Regulatory initiatives since the 2008 financial crisis have successfully reduced the concentration of risk in banks and insurers. This does not mean, however, that risk has disappeared; it has been transformed and dispersed throughout the financial system.
As participants in that system, pension funds now face the intended and unintended consequences of the policy response to the crisis. They should be mindful of emerging risks and the implications for portfolio construction. For example:
- More strenuous capital requirements (e.g. Basel III) have forced banks to reduce inventories of securities, turning “market-makers” who could warehouse risk into “match-makers” who facilitate transactions between buyers and sellers with less intermediation. This has significantly reduced the breadth and depth of available liquidity, making the financial system more fragile. In adverse market conditions, it will be harder to sell assets and buyers will demand a larger price concession. We are encouraging our clients to re-visit liquidity assumptions for different assets in their portfolio. In particular, mature funds with negative net cashflows should undertake liquidity planning to avoid forced sales of assets in periods of market stress
- Regulation like Basel III SLR, Solvency II and nFTK in the Netherlands are driving differences in the prices of government bonds and swaps, which can affect both sides of the pension balance sheet (assets and liabilities). The impact on a particular pension fund will depend on the mix of government bonds and swaps held as assets and the approach to valuing liabilities. We are encouraging our clients to measure and stress test net exposure to this basis risk, and to re-visit LDI benchmarks. In particular, funds who finance government bond exposure (through repo or the derivatives market) should give integrated consideration to bond-swap basis risk and financing costs
More broadly, it’s clear that asset prices are increasingly driven by factors (e.g. regulation) other than economic fundamentals. This means pension funds, their advisors and their asset managers need to “up their game” to take better account of the real world’s complexity when constructing portfolios and managing risk. Traditional tools like asset-liability models – which rely to a significant extent on over-simplification and unstable assumptions – are unlikely to result in portfolios that are robust and resilient. Of course, these challenges also present opportunities for investors who correctly understand real world complexity and risk, and whose governance models can react quickly to changes in regulation and market structure.