Fund Management and Systemic Risk – Lessons from the Global Financial Crisis

• Author: Elias Bengtsson
• Date: 01 May 2014
• Published date: 01 May 2014
• DOI: http://doi.org/10.1111/fmii.12016

Fund Management and Systemic Risk – Lessons from

the Global Financial Crisis

BYELIAS BENGTSSON

Fund managers play an important role in increasing efficiency and stability in financial

markets. But research also indicates that fund management in certain circumstances may

contribute to the buildup of systemic risk and severity of financial crises. The global

financial crisis provided a number of newexperiences on the contribution of fund managers

to systemic risk. In this article, we focus on these lessons from the crisis. We distinguish

between three sources of systemic risk in the financial system that may arise from fund

management: insufficient credit risk transfer to fund managers; runs on funds that cause

sudden reductions in funding to banks and other financial entities; and contagion through

business ties between fund managers and their sponsors. Our discussion relates to the

current intense debate on the role the so-called shadow banking system played in the global

financial crisis. Several regulatory initiatives have been launched or suggested to reduce

the systemic risk arising from non-bank financial entities, and we briefly discuss the likely

impact of these on the sources of systemic risk outlined in the article.

Keywords: Systemic risk, shadowbanking, fund management, credit risk transfer, liquid-

ity risk, financial crisis.

JEL Classification: G12, G23, G28, G01.

I. FUND MANAGEMENT AND SYSTEMIC RISK

That financial crises typically have wide-ranging effects is a well-established fact.

The global financial crisis (GFC) is certainly no exception. It even had an impact

on the way the financial system is conceptualized. The understanding of how

markets, financial actors and instrument function, interact and relate to each other

has evolved considerably since the firstsigns of financial stress appeared in spring

2007.

This article relies on the experiences from the GFC to discuss new insights on

how fund management can contribute to systemic risk.1Fund managers (FMs)

are understood as a form of institutional investor whose principal purpose is

to attain high risk-adjusted returns for their clients. In this article, we seek to

distinguish between traditional fund managers (TFMs) and hedge funds (HFs)

whenever such a distinction is meaningful and possible. Institutional investors –

including FMs- have a number of well-known efficiency and stability enhancing

features that decrease overall systemic risk.2However, it is also widely recognized

Corresponding author: Elias Bengtsson, bengtsson.elias@gmail.com

1In this article, systemic risk is defined as the risk of failure of one or several systemically important

financial institutions.

2Among other things, institutional investors provide opportunities to diversify, hedge and insure risk;

and they provide liquidity to and facilitate efficient functioning of markets (Davis and Steil, 2001).

They also reduce the (relative)weight of and thus systemic importance of banks in credit intermediation

(Davis, 2000). Unlike banks, they have not tended to take on excessive risk due to mispriced safety

nets (Schich, 2008).

C2014 New YorkUniversity Salomon Center and Wiley Periodicals, Inc.

102 Elias Bengtsson

that institutional investors can contribute to systemic risk by making asset prices

stray away from fundamentals, and fuelling financial bubbles and procyclicality

through herding behavior (c.f. surveys by Bikhchandani and Sharma, 2000; Borio

et al., 2001).

Yet, the experiences of the GFC showed that FMs may contribute to systemic

risk in other ways than merely fuelling financial bubbles.3In this article, we

use recent research coupled with empirical and anecdotal evidence to describe

a number of ways in which FM can contribute to systemic risk. We distinguish

between three ways that was largely overlooked prior to the crisis: credit risk

transfer to FMs; runs on FMs and financial markets; and business ties between

FMs and sponsors. Our insights are also compared and contrasted with the existing

literature on FM and financial stability.4

The topic of how FM may contribute to systemic risk is highly relevant in light

of the ongoing regulatory reform that the fund management industry is facing.

Financial Stability Board (FSB) has launched a substantial programme to consider

ways in which systemic risk from shadow banking –which many consider some

forms of FM a part of – can and should be mitigated through regulatory reform

(FSB, 2011). Also, considerable reform on money market funds (MMFs) is already

underway in the US (c.f. McCabe, 2012).

The remainder of this article is outlined as follows: In Sections II-IV, we

discuss the three new insights on ways in which FMs contribute to systemic risk.

In Section V, we conclude by reflecting on the findings in light of the general

financial stability literature. Wealso briefly discuss how regulatory reform to date

and regulatory initiatives being considered may impact on the three identified

ways in which FMs may contribute to systemic risk.

II. CREDIT RISK TRANSFER TO FUND MANAGERS

The availability of other channels of credit intermediation than banks (such as

fund managers) may enhance stability of a financial system and reduce systemic

risk. But during the GFC, it also became clear that credit risk transfer (CRT)

from originating banks to fund managers (and other market participants) can

contribute to systemic risk. A brief overview of the main CRT instruments and

markets, as well as the role played by FMs is provided below. Thereafter, we

review research and anecdotal evidence on situations where credit risk transfer to

FM has contributed and could contribute to systemic risk.

3Other asset managers than FMs may also, and have in different shapes and degrees, contributed to

systemic risk through the channels covered in this article. This topic is however beyond the scope

of this article, and is to some extent covered elsewhere (c.f. Mezzacapo (2009) for sovereign wealth

funds).

4While the distinction of the three ways FM contributeto systemic risk is useful for analytical purposes,

in reality manifestation of systemic risk from FM is likely to be an outcome of an interaction between

several sources (both those covered in this article, and other sources identifiedin the body of research

on FM and systemic risk). Also, we omit potential systemic risk stemming from banks’ investments

in fund shares.