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Title page

Monetary and Capital Markets Department

Investment Funds and Financial Stability

Policy Considerations

Prepared by an IMF staff team led by Antonio Garcia Pascual, Ranjit Singh, and Jay Surti


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Copyright ©2021 International Monetary Fund

Cataloging-in-Publication Data IMF Library

Names: Garcia Pascual, Antonio. | Singh, Ranjit Ajit. | Surti, Jay. | International Monetary Fund. Monetary and Capital Markets Department, issuing body. | International Monetary Fund, publisher.

Title: Investment funds and financial stability : policy considerations / prepared by an IMF staff team led by Antonio Garcia Pascual, Ranjit Singh, and Jay Surti.

Other titles: International Monetary Fund. Monetary and Capital Markets Department (Series).

Description: Washington, DC : International Monetary Fund, 2021. | Departmental paper series. | Includes bibliographical references.

Identifiers: ISBN 9781513593951 (paper)

Subjects: LCSH: Investments—Government policy. | Financial risk management.

Classification: LCC HG4524 .G37 2021

The Departmental Paper Series presents research by IMF staff on issues of broad regional or cross-country interest. The views expressed in this paper are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

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  • Executive Summary

  • 1. Introduction

  • 2. Portfolio Allocation, Systemic Risk, and Approach to Regulation

    • Rising Exposure to Liquidity and Credit Risk—Supply and Demand Factors

    • Systemic Risk Implications of Changes in Investor Risk Appetite and Funds’

    • Portfolio Allocation

    • Implications for Approach to Regulatory Oversight

  • 3. Policy Options for Money Market Funds

    • Motivation for Policy Action

    • Targeting Investor Incentives, Risk Management, and Market Frictions

    • Policy Implementation—Scope and Sequencing

  • 4. Policy Options for Open-End Funds

    • Motivation for Policy Action

    • Incentive Issues and Market Frictions Confronting OEFs

    • Addressing Strategic Complementarities Using Swing Pricing

    • Policy Options to Enhance OEF Liquidity Risk Management

    • Addressing Leverage Related Vulnerabilities in the OEF Sector

    • Supervisory Resourcing Must Keep Pace with Mandates and Complexity

  • 5. The Role of Investment Funds in Cross-Border Spillovers

    • Benchmark Driven Investors: Increasingly Important for Emerging Market and Developing Economies

    • Benchmark Driven Investors Have Significant Financial Stability Implications for

    • Unconstrained Bond Funds Can Also Be a Source of Outflows from EMDEs

    • Policies to Support Stability of OEF Cross-Border Funding

  • Conclusions

  • Annexes

    • Annex 1. Actions to Select Central Banks to Support Markets during March 2020 Turmoil

    • Annex 2. MMF Returns after the GFC

    • Annex 3. Detailed Presentation of MMF Policy Options

    • Annex 4. Recent Developments on International Standards for OEFs

  • References

  • Boxes

    • Box 1. Asset Management: Overview of FSAP Findings

  • Figures

    • Figure 1. Investor Flows to MMFs (January—June 2020)

    • Figure 2. MMFs and OEFs—Amplification during Sell-Of Episodes

    • Figure 3. Rising Relevance of Investment Funds in Credit Provisioning

    • Figure 4. Search for Yield Tendencies

    • Figure 5. Assets Managed by Prime MMFs (January 2015—July 2017)

    • Figure 6. Fund Flows (Q1—Q2) and Liquidity Management by Fixed-Income Funds (2019—20)

    • Figure 7. Selling Pressure and Fire Sales during and after March 2020

    • Figure 8. Rising Role Played by Cross-Border Nonbank Investors in Emerging Markets

    • Figure 9. Benchmark-Driven Investors are Becoming Large and Important

    • Figure 10. Benchmark-Driven Investors are Important for Financial Stability Issues

    • Figure 11. Frontier Markets and Cross-Border Spillovers

    • Figure 12. MSBFs: Concentrated EM Exposure

    • Figure 13. Emerging Market Flows from MSBFs through 2020:H1

    • Figure 14. MSBF Flows to Select Latin American Economies through H1:2020

Executive Summary

The marked growth of investment funds—particularly of money-market and open-end funds over the last two decades and especially after the global financial crisis (GFC)—has been a significant driver of the rising prominence of nonbank financial intermediation. These funds are critical to intermediation in core financial markets such as the United States Treasuries and corporate bonds and are a crucial driver of global capital flows to emerging market and developing economies.

A key feature of most investment funds’ business models is to offer daily liquidity to investors, similar to that offered by banks on their demand deposits.1 As these funds have ventured beyond large-cap equity and advanced economy sovereign bonds into corporate debt (including speculative-grade), real estate, and emerging market securities, their ability to make good on their promise of daily liquidity has come under increasing scrutiny and has repeatedly been under pressure in the face of occasional exogenous shocks. Unlike banks, investment funds generally do not benefit from public backstops in the form of discount window access or deposit insurance and an extensive literature has documented that they can be subject to fire sale externalities, illiquidity spirals, and, occasionally, even run risk.

These adverse feedback loops became evident during the turmoil triggered by the onset of the global COVID-19 pandemic that started in January 2020 and accelerated markedly in March 2020. As risk asset prices dropped rapidly in response to the pandemic shock, investors’ risk assessment grew sharply and triggered portfolio reallocation in favor of relatively safe assets, leading to a dramatic sell-of of risky assets. As emphasized in the April 2020 and October 2020 Global Financial Stability Reports (GFSR) and our previous analyses, the sellof amplified the initial shock as the rise of risk aversion, market illiquidity, and adverse feedback loops amplified the initial fall of asset prices. Under such stressful conditions, the liquidity mismatch between these funds’ assets and liabilities contributed to shock amplification, with investor outflows and the associated asset fire-sales by fund managers combining to eventually threaten broader financial stability. This motivated central banks to step in aggressively via repurchase agreements and outright asset purchases that were large, quickly scaled up, and broadly spread across asset classes. Arguably, these adverse feedback loops in the investment funds sector complemented selling pressures from other banks and nonbank financial institutions.

Policy makers were alarmed by the speed and magnitude of the amplification of asset price declines across markets and by the sudden illiquidity, including in the most liquid asset market of all—the US Treasury market. Selling pressures were amplified across a diverse set of institutions, including investment funds. While longer-term yields fell sharply throughout February and early March, in mid-March longer duration Treasuries sold of aggressively, leading to a sudden rise in yields, indicating that longer-term Treasury securities were no longer traded as a hedge asset.

All of these developments raised questions about the effectiveness of post-GFC financial sector reforms, and specifically, whether the reforms went far enough, to enhance financial market resilience to shocks. Concerning investment funds reforms, the focus has been on the adequacy of existing risk management and supervisory tools.

In this context, we identify four key policy objectives. First, we propose to address incentives of investors to front run others when adverse shocks occur. Second, we analyze the inherent tension between daily liquidity and exposure to illiquid assets. Third, we argue that frictions in some important asset markets need to be addressed. Fourth, we advocate for mitigating cross-border spillovers to emerging market and developing economies.

The paper identifies specific tools targeted to address these objectives. Investors’ early exit incentives can be best addressed by increasing the value of waiting to sell fund shares. And the risks inherent to the sector’s liquidity and maturity transformation can be reduced through a combination of liquidity management tools of increasing intensity to be deployed sequentially. In terms of liquidity backstops, market-based solutions, such as dealer pre-commitments or more robust trading arrangements, should be the first line of defense, buttressed in the event of tail episodes, by central bank emergency liquidity support. When combined with appropriate domestic macroeconomic and macroprudential policies, these measures can also lessen cross-border contagion, a risk increasingly material to financial stability in emerging markets and developing economies. The overall benefits of our policy recommendations, especially the reduced risk of market turmoil and financial instability, would carry significant welfare gains for issuers and investors that would more than offset any adjustment costs borne by them.

The paper’s analysis underscores the importance of the ongoing Financial Stability Board-led process of identifying policy options, involving national authorities and the International Organization of Securities Commissions and other standard setters. In this context, the global nature of the investment fund business and fungibility of financial flows makes it vital to ensure consistency of global policy choices that can secure financial stability by precluding regulatory arbitrage.

Investment Funds and Financial Stability: Policy Considerations
Author: Antonio Garcia Pascual, Mr. Ranjit Singh, and Jay Surti