The thesis of a new report from the International Monetary Fund is neither shocking nor groundbreaking. Despite progress, the United States must finish the work begun by the Dodd-Frank Act on financial reforms, it says. More telling is an assessment of what new areas systemic risk has bubbled into and why non-banks, especially insurance companies, should be the next big focus for regulators.
The IMF’s “Financial System Stability Assessment” for the U.S., released on Tuesday, is one of 29 reviews of jurisdictions with heightened importance to global finance. The assessments are conducted, on a rotating basis, every five years; the last U.S. review was in 2010. “Banks in the United States appear healthier and stronger than five years ago, but they are also bigger and more interconnected, and new risks have emerged in financial institutions like mutual funds and insurance companies,” the IMF wrote. Insurance companies, hurt by the prolonged period of low interest rates, are taking on greater risks and some have invested more in private equity, hedge funds, longer duration and lower credit corporate bonds, and real estate related assets, it explains.
The analysis also suggests that hedge funds, and other managed funds, contribute to overall financial risks in a proportion larger than suggested by their size. The systemic importance of mutual funds has grown since the crisis and assets under management have increased, especially in corporate high-yield, and emerging market bonds and debt funds. “Mutual funds could act as amplifiers to shocks to the financial system through asset liquidation—investors may rush to redeem their shares, while the funds may be invested in illiquid assets—and through direct exposures if funds exit from risky assets or limit their willingness to fund other key players in the system,” the report says, adding that liquidity risks in the exchange traded fund sector are also on the rise.
Among the recommendations the IMF report has for U.S. regulators:
Create an independent national regulator for the insurance industry to address gaps with international standards and ensure consistency in regulation and supervision.
Strengthen oversight of the asset management industry, including mutual funds.
Update risk guidance for banks on operational, interest-rate, and concentration risk.
Create enhanced stress tests for nonbanks, in particular insurance companies, mutual funds, and pension funds.
Expedite heightened prudential standards for designated non-bank SIFIs
Improve data collection and address impediments to inter-agency data sharing
Secure greater resources for the Securities and Exchange Commission and Commodity Futures Trading Commission and enhance their funding stability
Extend the Dodd-Frank Act’s Orderly Liquidation Authority powers to cover systemically-important insurance companies and U.S. branches of foreign-owned banks. e
Expanding the role of the Financial Stability Oversight Council, tasking it with the responsibility for system-wide crisis preparedness and management.
"While the enhanced supervisory focus on large banks is welcome, it should not result in supervisors overlooking small deposit takers,” the IMF warns. Although supervisory expectations are tailored to be less strict for smaller, non-systemic banks, small banks with higher risk activities should be encouraged to adopt better practices in corporate governance, risk management, and contingency planning commensurate with their risk profile, “especially given that previous episodes of crisis have originated in small and medium banks.”