The International Monetary Fund called on policymakers to bolster investment funds, after the Covid-19 crisis exposed "fundamental vulnerabilities" in the sector that could threaten global financial stability.
The Washington-based fund said reforms to investment funds are needed to avoid a repeat of the financial market turmoil triggered by the pandemic in 2020. It proposed a range of tools for asset managers to strengthen liquidity risk management in a 73-page report on financial stability and investment funds.
"If we are to safeguard financial stability at the national and global levels, we need to boost the resilience of investment funds," Kristalina Georgieva, the IMF's managing director, said. "Policymakers worked together to make banks safer after the global financial crisis – now we must do the same for investments funds."
The Investment funds' sector took a heavy hit in the aftermath of the pandemic-induced turmoil last year. The initial shock was amplified by rapid fund outflows and 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.
Central banks around the world had to step in to restore stability after steep falls in prices and volatility across financial markets during the past year were magnified by heavy selling by fund managers, who dumped stocks and bonds as their clients sought an exit.
"Today, the global economic recovery is under way – but there is also growing uncertainty, including rising concerns over stretched asset valuations," Ms Georgieva said. "It is, therefore, not surprising that policymakers and regulators are keeping a close eye on investment funds."
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 and this demands "greater vigilance to ensure that critical parts of the financial system do not freeze up when they are needed most", the IMF chief said.
The IMF report identified four key policy objectives for investment fund reforms.
"First, we propose to address incentives of investors to front run others when adverse shocks occur. Second, we analyse the inherent tension between daily liquidity and exposure to illiquid assets," the report's authors said.
"Third, we argue that frictions in some important asset markets need to be addressed. And fourth, we advocate for mitigating cross-border spill overs to emerging market and developing economies," they said.
Deploying an array of liquidity risk management tools means that funds would no longer have to rely on so-called redemption fees to regulatory thresholds – which was "problematic" last year, Ms Georgieva said.
The measures would benefit all investment funds, but especially those holding less liquid assets, she added.
A "more prescriptive" regulatory approach is also needed to address the risk of financial spillovers that could hit emerging and developing economies, the IMF said.
Over the past decade, almost $1 trillion in foreign investment were directed into emerging markets' sovereign debt – with investment funds accounting for about two thirds of these vital capital flows, according to the IMF.
To address this, the fund outlines proposals on how to mitigate capital-flow volatility and how to better manage cross-border fund flows in times of crisis.
As countries step up investment fund reforms, the IMF also highlighted the need to be "vigilant about those who try to game the system", Ms Georgieva said. "Fighting regulatory arbitrage across borders remains critical."
Strong international co-operations and fast investment fund reforms are needed as financial stability risks remain high and asset prices are stretched, she said.
"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," she added.