By Kristalina Georgieva, IMF Managing Director
Launch event for “Investment Funds and Financial Stability” paper
To illustrate the importance of our new report, we need to go back to the height of the crisis in March of 2020. We were facing the biggest economic shock in our lifetimes.
But we did not face another Global Financial Crisis last year, not only because of the extraordinary monetary and fiscal measures, but also because countries had worked together after the Global Financial Crisis to strengthen the resilience of the banking sector, to ensure that banks have more reliable liquidity and capital cushions.
Last year’s experience was less encouraging for the investment fund sector—because the crisis exposed fundamental vulnerabilities that could affect global financial stability.
Many investment funds were heavily affected by the financial market turmoil, and the initial shock was amplified by rapid fund outflows and rapid sales of assets as liquidity suddenly dried up in key markets. The so-called “dash-for-cash” extended across borders which triggered significant capital outflows from emerging and developing markets.
Today, the global economic recovery is underway; but there is also growing uncertainty, including rising concerns about overstretched asset valuations. It is, therefore, not surprising that policymakers and regulators are keeping a close eye on investment funds.
Over the past two decades, non-bank financial institutions have come to play such a key role that they now hold about 50 percent of global financial assets. This benefits everything from entrepreneurs growing their businesses, to families buying their first home, to saving for retirement.
These investment funds are vital engines of prosperity. They come in all shapes and sizes, such as money-market funds and open-end mutual funds and they are subject to a range of investor protection and market conduct regulations. But we also know that many funds have ventured into higher-risk investments, such as high-yield debt and real estate which leaves them more exposed to liquidity pressures in times of distress.
This in turn demands greater vigilance to ensure that critical parts of the financial system do not freeze up when they are needed most.
So, our key message today is this: if we are to safeguard financial stability at the national and global levels, we need to boost the resilience of investment funds.
What can policymakers do?
One priority is to further strengthen risk management, especially liquidity risk management. Our new report shows how this can be achieved with a combination of liquidity management tools.
The key is that these tools can be deployed sequentially as needed depending on the intensity of pressures facing a particular fund. It means that funds would no longer have to rely on so-called redemption fees and gates linked to regulatory thresholds which was problematic last year.
These measures would benefit all investment funds, but especially those holding less-liquid assets. We also believe that there is room for more prescriptive regulatory approaches in this critical area.
Here we can draw on the lessons learned in the banking sector. We saw a significant strengthening of risk management in banks, largely because of stronger regulatory frameworks put in place after the Global Financial Crisis.
This approach has served us well and it’s even more important now. Just think of the risk of financial spillovers that could hit emerging and developing economies.
Again, this is an area where investment funds play a central role. Over the past decade, we have seen almost $1 trillion in foreign investment in emerging market sovereign debt with investment funds accounting for about two-thirds of these vital capital flows.
In our report, we provide specific proposals on how to mitigate capital-flow volatility, how to better manage cross-border fund flows in times of crisis.
These are important measures, but we need to go further. Even as some countries strengthen their policies and step up investment fund reforms, we must continue to be vigilant about those who try to game the system. Fighting regulatory arbitrage across borders remains critical.
That is why we need strong international cooperation. It lies at the heart of the ongoing reform process led by the Financial Stability Board. And it’s reflected in the joint efforts of national supervisory authorities and central banks, the International Organization of Securities Commissions and other standard-setting bodies, and International Financial Institutions such as the IMF.
Policymakers worked together to make banks safer after the Global Financial Crisis; now we must do the same for investments funds. We know that financial stability risks remain elevated, and asset prices are stretched, so speed is of the essence when it comes to these reforms. Financial risks take time to build, but conditions can shift quickly and pose new and unforeseen challenges to the financial sector, as we saw during the turmoil last year.
Given the vital role of investment funds in fostering growth and safeguarding financial stability, we need to take the right actions now to boost their resilience.
With that, I look forward to hearing your views on this critical issue.