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WHERE will the next financial crisis occur? Not, almost certainly, where the last one did

Since the late 1990s, the world has coped with economic meltdown in South-East Asia, the dotcom boom and bust, and the American housing bubble and subsequent banking collapse. The place that regulators are worried about now is the fund-management industry.

In a sense, their worries are the result of the regulatory response to the last crisis. Banks now have to hold more capital than before, so they are less willing to lend money to companies or to act as marketmakers in the corporate-bond market, and companies are now more dependent on the bond markets (and thus asset managers) for finance. Investors have piled into corporate bonds, not least because central-bank policy has pushed down returns on government bonds. Speculative or junk bonds yield just 4.5% compared with 8.1% in October 2011.


This has led to crowded positions in a market where liquidity, by one estimate, has declined by 70% since before the 2007 crisis. Regulators are worried that if everybody tries to sell, the absence of willing buyers could cause prices to tumble, the cost of finance for companies to shoot up and the corporate-bond market to, in effect, closeas it did for emerging-market borrowers in the summer of 2013, when the Federal Reserve hinted at reducing the pace of its asset purchases. The damage to the economy could be big.

Regulators are contemplating action. One possibility, mentioned in a paper by the Financial Stability Board, a group of finance ministries and central banks, is to designate fund managers or individual funds as “systemically important financial institutions”, or SIFIs. This would put them in the same category as big banks like Goldman Sachs, potentially making them hold more capital, a cost that would be passed on to investors.

That would be an odd decision. Asset managers invest other people’s money, not their own, and that money is held separately. If an asset manager were to go bust, its clients’ money would be safe. Most asset managers borrow very little: HSBC, a British bank, has a balance-sheet 300 times larger than that of BlackRock, the largest fund manager. Mutual funds have not exacerbated past crises; indeed, retail investors seemed calmer than big institutions in the big equity bear markets of 2000-02 and 2008-09.


A gate worse than death


What about hedge funds and money-market funds? Hedge funds are potentially more worrying, as the collapse of Long-Term Capital Management in 1998 showed, because they use borrowed money; money-market funds suffered a run in 2008 after one fund incurred losses. Nothing is being done about the former but regulators are taking aim at the latter

America’s Securities and Exchange Commission introduced new rules for money-market funds last week, allowing some of them to set upgates” to limit withdrawals, or impose redemption penalties, at times of crisis. A similar restriction could be introduced to avert a bond-fund meltdown.

Such rules might sound sensible, but they risk being counter-productive. The mere prospect of investors being denied access to their money might cause the very run the authorities are trying to avoid.

Regulators are right to try to identify places where problems are building. After all, if they had done that more effectively before 2008, the worst recession since the 1930s might have been avoided. But regulations can cause problems as well as avert them. It is investors who should worry more than regulators: they need to remember that central banks will not prop up asset prices for ever.