The wrong solution: IMAGINE how the financial crisis of late 2016 might play out.
(imposing extra regulation on fund managers or funds judged systemically important financial institutions SIFIs).
A surge in wage inflation, caused by a tight labour market, prompts the Federal Reserve to push up interest rates more quickly than the markets expect. Both government and corporate bonds fall in price.
That creates a problem for funds that specialise in corporate debt. They had promised investors that they could redeem their holdings at any time, but the corporate-bond market is very illiquid; many bonds prove almost impossible to sell. Some funds are forced to impose “gates”, limiting fundholders’ access to their money. The restrictions cause a panic among investors, who scramble to sell all bond-fund holdings. Prices plunge, in effect closing the market for new issuers: firms find it impossible to raise new cash. Rumours about financial problems at a big fund manager start to circulate.
That scenario seems to be at the heart of a weighty consultation document issued by the Financial Stability Board (FSB), an international body charged with preserving the health of the global financial system. Regulators, it is generally agreed, were asleep at the wheel in 2005-06, when the subprime-mortgage bubble was about to pop. They are right to be thinking hard about where the next crisis will come from.
It is also pretty clear that liquidity in the bond markets has deteriorated. There have been some sharp moves in German government bonds of late. And Treasury bonds suffered a “flash crash” in October last year, with the yield on the ten-year issue falling by a third of a percentage point within minutes. Ironically, this loss of liquidity is the result of regulations imposed after the last crisis. Banks are now obliged to hold more capital to underpin their bond-trading business, making it less profitable and them less willing to make markets. This is a neat illustration of the balloon principle: squeeze risk in one area and it will pop up somewhere else.
Identifying the problem is one thing. It is harder to justify the regulator’s putative solution: imposing extra regulation on fund managers or funds judged systemically important financial institutions (SIFIs). History suggests it is the use of borrowed money (leverage) that drives financial crises. That is why banks, which by their very nature are dependent on leverage, are usually the main source of trouble. But most fund managers do not use leverage: they are investing money on behalf of others, not putting their own balance-sheet at risk.
Hedge funds do use leverage, of course, but the FSB does not focus on them specifically. Instead it proposes special rules for any firm that manages $1 trillion or more and for specific funds that have assets of more than $200 billion. That catches two of Vanguard’s low-fee stockmarket trackers. It is hard to see either fund as a systemic risk. Meanwhile, the many sovereign-wealth funds that have more than $200 billion of assets will not be treated as SIFIs, because they are government-backed.
What about the risk of a sell-off by fund investors leading to market panic? It could happen. But the industry’s stability has been tested twice this century: once when the dotcom bubble burst in 2000-02 and again in 2008-09 during the financial crisis. Money-market funds were a source of systemic risk in 2008. But that was because one fund “broke the buck”, imposing an unexpected loss on investors. Investors in bond or equity funds, by contrast, do not expect fund values to be stable; they are less likely to panic when they fall. Indeed, there was no rush for the exits in 2001 or 2008, despite plunging asset values.
Nor are mutual funds (or their close relatives, exchange-traded funds, or ETFs) the dominant investors in the bond market. Around $1.83 trillion is invested in American corporate-bond mutual funds (the biggest retail market) and another $160 billion in corporate-bond ETFs. But corporate-debt issuance was $3.2 trillion last year alone. Globally, the total amount of corporate bonds outstanding, according to Thomson Reuters, a data firm, is $20.5 trillion. Even if retail funds sold all their holdings, pushing yields dramatically higher, other buyers with long-term investment horizons—such as pension funds and insurers—would surely step in and bring prices back into line.
And what would be the practical effect of turning fund managers, or individual funds, into SIFIs? If they faced higher capital charges (as banks do), these would be passed on to investors in the form of higher management fees. It surely cannot serve any useful regulatory purpose to make small savers pay more.