'Systemic importance' designation still possible for pension funds

The Financial Stability Board (FSB) has held out the prospect of pension funds still being subject to policies designed to tackle ‘too big to fail’ institutions, saying it would consider financial stability risks posed by the former when it resumes its work – suspended last year – on methodologies for identifying global, systemically important financial institutions other than banks and insurers.

The Switzerland-based organisation hinted at the possibility in a report, published 22 June, that sets out its proposals for policies to address “structural vulnerabilities” from asset management activities that could destabilise the financial system or markets. 

Last March, a consultation by the FSB and the International Organization of Securities Commissions (IOSCO) on which non-bank, non-insurer global institutions should be classed as systemically important financial institutions (NBNI G-SIFIs[1]) suggested pension funds could be excluded.

This, however, was criticised by some of the world’s largest asset managers.

Falling into line with IOSCO, the FSB suspended its work on systemic risk posed by asset managers in July, saying it would finalise the methodologies after completing its work on structural vulnerabilities from asset management activities.

The latter are the focus of the policy recommendations the FSB unveiled for consultation yesterday.

The policy recommendations, of which there are 14, address four of five areas the FSB had in September identified for further analysis.

The fifth area, which the policy proposals do not address, concerns the potential risks to financial stability that stem from pension funds and sovereign wealth funds (SWFs).

The FSB explained this decision by stating that, although certain types of pension funds and SWFs may pose financial stability risks, these vary depending on the size, nature and legal settings of the individual entity.

“Therefore,” it said, “the FSB decided to conduct further assessment when it revisits the scope of assessment methodologies for identifying NBNI G-SIFIs.”

The FSB will be working with IOSCO when it reviews the scope of the methodologies designed to decide which institutions are of global systemic importance.

The review will happen when the policy recommendations for asset managers “are finalised”, according to the FSB.

The consultation closes on 21 September this year.

However, the FSB said the “relevant authorities” may in the meantime want to take into account the FSB’s policy recommendations for asset managers “in considering their policies towards pension funds and SWFs in their jurisdictions if they consider them appropriate”.

Pension fund vulnerabilities

The FSB said pension funds “generally” make a positive contribution to financial stability, and have relatively low levels of liquidity transformation and financial leverage.

“Nonetheless,” it said, “pension funds can engage in activities that give rise to vulnerabilities, in the event that liquidity or asset reallocation pressures may arise.”

It identified three main sources of risk.

One is the potential for liquidity risk in some types of defined contribution pension funds, where plan rules allow members to withdraw invested amounts.

This means some pension funds are vulnerable to redemption pressures in a similar way that open-ended investment funds are.

Another source of risk, according to the FSB, is the build-up of leverage in pension funds.

It acknowledged that pension funds do not generally take on significant financial leverage but said “they may take on other forms of leverage”.

This could be by investing in funds that take on leverage, engaging in leveraged strategies as part of liability-driven investment strategies or investing in “less liquid” alternative assets.

Pension funds’ use of derivatives, for enhancing return and mitigating longevity risks, also raises questions about counterparty risk and the “interconnectedness in the financial system”, according to the FSB.