This paper (i) provides evidence on the procyclical investment behavior of major institutional investors during the global financial crisis; (ii) identifies the main factors that could account for such behavior; (iii) discusses the implications of procyclical behavior; and (iv) proposes a framework for sound investment practices for long-term investors. Such procyclical investment behavior is understandable and may be considered rational from an individual institution's perspective. However, our main conclusion is that behaving in a manner consistent with longterm investing would lead to better long-term, risk-adjusted returns and, importantly, could lessen the potential adverse effects of the procyclical investment behavior of institutional investors on global financial stability.
This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate.A decade-long diversification of official reserves into riskier investments came to an abrupt end at the beginning of the global financial crisis, when many central bank reserve managers started to withdraw their deposits from the banking sector in an apparent flight to quality and safety. We estimate that reserve managers pulled around US$500 billion of deposits and other investments from the banking sector. Although clearly not the main cause, this procyclical investment behavior is likely to have contributed to the funding problems of the banking sector, which required offsetting measures by other central banks such as the Federal Reserve and Eurosystem central banks. The behavior highlights a potential conflict between the reserve management and financial stability mandates of central banks. This paper analyzes reserve managers' actions during the crisis and draws some lessons for strategic asset allocation of reserves going forward.
The recent global financial crisis has significantly affected sovereign wealth funds' (SWFs') financial performance and their investment activities. The crisis shed a new light on SWFs' objectives and priorities. SWFs need to review critically their strategic asset allocation (SAA) within a sovereign asset and liability management (ALM) framework, and their assets should be analyzed over complete economic cycles including market turbulences. The crisis raises also the question of whether some of the underlying objectives of the Santiago Principles-maintaining a stable global financial system and maximizing financial returns-are perhaps conflicting. We argue that any conflict was from a wrong interpretation of the principles, not from the principles themselves. Ultimately, stable financial markets are in each SWF's self interest, also from a narrow financial perspective. In this respect, financial stability and financial risk ⁄ return can be mutually reinforcing objectives rather than conflicting.
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