This suggests that other factors are likely to have amplified the procyclical selling by investment funds. Three such factors stand out, which I will discuss in turn. Increasing liquidity risk The first is the mismatch between asset liquidity and redemption policies. Bond and equity funds entered this episode with historically low cash positions and other liquid asset holdings, which had declined consistently over previous years, also reflecting wider risk-taking in a search for yield. https://www.ecb.europa.eu/press/key/date/2020/html/ecb.sp201119_1~4a1ff0daf9.en.html  2/7  20/11/2020  COVID-19 and the liquidity crisis of non-banks: lessons for the future  Fund-level analysis by ECB staff finds that the relationship between cash holdings and asset illiquidity was much weaker in the period immediately preceding the pandemic than it had been between 2012 and 2017, indicating that funds with illiquid assets have reduced precautionary cash holdings over time (see left chart slide 7). [7] As a result, fund managers sought liquidity when the capacity of markets to provide that liquidity had diminished sharply, resulting in forced asset sales and the amplification of adverse market dynamics. Although the extent of liquidity shortfalls is likely to have varied substantially at the fund level, outflows clearly exceeded median cash holdings for all types of corporate bond funds (see right chart slide 7). Leverage as an amplifier of market stress The second factor relates to fund leverage. [8] A recent ECB study finds that investors in leveraged funds tend to respond more strongly to deteriorating fund returns, adding to volatility in a bear market.

https://www.ecb.europa.eu/press/key/date/2020/html/ecb.sp201119_1~4a1ff0daf9.en.html  1/7  20/11/2020  COVID-19 and the liquidity crisis of non-banks: lessons for the future  But the trend towards non-bank finance also creates challenges. For example, non-banks typically do not have access to central bank balance sheets, which raises important questions about the role of a lender of last resort. The current system puts the onus on the ability of market makers to provide liquidity during periods of stress. In a similar vein, while the regulatory responses to the global financial crisis have succeeded in making the banking sector more resilient, the policy framework for the non-bank financial sector is far less developed. In particular, the macroprudential framework for the non-bank financial sector is still in its infancy, which limits the ability of authorities to address emerging risks and vulnerabilities. The role of non-banks during the spring market turmoil These regulatory gaps were clearly visible during the market turmoil in spring. When the pandemic broke out in Europe, systemic stress surged to levels close to those seen during the peak of the global financial crisis, in both the euro area and the United States (see slide 3). Diverging corporate sector bond spreads and credit default swap (CDS) spreads signalled that bond spreads widened beyond the rise in perceived default risk (see left chart slide 4). The widening in net asset value spreads for exchange-traded funds, which was the largest on record for these instruments, also pointed towards a remarkable decline in liquidity (see right chart slide 4).