Out-Law News 2 min. read

Stress tests and liquidity disclosures among proposals to address fund 'vulnerabilities'


Financial regulators may need to collect more and better information about the liquidity of investment funds registered in their jurisdictions, and should require "stress testing" of open-ended funds in particular, according to global financial watchdogs.

The proposed measures are two of 14 recommendations made by the Financial Stability Board (FSB) to address what it describes as "structural vulnerabilities" from asset management activities that could lead to financial stability risks. It is now consulting on the proposals, which it intends to finalise before the end of the year.

The FSB, which is chaired by Bank of England governor Mark Carney, began its review in March 2015 in recognition of the significant growth in AUM in the asset management sector over the past decade. Although it has ruled out designating the biggest funds as 'systemically important' and subjecting them to stricter regulatory requirements for the time being, it has warned that insufficient leverage and liquidity "mismatches" on investor redemption could put pressure on the global financial system.

"The growth in market-based finance has diversified the sources of credit and investment," said Carney. "Given its increased importance, a resilient asset management sector is vital to finance strong, sustainable and balanced growth. These policy recommendations are designed to ensure that across the FSB membership, asset managers can continue to fulfil these roles to the benefit of all."

Global assets under management (AUM) have grown from $50 trillion in 2004 to $76 trillion in 2014, which includes $31 trillion invested in open-ended mutual funds, according to the FSB. The 2014 total accounted for 40% of global financial system assets.

Investment funds have not yet created any particular financial stability concerns, with the exception of "some money market funds", according to the FSB. However, it intends to take action now in order to "ensure that any financial stability risks associated with the asset management sector are properly understood and addressed". Of particular concern was the increasing amount of investment through open-ended funds that was concentrated in certain asset classes, given investors' ability to withdraw their money immediately, it said.

"If market prices were to drop sharply and liquidity were to deteriorate, investors in less liquid asset classes through open-ended funds could experience greater and more sudden losses than expected, which could result in a significant number of fund investors attempting to exit these asset classes at the same time," the FSB said in its report. "The action of these fund investors could amplify downward repricing of assets and increase the severity of liquidity strains in the affected asset classes."

For this reason, the FSB's recommendations to tackle liquidity mismatch are aimed exclusively at open-ended funds. They include new reporting and disclosure requirements for open-ended funds, "proportionate to the risks they may pose from a financial stability perspective"; stress testing "at the level of individual open-ended funds to support liquidity risk management"; and "liquidity risk management tools" such as the ability to place limits on redemptions or additional redemption fees.

The FSB has also called for the introduction of a "simple and consistent" leverage measure, which would enable regulators to easily compare the use of derivatives or borrowed money by funds. This should be developed by the International Organisation of Securities Commissions (IOSCO), the global consortium of securities regulators, by 2018, according to its report. The report also makes a number of recommendations to address operational risk, which are aimed at large, complex asset managers and those that provide "critical services".

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