The Bank for International Settlements (BIS) investigates the microeconomic determinants of leverage decisions by investment managers and does not seek to measure actual economic exposure.
The Bank for International Settlements (BIS) Working Paper No 517 investigates the microeconomic determinants of leverage decisions by investment managers and does not seek to measure actual economic exposure. It is interesting that the BIS is initiating work in this area because of the ongoing debate as to whether the investment management industry is systemic to the wider economy. It would seem that the debate around systemic risk is becoming more nuanced and this latest study indicates that policymakers continue to pursue the ‘too big to fail’ agenda across the whole of Financial Services, rather than the focus on the role of banks in the post global financial crisis world.
The conclusion is that only a minority of investment funds use leverage and that it is more prevalent in emerging market funds and bond funds. The data does not incorporate derivative exposures, for the simple reason that these data are not available in the BIS database. The fund sample comprises mainly actively managed retail and institutional funds, not hedge funds. Given the ongoing debate about investment management activity/investment funds and systemic risk, research into the use of leverage in funds may receive particular attention. These limitations in the BIS research raise a question about the strength of its conclusions to the systemic risk debate.
The key constraint to any form of economic research and limitation of conclusions is the dataset. The paper asserts that “Balance sheet information for investment funds is much less readily available than for highly leveraged banks.” This is somewhat surprising given that funds produce annual audited accounts, but the emphasis here may be on the data not being readily accessible in one place. Also surprising is that the data do not include derivative exposures, which may be used to reduce risk or to enhance it, depending on the strategy of the fund and within the constraints of regulatory exposure limits.
Since financial stability in the context of international financial flows is the ultimate concern of this research, it explores the impact on buy-side leverage of capital controls (KCs) and macro-prudential policies (MPPs). It finds that KCs encourage managers to increase leverage rather than reduce it, especially where the measures are targeted at the fixed income markets, whereas MPPs have no impact. In explaining the finding on the impact of KCs, the paper makes a number of assertions, such as that portfolio managers might view the imposition of KCs as confirmation of their own bullish views on the country’s assets.
The key policy conclusion of the research, is the need for caution in the evaluation of policy tools. Assessment should not be based simply on the measurable ability of the tool to achieve a certain objective but also on a careful consideration of all possible side effects, which requires policy makers to have a closer interaction with market participants.
Throughout the paper there is no recognition of regulatory constraints on exposures and on borrowing, nor on the requirement for managers of open-ended funds actively to manage the fund’s liquidity profile to meet expected redemption activity. Regulation impacts the ability of managers significantly to increase leverage in reaction to changing economic circumstances. It is unclear how pertinent this research is to the systemic risk question.