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Investment funds pose ‘procyclical’ threat to stability: RBA

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By Charbel Kadib
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5 minute read

The burgeoning international asset management industry has been tagged among a group of non-systemic entities posing “procyclicality” risks to financial stability.

High-profile banking collapses in the United States and Europe earlier this year brought to light new challenges threatening to undermine the stability of the global financial system.

Rapid bank deposit withdrawals, supported by digital money transfer technologies, accelerated the downfall of three US regional banks (Silicon Valley Bank, Signature Bank, and First Republic Bank) and global investment banking giant Credit Suisse.

According to figures from the US Federal Deposit Insurance Corporation (FDIC), Silicon Valley Bank lost as much as 30 per cent of its deposit base in just hours at the height of its crisis and a further 50 per cent on the following day.

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In an address to the Australian Finance Industry Association Conference on Tuesday (31 October), assistant governor (financial system) of the Reserve Bank of Australia (RBA) Brad Jones warned the speed and scale of these withdrawals could precipitate the demise of any banking institution.

“In our current system, any bank would struggle to survive a run of this magnitude,” he said.

Underpinning this dynamic, Mr Jones observed, were “herding effects” associated with the rapid transmission of information, particularly via social media.

While conceding the role of technology was not a “root cause” of recent instability, he said it served as an “amplification mechanism”.

As such, Mr Jones said non-systemic entities could now pose threats to broader financial system stability by “amplifying’ economic trends, or in other words, driving “procyclicality” risks.

“Institutions that might have little direct connection to the original source of stress, but are perceived to have broadly similar business models, seem particularly vulnerable in an environment of ‘shoot first, ask questions later’ – especially when the ‘shooting’ can happen faster than ever,” he said.

The “fast-growing” international asset management industry was named among non-systemic institutions posing such threats.

“As they don’t accept deposits, investment funds operate with less intensive regulation and oversight of their liquidity management and use of leverage compared with banks,” Mr Jones observed.

“Nor do they benefit from public backstops that can dampen liquidity stress, such as central bank liquidity access or deposit insurance.”

He said herding effects can be amplified when investment funds are tied to similar benchmarks, offering redemption terms to investors that are undermined in “stressed market conditions” and thus could lead to “asset fire sales”.

“The periods of market dysfunction in key bond markets in early 2020 and 2021 were associated with this dynamic and saw a number of central banks respond,” Mr Jones observed.

“…While the make-up of the Australian financial system means we are not as directly exposed to these fire sale dynamics, our funding markets have been significantly disrupted by international events.”

Mr Jones said as a result of these spillovers amplified by non-systemic institutions like small banks and investment funds, regulators are questioning whether to lower the bar for what institutions are considered “systemic” in the financial system.

Other considerations include whether “more onerous” regulations should be imposed on smaller banks without limiting competition; and the extent to which investment funds can continue to play a role in “intermediating savings” while also minimising liquidity risks capable of “severely destabilise the functioning of critical financial markets”.

“All of these issues are now under active international review,” Mr Jones said.

Mr Jones’ remarks come just weeks after chair of the Australian Prudential Regulation Authority (APRA) John Lonsdale sought to reassure stakeholders of the resilience of the Australian financial system.

But Mr Lonsdale said the regulator must remain vigilant to ensure local banks and financial institutions withstand future shocks to the system.

As part of this campaign, APRA has put 11 of Australia’s largest banks through another stress test scenario using the new bank capital framework, which came into effect earlier this year.

In the stress test scenario, a “severe downturn” and elevated inflation lifted the unemployment rate to 10 per cent, and residential property lost a third of its value.

Mr Lonsdale said APRA was still reviewing the results, scheduled to be released to the public early next year.

However, the chair revealed none of the banks breached their capital requirements, all “retained sufficient liquidity”, and banks continued to support the flow of credit to households and businesses.

“Although a hypothetical exercise, these results provide confidence in overall financial system resilience,” he said.

“The scenarios used for APRA’s stress tests are designed to be severe yet still plausible. That’s why, in addition to hypothetical factors such as a domestic recession and high unemployment, we often insert a sudden non-financial shock – such as a natural disaster or a major cyber attack.”

This was the second reported assessment in 2023, with APRA conducting a stress test months out from the banking crisis in the United States and Europe.

Investment funds pose ‘procyclical’ threat to stability: RBA

The burgeoning international asset management industry has been tagged among a group of non-systemic entities posing “procyclicality” risks to financial stability.

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