Creating Bubbles: Are Asset Managers a Culprit?
Do asset managers pose systemic risks to the financial system? As regulators have looked beyond the banking industry to anticipate stresses to the financial system in future crises, asset managers are once again in focus. The Financial Stability Board (FSB) and International Organization of Securities Commissions (IOSCO) have just published a consultation paper on proposed assessment methodologies for nonbank noninsurer global systemically important financial institutions (NBNI G-SIFI to advance the art of nonsensical acronyms). And following on a widely criticized paper issued by the US Office of Financial Research (OFR) that imagined a variety of risks that didn’t easily square with the reality of the asset management business, the US Financial Stability Oversight Council (FSOC) has issued a consultation seeking comment on asset management products and activities, reflecting growing understanding of the need to consider how asset management activities might contribute to systemic risks rather than taking tempting shortcuts that use proxies (such as the magnitude of assets under management) to assess potential risks.
The asset management industry, unsurprisingly, has recoiled from the prospect of more regulatory attention, pointing out the essential differences between banks and asset managers (especially the relative lack of leverage, and their role as agent for a multitude of client accounts rather than concentrating risk on their own balance sheets.) CFA Institute has also weighed in, and while we think there are ways to reduce some of the opacity around asset management activities that could give regulators comfort, we also believe that the business model is far less susceptible to originating or transmitting risks that could topple the system.
In this context, we note an excellent new working paper from Dr. Brad Jones at the International Monetary Fund (“Asset Bubbles: Rethinking Policy for the Age of Asset Management”) that considers the policy implications of asset manager business customs and incentives as related to regulators’ efforts to address asset price bubbles. The structured credit price bubble of the mid-2000s was an important element of the global financial crisis, suggesting the relevance of Jones’ analysis to current reform efforts around systemic risk.
Jones frames his analysis of asset management activities in the context of two broad strategies to deal with bubbles. A “clean” strategy presumes that government actors can’t recognize bubbles in real time. When bubbles burst, this school of regulatory oversight suggests that there are familiar central-banking tools available to clean up the mess, including lowering policy rates, purchasing programs to support prices, and currency management to stimulate exports. But the reality of bursting bubbles inflicts costs and pain. An alternative “lean” strategy encourages regulators to risk short-term economic performance in favor of proactive countercyclical measures to cool things off, prioritizing longer-term stability, and accepting that at least some measures would be uncalled for in perfect hindsight. “Leaning against the wind” has gained favor after the global financial crisis, in recognition of the menace posed by bubbles left to burst on their own.
Bubbles themselves are interesting phenomena. In an age of hyper-information and cheap, accessible data-processing power, how do asset prices get bid up to unsustainable levels? Jones considers four models to explain. First, “limits to learning” suggests that investors can and do process information rationally (consistent with efficient markets theory), but because the economy is so complex and the number of relevant data points so vast, there are limits to what individual actors can process and understand. Second, “frictional limits to arbitrage” may exist that bias the market upward; for example, short sales to express conviction of high prices may not be as easy to conduct as purchases because of funding or availability issues. Third, “institutional limits to arbitrage” recognizes the increased prominence of institutional investors (for example, from holding 6% of US stocks in 1952 to 45% in 1991 to 67% in 2010), and the tendency for business risk and compensation practices to encourage herding behavior by investors and strong aversion to assuming career risk by being wrong in the shorter term (so-called “rational bubble-riding,” where missing the momentum of rising prices because of longer-term concerns can easily result in being terminated from mandates, and perhaps from employers, as a penalty for being too early). The fourth model to explain bubbles is “irrational behavior,” in which misconceptions are systematic, and investors tend to herd, extrapolate, and be overconfident.
Jones’ real contribution is to relate policy responses to these possible models of bubble formation, and to point out the challenges of more traditional, “lean” countercyclical policies to asset price booms. His focus in particular on some of the dysfunctions of the incentives between investors and agents, the procyclical effects of market-weighted benchmarks of performance, and a call for longer-term performance appraisal are all useful prescriptions to address institutional practices that may be creating the circumstances for bubbles needlessly. And while Jones’ work doesn’t settle the question of whether asset management firms or their activities are dangerous sources of systemic risk, his contribution to understanding the role of the asset management industry in building asset price bubbles is important to framing the analysis by FSOC and the FSB appropriately.
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