Too big to fail?
Are US asset management firms ‘too big to fail’? In other words, do they represent systemic risks similar to those posed by the largest banks, so much that they must be subject to ‘enhanced’ supervision? Asset managers are already under the supervision of the Securities and Exchange Commission (SEC), and they claim to be the most transparent and controlled financial institutions. But the largest are in danger of becoming like three non-banks that have already been classified as “systemically important”: American International Group, General Electric Capital and Prudential Financial.
The Treasury Department’s Office of Financial Research (OFR) raised the issue two months ago with its report Asset Management and Financial Stability, prepared for the Financial Stability Oversight Council (FSOC), the top regulator created by the Dodd-Frank Wall Street Reform and the Consumer Protection Act in 2010. Now the FSOC is reviewing the OFR study and the potential next steps, the most likely of which is the request for more data from asset managers, especially about separate accounts created for wealthy individuals and institutional investors.
The FSOC will now take into account comments that the SEC has received from asset managers. Some of the remarks have been scathing. For example, as Federated Investors defined the OFR report as “misleading and inaccurate”, while the Investment Company Institute (ICI) insisted that “designation as systemically important financial institutions… is not an appropriate regulatory tool for addressing risks, if any, that registered funds or their advisers might raise regarding financial stability”.
However the issue is not going away because, before OFR, other authorities – such as the US Federal Reserve and the international Financial Stability Board (FSB) – had pointed to asset managers as part of the “shadow banking system”, the network of financial institutions that act like banks (engaging in credit intermediation) but are not supervised like banks.
“Some types of asset-management activities are similar to those provided by banks and other non-bank financial companies, and increasingly cut across the financial system in a variety of ways,” the OFR report says.
The study identifies four factors that make the asset management industry vulnerable to financial shocks: “Reaching for yield” and herding behaviours; redemption risk in collective investment vehicles; leverage, which can amplify asset-price movements and increase the potential for fire sales; and firms as sources of risk.
The risks are amplified by the size and high level of concentration of the $53trn (€39trn) asset management industry, according to OFR.
It is true that asset managers invest money for clients who bear the losses, but they also perform activities at the firm level, the OFR report emphasises, “including securities trading, derivatives trading, securities lending, and repo transactions”. Repos and securities lending, in particular, are forms of borrowing but data about these activities are inadequate. There is a lack of information about the health of asset managers’ trading counterparties in these activities that could become a source of financial instability.
“During a period of market stress in which funding liquidity is drying up, firms with large repo books and an array of interconnections may have difficulty unwinding clients’ investments quickly,” the OFR points out. “Because such a situation could dislocate markets and heighten fire-sale risk, data on repo activity are critical to monitoring developments that could indicate stress. Currently, many repo transactions can be monitored only indirectly.”
Another opaque area of the industry is in “separate accounts” according to the OFR: “The top five asset management companies alone manage $5.5trn in separate accounts. Data about the types of assets held in these accounts, their counterparty and other risk exposures, and amounts of leverage are limited. As a result, supervisors today are unable to fully assess the nature or extent of any financial stability risks that could be amplified or transmitted by the activities of these accounts.”
Among clients with separate accounts are private pension plans, which are under the supervision of the Department of Labor, while the SEC controls the advisers. These regulators “do not routinely collect information about separate account holdings, leverage, risk exposures, or liquidity” the OFR report states. It suggests “filling gaps in these data for better macro prudential monitoring of related risks”.
The FSOC has no deadline to make any decision.