USD90bn of Central Bank Support Underscores Mutual Fund Systemic Risks

Tuesday,May 05, 2020 / 02:38 PM / By Fitch Ratings / Header ImageCredit: Fin24

Fitch Ratings estimates that central banks around theworld have provided facilities in excess of USD90 billion to support mutualfunds amid the coronavirus pandemic. The scale of support shows regulators'sensitivity to the potential systemic risks that funds pose through potentialspill-over effects to financial markets. Mutual funds have become much largerrelative to the global economy than at the time of the last global crisis.Mutual fund assets under management (AUM) were USD55 trillion (64% of globalGDP) at end-2019, compared with USD24 trillion (38% of GDP) at end-2008,according to ICI Global.

Fund stress could lead to increased financial marketvolatility in regions or countries where central bank facilities are lesswidespread or comprehensive, or where their effectiveness is constrained. Themagnitude of support brought to bear also suggests that the liquiditymanagement tools available to funds may be inadequate for a severe stressscenario.

India is the latest country to implement a mutual fundsupport facility, providing INR500 billion (USD6.6 billion) of 90-day repofunding to banks to extend liquidity to funds (or purchase commercial paper anddebt securities from them). This followed the suspension of redemptions in sixfunds with combined AUM of USD4.1 billion. Fitch is sceptical about howeffective the support will be as India's banks have low capital headroom andcould be reluctant to extend liquidity to funds given the lack of capitalrelief on the facilities (see here).

The largest facility has been the US Money MarketMutual Fund Liquidity Facility (MMLF). This was launched in March with aninitial term of just over six months, in response to severe illiquidity in thesecondary market and large redemptions from money market funds (MMFs). It hadUSD51 billion of outstanding loans at 14 April. There is no comparable facilityin Europe but stress in European MMFs decreased due to improved secondarymarket liquidity when the MMLF was activated. A key element of the MMLF'seffectiveness is that advances are without recourse to the borrower (subject tocollateral eligibility requirements), in contrast to the Indian facility.

Thailand and Colombia have implemented or expandedcentral bank repo facilities allowing mutual funds to exchange certainsecurities for cash to meet redemption requests. No Colombian funds havesuspended redemptions but four Thai funds, with combined AUM of USD4.6 billion,suspended redemptions in March before Thailand's repo facility was implemented.Thailand's facility covers eligible assets of about THB1 trillion (USD31.2billion). Colombia's pre-existing facility was increased to COP20 billion (USD5billion) after being made available to mutual funds.

Countries that have implemented support facilitieshave not experienced additional redemption suspensions. In Europe, however,where facilities have not been introduced, more than 80 funds with combined AUMof over USD40 billion implemented extraordinary liquidity management measuresin March (see here). Nevertheless, liquidity in European funds has improvedfollowing broader market support initiatives and several funds have re-opened.

Mutual funds are a conduit between investors andfinancial markets. Most funds exhibit liquidity risk, offering investors theability to redeem daily but investing only a limited part of their portfoliosin highly liquid assets. Liquidity mismatches are most acute in funds investingin illiquid assets such as properties. Redemption suspensions and theimplementation of support facilities during the pandemic suggest thatregulation has yet to fully address the liquidity risk that may materialiseamid severe stress. This is despite increased regulatory attention to liquidityin recent years.

Fitch highlighted in 2019 that without extraordinaryliquidity measures such as redemption suspensions, runs on funds could havespill-over effects to financial markets, particularly during macroeconomicstress such as that currently being experienced.