Washington, D.C., April 15, 2015 - Reduced secondary bond market liquidity in the context of a sustained low-rate environment could pose serious risks for the financial system, noted the Institute of International Finance in a letter to the International Monetary Fund and World Bank ahead of their Spring Meetings.
"In the wake of both regulatory and market developments that have changed the economics of market-making, market depth and liquidity have deteriorated-a problem that is not yet fully recognized or understood," wrote the IIF. "While reducing risk in the banking sector has been an important and intended consequence of regulatory reform, the resulting reduction in market liquidity goes far beyond banks."
The IIF noted that over the past 15 years, global bond markets have grown substantially, from some $30 trillion in 2000 to nearly $90 trillion at present. However, trading volumes in U.S. bond markets were some 20 percent lower in 2014 than in 2005, while corporate bond inventories held by banks have been reduced by 75 percent in the U.S. and over 50 percent in Europe since 2007.
Addressing the sustained low-rate environment, the IIF noted that central bank quantitative easing has been essential to supporting the global economic recovery, but has also prompted a notable shift towards investment strategies aimed at income generation-"search for yield."
As a result, the IIF noted, even as the banking sector has cut back on risk, institutional investors have built up exposure. For example, global pension funds now have allocations of 25 percent to alternative investments (e.g. commodities, derivatives, real estate), up from 5 percent in 2000. In an environment of reduced secondary bond market liquidity, exiting higher-risk investment strategies may prove difficult and costly as rates normalize.
Another notable risk associated with sustained low rates is the problem of pension underfunding and under-saving for retirement in general. This is a serious public policy challenge in many countries, particularly given aging populations and rising life expectancy.
Additionally, the IIF underscored its support of the significant progress in completing the G20 regulatory reform agenda, and efforts underway to finalize remaining core elements-but emphasized the need for impact analysis. Key topics discussed include:
- Ending "too-big-to-fail" and finalizing a global bank resolution regime;
- Calibration of a resolution framework for systemically important insurers; development of a global insurance capital standard;
- Maintaining the necessary level of risk-sensitivity in capital measures and strengthening internal models; potential impact of proposed market-risk capital charges for trading books;
- Re-examining the liquidity coverage ratio and net stable funding ratio; and
- The importance of focusing on underlying activities (rather than the size of the firm) in developing a regulatory regime for non-bank, non-insurance entities.
The IIF also addressed ongoing collaboration with global bodies on a number of fronts to facilitate private-sector support for investment, job creation and economic growth, including:
- Addressing the infrastructure financing gap;
- Ensuring financing for the SME sector;
- Supporting stable capital flows; and
- Promoting financial inclusion, including via new financial technologies.
The letter was addressed to the Chairman of the International Monetary and Financial Committee at the IMF and the Chairman of the Development Committee of the World Bank.
The Institute of International Finance is the global association of the financial industry, with close to 500 members from 70 countries. Its mission is to support the financial industry in the prudent management of risks; to develop sound industry practices; and to advocate for regulatory, financial and economic policies that are in the broad interests of its members and foster global financial stability and sustainable economic growth. IIF members include commercial and investment banks, asset managers, insurance companies, sovereign wealth funds, hedge funds, central banks and development banks. For more information visit www.iif.com.