A report from this group will be published later in the year. Academic and industry evidence points to at least three channels through which ICPF behaviour could generate pro-cyclicality: Market Conventions: Investors face an acute information problem when judging the performance of their fund manager (Rajan (2005)). One way of mitigating that problem is by benchmarking fund performance, either to others in the industry or to an industry-wide index. That is an important reason why relative return benchmarking and index-tracking is commonplace. There is also evidence that investors adjust their portfolios on the basis of these relative metrics – for example, with stronger inflows into funds whose relative performance has been superior (Chevalier and Ellison (1997), Feroli et al (2014)). These market conventions have the potential to amplify pro-cyclical swings in asset prices and investor flows. For example, in market upswings fund managers are likely to try and juice-up returns by searching for yield in an attempt to outperform their benchmark. The reverse occurs in the downswing when there will be a quest for safety to boost relative return rankings. But if everyone is playing this game, the result will be pro-cyclical pressures on asset prices, adding exuberance to the upswing and pessimism to the downswing. This increases the potential for mis-pricing in asset markets – by turns, risk premia becoming first too thin and then too fat. Relative return benchmarking creates, in effect, a Red Queen Race for the asset management industry (Ridley (1993), Haldane (2012b)). Other asset management conventions may also generate pro-cyclical swings.

While these measures have merits in safeguarding financial stability, they could have complex and cross-border impact. Even on the monetary policy front, unconventional measures are becoming more conventional. Central banks in the major economies have increasingly used unconventional monetary easing. Though necessary to stabilize their economies at this juncture, these policies have side effects of large and volatile capital inflows into Asia. This  BIS central bankers’ speeches  1  further complicates safeguarding of financial stability in other countries including Asia, and could, in turn, trigger some countries to resort to macroprudential measures themselves. Thus, in terms of policy space, we are dealing with a new paradigm of expanded policy tools, with new transmission mechanism, and requiring their own policy framework and governance. So we need to recognize the need for cross-border coordination as well as flexibility in execution given emerging uncertainty. Turning to the more medium-term structural issues, major regulatory reforms especially Basel III, Financial Stability Board reforms, and Dodd-Frank Act are still a known-unknown. We do know that they are designed to redress weaknesses that caused the crisis by enhancing capital and liquidity, while addressing the problems of procyclicality, and too-big-to-fail of SIFIs. For this, their merits are well recognized. But these reforms will reshape the global financial landscape and raise cost of financial intermediation. They will also have implications for cross-border level playing field, regulatory arbitrage, and alter risk profile of banks.