A large and growing sector that can systematically count on central banks absorbing large amounts of credit and duration risk on their balance sheets in periods of stress will create bad incentives. The depth and persistence of the current shock amplifies these risks: interest rates will stay low for even longer than anticipated before the crisis, spurring risk-taking behaviour in the non-bank financial sector. [22] Indeed, many funds started to take up liquidity risk soon after the March turmoil. It is also important to reduce the related but distinct risk of financial dominance – that is, the risk that financial stability concerns may over time distract monetary policymakers from their primary mandate of securing price stability. [23] Ensuring that central banks can pursue their mandates without risking financial stability requires a rethink of our current prudential framework. It must be strengthened from a systemic risk perspective to ensure that it can be an effective first line of defence. Let me highlight three areas where I see the need for further regulatory reforms. First, we need to reduce the risks of mismatch between funds’ asset liquidity and their redemption policies. Investing in illiquid assets is a central strategy of many types of fund. But such funds then need aligned redemption policies, in particular with respect to the length of notice periods, as well as substantial precautionary cash holdings. Without these buffers, they are unable to respond to short-notice redemptions or margin calls without engaging in forced asset sales.
See, for example, Lewrick, U. and Schanz, J.F. (2017), “  Is the price right? Swing pricing and investor redemptions”, BIS Working Papers, No 664, October; and Jin, D. et al. (2019), “  Swing Pricing and Fragility in Open-end Mutual Funds”, IMF Working Papers, No 19/227, International Monetary Fund, November. [20] D’Avernas, A., Vandeweyer, Q. and Darracq Pariès, M. (2020), “  Unconventional monetary policy and funding liquidity risk”, Working Paper Series, No 2350, ECB, January. [21] Even before the launch of the PEPP, purchases under the corporate sector purchase programme (CSPP) likely provided an important backstop to investors in less liquid markets and thereby contributed to the outperformance of CSPP-eligible bonds. Changes to the concentration limits for unsecured bank bonds have also helped alleviate market stress. See de Guindos, L. and Schnabel, I. (2020), “Improving funding conditions for the real economy during the COVID-19 crisis: the ECB’s collateral easing measures”, The ECB Blog, 22 April. [22] ECB (2020), Financial Stability Review, Chapter 4, November, forthcoming. [23] Garicano, L., Saa-Requejo, J. and Santos, T. (2020), “  Tackling inflation if it reappears”, VoxEU, 6 October; Diessner, S. and Lisi, G. (2020), “Masters of the ‘masters of the universe’? Monetary, fiscal and financial dominance in the Eurozone”, Socio-Economic Review, Vol. 18, No 2, April, pp. 315-335. For the related discussion about fiscal dominance, see Schnabel, I.