The Financial Markets Authority (FMA) has poured cold water on the NZ fund industry’s “overly optimistic” self-assessment of liquidity risk management skills, issuing 17 recommendations in a new report handed down last week.
According to the FMA report, the regulator’s August 2020 survey of 51 licensed managed investment scheme (MIS) firms, representing over $135 billion found most respondents “in general appear to have a positive view of their liquidity risk management capabilities, including stress testing”.
“We consider this overly optimistic, based on the responses to detailed questions about their capabilities, and also considering the expectations set out in our liquidity risk management good practice guide published in April 2020,” the FMA paper says. “There were exceptions, but even the stronger performers showed some significant gaps across particular areas of capability, e.g. frequency of stress testing, use of available liquidity management tools (LMTs) and metrics.”
Among the 17 recommendations – ranked from low- to high-priority – the regulator says MIS managers should carry out liquidity stress-tests at least once a year, or more depending on fund structures and market conditions.
“If the stress testing is undertaken by a third party on behalf of the fund, this does not absolve MIS management and board members from taking responsibility for the tests and satisfying themselves that the results have been taken into account and factored into decision-making,” the FMA says.
The report also recommends also managers incorporate more LMTs and develop better liquidity “risk governance, frameworks, processes and metrics” to meet expected standards.
For example, the FMA survey found just half of the respondents had previously used a LMT “of any kind”.
LMTs include options such as swing pricing (ie adjustable buy-sell spreads), redemption gates, side-pockets and ‘in-kind’ redemptions.
But the lack of practical experience in the industry in using such measures calls “into question [MIS managers] ability to select an appropriate LMT, including those suited to a variety of crisis situations, at an appropriate time/stage of the crisis escalation”, the report says.
“This, coupled with an overreliance on liquid assets as the default response to a liquidity crisis, could lead to liquid assets proving insufficient,” the FMA says. “The collective impact of such a response may conflict with the fundamental principle of fair treatment of investors.”
The regulator says both MIS boards and senior management should have greater oversight of liquidity risks as well as the ability to “challenge” current practices in their organisations.
“While survey respondents did identify their critical liquidity risk management infrastructure components, some contradictions and inconsistencies in responses tell us there is further scope for integration of all components,” the report says.
Almost half of those surveyed, for instance, did not have a consistent definition of ‘illiquid assets’, a problem highlighted in the UK in 2019 following the suspension of a popular fund managed by the once-revered Neil Woodford. The Woodford scandal, in fact, helped trigger the FMA review of MIS liquidity measures in 2019
“Issues such as this are likely to grow in prominence as mutual funds increasingly seek out and/or rely upon illiquid assets to generate greater returns in the prevailing and foreseeable low interest rate environment,” the report says. “For these reasons the FMA believes having a clear definition of ‘illiquid assets’ to assess assets against is an important tool in managing fund liquidity risk.”
The regulator says research in the wake of the GFC shows financial firms with higher-quality governance tended survive the crisis in better shape than others.
“For this reason, we expect MIS boards to review this report and take action where required,” the report says. “New Zealand weathered the impact of the GFC well, primarily based on the choice not to invest in collateralised debt obligations or mortgages. The liquidity impacts were still felt in New Zealand, however, and in the next event we might not be so lucky.”
The FMA says it will follow-up with another survey of MIS managers to test how they would react to “two hypothetical liquidity risk stress scenarios”.
“We have not yet decided on the timing of this proposed work,” the report says.
Last August, the FMA established a new team focused on the MIS sector, hiring former Pie Funds chief operating officer, Paul Gregory, to head the division.