Over the last year, our working party (Varun Bajaj, Gareth Mee, Dick Rae, Raj Saundh, Adeline Tan, Pablo Vasquez Lopez, Denis Walsh) researched procyclicality within financial markets globally. We reviewed 42 papers and articles, observed market practice and tested 8 hypotheses relating to the markets.
Perhaps as expected, we found evidence of procyclicality in some markets (notably in the pensions markets) and evidence that countercyclical measures worked in other markets (e.g. insurance). Like predecessor working parties, there is evidence of herding in different markets driven by regulation and social norms – this is a far bigger driver of asset allocation and changes in asset allocation than procyclicality. We also found it fascinating to see investors tackle the same problem (meeting long term liabilities) with markedly different strategies due to regulatory incentives.
Another conclusion was the widespread derisking that has been seen in the market despite lack of evidence of systematic procyclicality. This is a long running trend that has seen reduced allocation from equity markets by institutional investors globally in favour of lower risk investments.
We expected to find that credit ratings are procyclical, particularly as the ratings agencies themselves confirm that ratings do move in line with cycles. However, they are broadly stable over time and we found that it was more the use of the credit ratings within regulation that leads to procyclicality.
Finally, we found that there is much to learn from the banking regime for institutional investors, though the banking sector has evolved from dynamic provisioning mechanisms to newer mechanisms such as IFRS9 but this still needs refinement and intervention from regulators to maintain consumer lending in a crisis whilst avoiding reserves increasing at an inconvenient time.
We hope that research into procyclicality will continue and that this paper is a useful reference point to pass the baton to the next willing set of researchers!