Summary
Focus
As the asset management sector has grown over the past decades, so has its impact on financial market liquidity. A recurrent argument is that asset managers exacerbate market stress because their liquidity mismatches come to the fore alongside dealer banks' constrained balance sheet capacity. Focusing on banks' role as market-makers, this paper examines the implications of their regulatory constraints on asset managers' risk-taking behaviour.
Contribution
We challenge the notion that bank regulation necessarily amplifies asset managers' destabilising behaviour – a notion that rests on the assumption that more liquidity is always better. We argue instead that in assessing cross-sectoral implications of bank regulation, it is crucial to establish whether there are distortions in the asset management sector that make it inherently prone to excessive risk-taking. We study the data for evidence of one such distortion – reputational herding.
Findings
We find evidence consistent with reputational – as opposed to information-driven – herding by US money market funds. In our theoretical model, we derive conditions under which such herding leads asset managers to take on excessive liquidity risk. When this is the case, the model implies that bank regulation plays a beneficial role by disciplining risk-taking in the asset management sector. In other words, a binding leverage ratio requirement raises social welfare.
Abstract
We challenge the argument that bank regulation amplifies the adverse effect of asset managers' fire sales. Evidence from investments by US money market funds over the past decade is consistent with asset managers herding for reputational reasons. In the presence of such herding, we derive that the asset management sector may take on too much liquidity risk from a social perspective. Importantly, asset managers' investment decisions today are affected by the spread that banks will charge for absorbing fire sales tomorrow. When regulation constrains banks' balance-sheet space, the resulting higher spread reins in asset managers' excessive risk-taking, thus raising social welfare.
JEL codes: G21, G23, G28, D62
Keywords: investment funds, herding, bank regulation, leverage ratio, social welfare
