IMF points to growing dangers in key area of financial system
A chapter of the International Monetary Fund (IMF) Global Financial Stability Report prepared for this week’s semi-annual meeting in Washington identified the source of a potential crisis for the global financial system.
It concerns the operation of open-ended investment funds (OEFs) which allow investors to redeem their investments on a daily basis while the funds invest in long-term illiquid assets which cannot be quickly converted into cash.
The mismatch between the adversarial short-term and long-term nature of investments is a permanent feature of financial markets and has always been a major factor in financial turmoil.
But the growth of OEF funds means they have become much larger over the past decade and a half.
Summarizing their expansion, the report states: “Since the global financial crisis, there has been remarkable growth in open-ended investment funds. The total value of their net assets has quadrupled since 2008, reaching $41 trillion in the first quarter of 2022 and accounting for about one-fifth of non-bank financial sector assets.”
Although these funds play an important role in financial markets, he said, “those that offer daily redemptions while holding illiquid assets can amplify the effects of adverse shocks by increasing the likelihood of investor runs and Massive asset sales This contributes to volatility in asset markets and potentially threatens financial stability.
The rise of these funds illustrates a now well-established process in which attempts by governments and regulators to control one area of disruption lead to its re-emergence in another area while finance capital, still involved in the search for profit, seeks new avenues for speculation.
The big banks were at the center of the 2008 financial crisis and measures were put in place to curb some of their most egregious speculative activities. But as the IMF report explains, the growth of OEFs “reflects the growing shift of financial intermediation from banks to non-bank financial institutions, which can be attributed at least in part to the tightening of banking regulations as well as ‘to the deleveraging of balance sheets following the global financial crisis’. crisis.”
He noted that OEFs generally invest in equities in advanced economies, but that “the share of funds investing in relatively less liquid assets, such as corporate bonds or emerging market bonds and stocks, has increased rapidly. .
Concerns about the financial stability of OEFs emerged during the financial market turmoil in March 2020, at the start of the pandemic. The sector’s “resilience” “could be tested again if financial conditions tighten sharply as central banks normalize the monetary policy stance.”
Already, interest rate hikes by the Fed and nearly every other central bank, described by economic historian Adam Tooze as “the most comprehensive tightening of monetary policy the world has seen,” have led to substantial outflows from high-yield corporate bonds and emerging countries. market equity and bond funds.
The IMF analysis noted that despite the risks to financial stability, “effective implementation of policy or regulatory measures to mitigate vulnerabilities associated with OEFs holding illiquid assets is lacking.”
An existential problem facing would-be reformers, however, is rooted in the very nature of this sector of financial markets.
It was introduced by former Bank of England Governor Mark Carney at a UK parliamentary hearing in June 2019 – long before the onset of the pandemic and associated financial turmoil – in the collapse of a UK equity fund.
The structure of these funds was a “big deal” and “you can see something systemic”.
“These funds are built on a lie that you can have daily cash, and that for assets that are fundamentally illiquid.”
The lack of adequate liquidity management by the funds, according to the IMF report, means that “central banks have intervened during episodes of high market stress to provide safety nets to financial sectors, including OEFs”. .
This phenomenon was illustrated again in the £65bn bond buying program launched by the Bank of England when UK pension funds were threatened with insolvency due to collapsing prices. bonds, which they had used as collateral to obtain loans to finance transactions in the derivatives markets. .
There was the real prospect of a “catastrophic loop” in which the funds had to sell long-term government bonds, gilts, to meet margin calls from their lenders, threatening to drive down bond prices further. and exacerbate the crisis.
The same scenario could play out again in the OEF sector, notes the IMF report. Those who hold illiquid assets may experience outflows in times of market stress, forcing them to sell assets and putting further downward pressure on prices amid tighter financial conditions.
“Furthermore, in the presence of uplift by the funds, trading activity in the same direction could exacerbate selling pressure” leading to lower asset values, inducing “further redemptions and asset sales in fire, amplifying the impact of shocks”.
The liquidity of OEF portfolios had “deteriorated dramatically during the market turmoil of March 2020 and has deteriorated in recent months”.
“The liquidity of fund portfolios deteriorated again in the first half of 2022, especially for high yield and emerging market bond funds. Indeed, for the latter, liquidity has reached levels similar to that observed in March 2020.”
OEFs are by no means the only source of the growing crisis in the global financial system. Another is private equity funds which are big investors in so-called junk bonds, those rated below investment grade but which bring a higher rate of return.
As FinancialTimes (FT) columnist Gillian Tett commented that junk bond prices “have recently fallen” and it has not been possible to track the true value of assets held by private funds. “Maybe they grade them correctly. But I doubt it, especially since they are selling more and more assets. Expect future settlement.
This phenomenon was highlighted in an article published last month in the FT quoting a comment from a senior executive of Denmark’s largest pension fund in which he compared the private equity market to a pyramid scheme.
According to the report: “Mikkel Svenstrup, chief investment officer at ATP, expressed concern that over the past year more than 80% of portfolio company sales by the private equity funds in which ATP has invested were either to another buyout group or were “continuation fund” transactions, where a private equity group moves it between two different funds that it controls.
Svenstrup used measured language. But he said it was “potentially” the start of a “pyramid scheme” before describing what is happening. “Everybody is selling to each other… The banks are lending against it. These are the concerns I share,” he said.
The FT report noted that similar comments were made in June by Amundi Asset Management chief investment officer Vincent Mortier. He told a private equity conference in Cannes that parts of the industry “kinda look like a pyramid scheme”.
This description can increasingly apply to the financial system as a whole.