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The prevalence of pro-cyclicality in the financial industry

Denis Walsh, Senior Investment Consultant and Insurance Client Segment Leader with Mercer Australia, with input from within the COVID-19 workstream, provides initial observations considering the topic of pro-cyclicality and its prevalence across the financial industry arising from the use of quantitative models.

The topic of pro-cyclicality within the financial system has represented a regular feature of discussions amongst investment market participants, regulatory institutions, and policymakers alike.  Its relevance lies in the tendency for behaviours and actions by institutional investors and financial intermediaries (either unintentionally or otherwise), to exacerbate trends, with such actions leading to negative or worse outcomes than might otherwise have been achieved.

Previous exploration of this topic via a panel discussion[1] by the IFOA considered pro-cyclicality with respect to a sub-group of institutional investors (insurance companies and pension funds). As part of that discussion, pro-cyclicality was defined as:

  • in the short term, the tendency of insurance companies and pension funds to invest in a way that exacerbates market movements and asset price volatility, and, in the long term, the tendency to invest in line with asset price and economic cycles so that the willingness to bear risk diminishes in periods of stress and increases in upturns.

In an extension of this discussion, with the recognised widespread use of quantitative models within the financial industry, the focus of this ICAT group has been the prevalence of pro-cyclicality arising from the use of such models and the potential impact on investment decision making.  To date, the working group’s focus has been an examination of existing literature, which indicates the topic of pro-cyclicality has featured as the subject of research and analysis across a wide range of financial industry articles and academic papers.  Furthermore, the topic appears to have been considered from a variety of perspectives across different segments of the financial industry. 

Our group’s examination of investment papers and materials on the topic and subsequent discussions to date have considered the following;

  • Within the banking sector, we find a number of articles examining the pro-cyclical trends of bank capital and bank lending, highlighting the importance of this topic for banking institutions given their role as financial intermediaries for the real economy. 
  • Noting different regional jurisdictions, existing literature contends that regulatory regimes governing financial institutions may have in the past (and arguably continue to), represent a possible source of pro-cyclical behaviour.  These behaviours may arise for example from the regulatory requirements for minimum credit ratings for investment portfolios or for stipulated levels of capital (for banks or insurers).  Through our discussions, we note that recent revisions to regulatory regimes (Basel III for example), or approaches to capital setting (dynamic provisioning) have sought to mitigate pro-cyclical effects to some extent. 
  • We have observed research studies[2] which have examined the behaviour of long term institutional investors during recent crises.   The findings are suggestive of some evidence of pro-cyclical behaviour by these investors.
  • We have discussed the role credit ratings may play in pro-cyclical behaviour, to the extent that they represent an appropriate bellwether of market stress, while at the same time, noting that an over-reliance on credit ratings (to the extent they themselves are pro-cyclical) may translate into decisions being made at the ‘wrong time’.
  • Our discussions have also considered the reliance by industry participants (including institutional investors) on market benchmarks that are by nature pro-cyclical, and the interaction of such measures with long-term objectives.

Evidenced by our observations of the research literature to date, there remains a high level of interest in the topic of pro-cyclicality by many participants across the financial system.

The working group will continue to explore the topic and provide an update of our observations and findings as we progress.