Monday April 12 2021
News Source: Fund Regulation
Focus: Liquidity Risk Management
Country: European Union
The European Central Bank (ECB) has published a number of Macroprudential Bulletin providing insight into their ongoing work in the field of macroprudential policy. The topics in the bulletin include:
- Regulating Money Market Funds
- Fund suspensions during the pandemic
- Modelling liquidity management and policy measures
The aim of the Macroprudential Bulletins are to raise awareness of macroprudential policy issues in the euro area by bringing greater transparency to the ECB’s ongoing work and thinking in this field, and to foster broader discussion on key macroprudential issues.
Regulating money market funds
Market events in March 2020 tested the strength of the money market fund sector, raising questions about the ability of the EU’s regulatory framework to tackle systemic risks. What lessons can be learnt from last year’s episode and what do they mean for future policy?
This article assesses the effectiveness of the EU’s regulatory framework from a financial stability perspective and identifies three important lessons. First, investment in non-public debt assets exposes MMFs to liquidity risk, highlighting the need to limit investment in illiquid assets. Second, low-volatility net asset value (LVNAV) funds are particularly vulnerable to liquidity shocks, given that they invest in non-public debt assets while offering a stable net asset value (NAV). Enhanced portfolio requirements could strengthen their liquidity profile. And third, MMFs seem reluctant to draw down on their liquidity buffers during periods of stress, suggesting a need to make buffers more usable.
Fund suspensions during the pandemic
Following the onset of the coronavirus (COVID‑19) crisis, a significant number of European investment funds suspended redemptions. The ECB found that many of those funds had invested in illiquid assets, were leveraged or had lower cash holdings than funds that were not suspended. Furthermore, suspensions were more likely to be seen in jurisdictions where pre-emptive liquidity measures were not available.
The ECBs findings also suggest that suspensions have spillover effects on other funds and sectors, highlighting the importance of pre-emptive liquidity management measures.
Modelling liquidity management and policy measures
Large differences between the liquidity of investment funds’ assets and liabilities (i.e. liquidity mismatches) can create vulnerabilities in the financial system and expose funds to a risk of large outflows and sudden drops in market liquidity. From a macroprudential perspective, the current regulatory framework may not sufficiently address the risks stemming from liquidity mismatches in investment funds.
By modelling the liquidity management of an open-ended fund, this article provides theoretical justification for pre-emptive policy measures such as cash buffers that enhance financial stability by helping to increase the resilience of investment funds.
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