Assessing Systemic Risk of Asset Managers: No Need to Name SIFIs but Monitor Industry
Ask most people in asset management about the likelihood that their industry is systemically troubling to financial markets and you most likely would hear a disgusted humph in reply. Nothing could be more ridiculous than an industry that takes orders from its clients to buy, sell or hold marketable assets, holds those assets in custody on their behalf, and earns fees based on oversight and providing for the safekeeping of those same assets they manage igniting a global financial crisis. More likely, what you’ll hear, is that they will bear the brunt of a crisis beginning elsewhere, where firms with a slim layer of capital invest customer funds in illiquid, highly speculative assets in an increasingly narrow range of business opportunities.
All these things are accurate and indeed true, for the most part. Debt is prohibited for most of the largest investment funds managed by these firms. A large number of small(ish) fund firms (hedge funds manage a total of $2.5T, versus $15.9T for the regulated mutual fund sector) use leverage as part of their investment strategies, though even large private equity firms that lever their holdings are unlike the kind of widely interconnected, massive banking institutions that helped lurch the global financial system toward the abyss in 2007 and 2008.
In less certain moments, however, some of the less-ardent of these asset managers are willing to consider the potential pitfalls of the kind of leverage seeping into the traditional fund system. So-called “liquid alts,” and liability-driven investment funds (LDIs) are increasingly using leverage as part of their investment strategies. There also are potential problems resulting from securities lending (a full discussion in our commentary to FSOC on whether asset managers pose a systemic risk to the US financial system). Point out all these potential pitfalls and before long, there is at least some grudging recognition, however slim, that while this ain’t like banking — heads I win, tails the taxpayer pays and I don’t lose — there is a potential for things going awry.
The Financial Stability Oversight Council — otherwise known as the FSOC or the college of regulators — is the US organization charged with monitoring these matters. It is facing its own heat. We have heard from a number of Congressional offices on both sides of the aisle that they don’t understand the FSOC’s end game with regard to asset managers and insurers as potentially systemic institutions. Indeed, there is at least one House bill awaiting review, and others could follow.
The FSOC certainly has its troubles. Some have complained that its SIFI determination process leaves plenty to be desired (this bill seeks to address this), and its first foray into considering the systemic possibilities of asset management in late 2013 was an unmitigated disaster. So bad was the report from the Office of Financial Research — FSOC’s less-than-independent research arm — that the SEC, a sitting FSOC member, marshaled opposition to the report.
Those issues are secondary, though, to the need for prudence in avoiding, or at least mitigating, a future financial market meltdown. The Cassandras alerting the rest of the market in vain to the problems of AIG, for example, were few and far between. In hindsight, it all seems so clearly destined for disaster. In real time, though, it seemed business as normal. Such is the nature of the current endeavor.
In the end, it is highly unlikely, even wise we might say, for the FSOC to pass on naming any of the current roster of asset managers as SIFIs. But prudence dictates that the entities established to oversee the financial sector, and those called upon to monitor what is happening in our world should keep a keen eye on all parts of the financial sector, asset management included. It is the least we should expect.
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Image credit: Paul Blow, 2014
