The turmoil of March 2020, triggered by the onset of the Covid-19 pandemic, led to widespread redemption of investors’ shares from funds. The chaos resulted in renewed regulatory focus on the issue of liquidity at non-bank financial institutions.
During that month, sterling-denominated money market funds, a type of non-bank, saw outflows of around £25bn or 11 per cent of their total assets, according to a 2023 consultation paper published by the UK Financial Conduct Authority. The document found the outflows to be outsized compared with anything previously observed.
Other episodes in the past few years made this risk more evident, for example the UK government’s “mini” Budget of September 2022, which triggered a liquidity crisis in the pension sector after a sell-off in gilt markets.
These and other market stress episodes underline the need to strengthen NBFI space resilience for a wide range of entities and activities, especially in relation to liquidity preparedness and leverage, said the European Central Bank in its 2023 Financial Stability Review.
“The most important risk of a bank is credit risk, while the real issue with money market funds is liquidity. But that’s a huge risk,” says Jakob de Haan, professor of political economy at the University of Groningen and adviser to the European parliament on financial stability issues.
Indeed, many non-banks are exposed to a ‘liquidity mismatch’ between the competing demands of holding high levels of illiquid assets, such as property or corporate debt, while allowing investors to withdraw funds on a daily basis.
Potential spikes in the demand for liquidity and deleveraging can push some NBFIs towards disorderly asset sales or large cash withdrawals.
In some recent market stress episodes, wider contagion was only averted by extraordinary policy action taken by central banks to stabilise markets, a situation that could lead to moral hazard and the use of taxpayers’ resources in the future.
In most jurisdictions, non-banks do not have access to the lender of last resort represented by central banks, while emergency liquidity assistance to banks is a core responsibility of central banks.
However, things may change as the NBFI space grows in relevance. The Bank of England is set to create a backstop facility amid concerns over elevated liquidity risk hitting the NBFI space, said the bank’s deputy governor for markets and banking Dave Ramsden in a speech last November.
The regulation so far
The common narrative describes NBFIs as almost totally unregulated. However, over the years a number of asset classes and institutions have been subject to some liquidity requirements.
A lot of regulatory focus has been given to open-ended funds, including money market funds, given their relevant market size and openness to retail investors. Instead, alternative investments have been historically limited to institutional investors.
Money market funds in particular play a key role in short-term funding markets with more than $9tn in assets under management globally at the end of 2021, says the Bank for International Settlements, citing data from the Financial Stability Board. As of September 2023, US MMFs held $6.1tn in AUM. By comparison, total commercial bank assets in the US stood at $23tn.
Looking at regulation in Europe, the Money Market Fund Regulation includes measures to address liquidity mismatch for money market funds by enhancing the liquidity of assets (such as minimum amounts of liquid assets that mature daily/weekly).
For alternative investment funds (including hedge funds, private equity funds and real estate funds), the EU’s Alternative Investment Fund Managers Directive looks at measures to enhance risk management practices, including liquidity risks.
However, “there isn’t a single comprehensive regulatory framework that has been created based on a coherent vision”, says Jonathan Herbst, global head of financial services at law firm Norton Rose Fulbright. “One of the challenges for policymakers is figuring out if a horizontal set of requirements is necessary and what it would look like.”
Due to heterogeneity in the non-bank sector, differences in market structures and business models across jurisdictions, regulation has required some degree of flexibility.
An example of divergence between jurisdictions is visible in the implementation of money market fund reforms. In the US, the authorities adopted significant MMF reforms in 2023, such as raising liquidity requirements to 25 per cent and 50 per cent of a fund’s total assets for daily and weekly liquid assets respectively. Currently, in the EU, the same thresholds for similar types of funds can be as low as 7.5 per cent and 15 per cent.
In Europe itself, aside from funds regulated at EU level — so-called Undertakings for the Collective Investment in Transferable Securities — there is still divergence in regulation between member states.
In Italy, for example, real estate funds are structured as closed-end funds that limit investors’ rights to redeem their units.
While some degree of heterogeneity makes sense, it has created space for potential regulatory arbitrage and risk-shifting across industries in a sector where interconnectedness among different institutions generates financial stability risks.
International institutions are keeping a close eye on the topic. Following the market stress caused by Covid-19, the Financial Stability Board and the European Securities Markets Authority, among other institutions, proposed various reforms to make MMFs more resilient. The institutions identified three structural vulnerabilities in the NBFI sector, including liquidity, that contribute to the build-up of systemic risk, and which are only partially covered by macroprudential policies today, said the European Commission in a January report.
Enhancing liquidity preparedness of non-banks for margin and collateral calls is one of the topics the Financial Stability Board will work on this year, according to the organisation’s 2024 work programme.
However, while international standard-setting bodies are working on potential modifications of the current rules, legislative progress has been lagging. In 2022, Esma suggested to the commission that it reform the MMF regulation. In a July 2023 report, the commission, the authority tasked to advance regulatory action in the bloc, reached the conclusion that the current regulation had enhanced financial stability.
“The commission was rather optimistic in its conclusion. At least they clearly indicated that there may be underlying weaknesses in the MMF sector,” adds de Haan.
Money market funds
In Europe, the most important non-banks are money market funds, which provide 20 per cent of all credit, explains de Haan.
Over the years, these funds have been asked to increase their liquidity buffers and have been given more instruments to manage liquidity, such as the ability to suspend redemptions in a more orderly way.
Liquidity management instruments such as redemption gates, which only allow redemption of a part of the capital invested if the fund gets close to a particular liquidity level, may prove a double-edged sword.
“The problem with this requirement is that they may end up generating panic. Esma has proposed to change, along with other changes, that part of the recommendation, and I think rightly so, because this is the kind of regulation that backfires,” says de Haan.
The issue of gates and redemptions is a very hot topic in a number of jurisdictions. ”When you stop redemptions to avert a liquidity run, to what extent are you limiting the investment in some of those funds?” adds Herbst.
Moreover, while in the US there is a clear distinction between MMFs at constant net asset value and those at variable NAV, the EU has allowed a third category: those that can move from constant to variable NAV. “This category is the one which can generate systemic risk, as we have seen during the Covid-19 pandemic,” says Andrea Resti, associate professor at Bocconi University and advisor on banking supervision to the European parliament.
The well-defined distinction between the two types of funds in the US is a better approach, according to Resti. “In my opinion, this clear-cut approach is positive, because shadow banking thrives precisely where the rules are loosest,” he says.
Other potentially risky asset classes
Other asset classes may have been neglected by regulators. “There are asset classes, and funds holding other asset classes, such as commercial properties, where you do have very significant cyclical movements of the market. You would want those funds to have rather larger buffers as well,” says Christian Stiefmüller, senior adviser at NGO Finance Watch.
According to Resti, German real estate funds are particularly worrying in terms of systemic risk, because they invest a lot in the volatile commercial real estate sector, which is open-ended and/or allows redemptions before maturity. “The risk is even higher if they are allowed to use leverage to face redemption calls,” says Resti.
Another issue that has not yet been fully taken into account is the contribution of the derivatives markets to more or less regular liquidity bottlenecks. “In the repo markets, and in other derivatives markets, the re-use of collateral creates huge liquidity and leverage. And then, when things go bad and markets lose confidence, all of a sudden this liquidity dries up,” says Stiefmüller.
That is what happened in September 2019 in the US when interest rates on overnight repurchase agreements, or repos, which are short-term loans between financial institutions, experienced a sudden spike. It was down to the Federal Reserve to jump in and provide billions of dollars in liquidity.
In the repo market, haircuts tend to decrease in phases of abundant liquidity, when volatility is low and financial institutions compete to offer more generous terms. “We may consider the idea of setting a floor on haircuts, to avoid having to briskly raise them in the face of a liquidity squeeze,” says Resti.
“There is a very strong case in my view not only to increase transparency, as is already happening in Europe, but also to put more oversight in place over the repo market,” says Stiefmüller.
The missing perspective
Aside from changes in liquidity provisions for specific asset classes, there is a strong need to take a macro perspective, too. Individual institutions may look fairly healthy in terms of liquidity, but if one looks at the sector as a whole, the story may be very different, especially if many institutions face large amounts of redemptions at once.
“This macro perspective is entirely missing in what the European Commission is discussing right now, which I think is a shame because we learned during the global financial crisis that we have to go beyond microprudential supervision and regulation,” says de Haan.
Bank-like liquidity requirements
Ultimately, a relevant policy question remains: would it make sense to ensure non-banks have to adhere to specific liquidity or capital requirements, as with banks?
“If a fund can generate losses when it sells some assets, why not? There is ample room for solutions of this type, which obviously the industry may legitimately oppose, but whenever a product creates systemic risk, they should be evaluated,” says Resti.
Shayna Olesiuk, director of banking policy at US NGO Better Markets, explains: “Requiring non-banks to be supervised and to have the same sort of capital requirements — for example, the ones that banks have — would go a long way to preventing non-banks and shadow banks from experiencing the type of stress that we saw during the pandemic.”
Systemically important NBFIs
Stiefmüller does not think it makes sense to talk about liquidity risks without also touching on systemically important banks and prudential regulation.
“Why do liquidity issues potentially become so contagious and so systematically threatening? It is because, in the non-bank sector, just like in the banking sector, there is this really large degree of concentration,” he says. “The major asset management firms, pension managers, insurers, major hedge funds, all of these are systemically important in their respective markets, in terms of size and interconnectedness.”
Not everybody agrees this is the way forward. “This whole issue of being systemically important is not the right question to ask. Lehman Brothers and Silicon Valley Bank were clearly not systemically important, according to all the measures that we applied at the time,” adds de Haan.
“There was an effort, 10 years ago, to regulate the non-banks, which was stopped in the US and can probably only be brought back by the US, especially as this is a very US-centric industry. I don’t see how European regulators will become active unless this happens,” says Stiefmüller.
Finally, there is always the looming risk of fighting new wars with old weapons. The most important theme to keep in mind is technological innovation, trying to understand new channels of contagion, and assessing the riskiness of emerging asset classes.
“Stablecoins are new and potentially disruptive. The European regulation was intentionally kept flexible because the main objective is not to block innovation, but this may also mean that the new rules prove too loose to be effective,” says Resti.
