Risk-taking by asset managers and bank regulation

March 2021 (revised May 2023)

Summary

Focus

As the asset management sector has grown in size over the past decades, so has its importance for financial stability. A recurrent argument is that asset managers exacerbate market stress because their liquidity mismatches come to the fore alongside constraints on dealer banks' balance sheet capacity. Focusing on banks' role as market-makers, we examine the implications of their leverage-ratio regulatory requirement on asset managers' risk-taking.

Contribution

We challenge the notion that bank regulation necessarily amplifies asset managers' destabilising behaviour. We argue instead that it is essential to compare two effects of bank regulation: that on dealers' capacity to absorb fire sales and that on asset managers' exposure to the risk of redemption-driven fire sales. We perform this comparison in an environment with central bank liquidity backstops, similar to those deployed in the aftermath of the Covid-19 outbreak. We also study empirically whether the managers of US money market funds (MMFs) do respond to the implementation of the leverage-ratio regulation.

Findings

In our theoretical model, we find that the anticipation of central bank liquidity injections leads asset managers to take on excessive risk from a social perspective. In such an environment, bank regulation plays a beneficial role by disciplining the risk-taking in the asset management sector. In other words, less ex-post liquidity raises social welfare ex ante. Using two alternative measures of risk-taking by MMFs, we find robust evidence of a cross-sectoral disciplining effect of the leverage-ratio regulation.

Abstract

A beneficial effect of bank regulation may play out through the asset management sector. When asset managers count on a central bank to support market liquidity in a systemic event, they take on fire-sale risk that is excessive from a social perspective. However, the extent of risk-taking today also incorporates the spread that bank dealers would charge for absorbing fire sales tomorrow. If regulation constrains banks' balance-sheet space, the expected spread would be higher, reining in excesses in asset managers' risk-taking and ultimately raising welfare.

JEL codes: G21, G23, G28, D62

Keywords: endogenous risk-taking, investment funds, liquidity injections, bank regulation.