.”
He added: “We probably do not need more regulation, but we want to still have debates to see if there is anything that we can look into.”
One risk outlined in the report is the influence mutual fund investments have on asset prices – at least in the less liquid market such as bonds. Assets that are held in a concentrated manner by funds perform worst during periods of market uncertainty.
The report says: “These effects can have broader economic implications. For example, if intermediation through funds raises the probability of fire sales of bonds that are held by key players in the financial sector or that are used as collateral, then the risk of destabilising knock-on effects on other institutions rises, with potentially important macro-financial consequences.”
Secondly, the delegation of day-to-day investment decisions introduces incentive problems between the end investors and portfolio managers that can induce destabilising behaviour and amplified shocks, the IMF said.
It added that the comparison of fund performance with peers and benchmarks can result in a variety of trading dynamics with potentially systemic implications, such as excessive risk-taking, contagion or herding.
Easy redemption options offered by funds is another risk due to first-mover advantage – which allows investors redeeming earlier than others to recover more money as the liquidation value of fund shares declines.
According to the IMF, open-ended funds in particular are exposed to redemption risk because investors have the option to cash in their shares – usually on a daily basis – while funds have increasingly been investing in relatively illiquid securities such as high-yield corporate bonds and emerging market assets.
“Large-scale sales by funds may exert significant downward asset price pressures, which could affect the entire market and trigger adverse feedback loops. The effects on asset prices could have broader macrofinancial consequences: affecting the balance sheets of other players in financial markets, reducing collateral values and reducing credit financing for banks, firms, and sovereigns.”
However, the IMF acknowledged that asset managers appear to actively manage their liquidity risks with precautionary cash buffers – particularly those investing in relatively less liquid assets.
In addition, fund investing in more illiquid assets tends to set higher fees than those investing in liquid assets which mitigates redemption pressures during stress periods, according to the study.
A spokesperson for Vanguard, which handles approximately $3.1trn (£2.08trn) in assets, said: “Vanguard carefully considers liquidity risk in managing portfolios and takes an approach that is tailored to the portfolio and has multiple layers of protection.”
She added: “When confronted with redemptions, our objective is to maintain the risk exposures of the fund by selling across the funds’ holdings, while also factoring in trading costs.
“We do not typically allow liquidity reserves to run off as we do not have perfect foresight as to when the redemptions will subside, and want to ensure adequate liquidity going forward.”
According to the IMF document, funds managed by large asset managers do not necessarily contribute to systemic risk. Instead, the investment focus appears to be relatively more important than size.
This is important when exploring whether large asset managers and funds should be designated as systemically important financial institutions – an issue discussed by regulators globally, according to the IMF.
The risk to global stability that is posed by the ownership of a number of AMCs by bank and insurance companies remains unclear, according to the IMF.
It adds that without proper oversight of related-party exposures and concentrated exposures, funds could be used as funding vehicles for their AMC’s parent banks.
The report said: “These inter-relationships increase the concentration of financial services providers across various sub-segments of the financial sector, creating potentially very influential and complex mega conglomerates.”
In addition, information-sharing between a bank and its group AMC is another potential concern.
However, it said bank affiliation could prove beneficial from a financial stability point of view, including access to a central bank’s emergency liquidity facility through AMCs’ parent banks and more supervisory scrutiny.
Although acknowledging the regulatory framework currently implemented in the AMC industry, the IMF report claimed that it currently lacked specificity, and called for a clearer definition of liquid assets and more specific guidance to match the liquidity profile of each fund category to its redemption policy.
It added: “Regulators should regularly monitor market conditions and review whether funds’ risk management frameworks are sufficient, especially with regard to liquidity risks. Greater resources should be devoted to supervising risks, including developing analytical and stress-testing capacities so that regulators can effectively challenge asset managers’ practices.”
The spokesperson for Vanguard said: “Asset managers are simply agents of funds and provide management services to them [clients] in a fiduciary capacity. Consequently, we strongly believe that the existing regulation of comprehensively regulated investment funds already effectively manages and mitigates risk. Investors could bear considerable costs and consequences resulting from imposing unnecessary bank-like regulation on asset managers and mutual funds. “
Myron Jobson is a features writer at Financial Adviser
Key points
Asset managers should undergo a more rigorous framework of scrutiny including stress tests according to the International Monetary Fund.
Open-ended funds in particular are exposed to redemption risk because investors have the option to cash in their shares.
Funds managed by large asset managers do not necessarily contribute to systemic risk.
