The Financial System Oversight Council (FSOC) is considering whether any asset managers should be designated as systemically important financial intermediaries (SIFIs), making them subject to supervision by the Federal Reserve. In the same vein, the Financial Stability Board recently proposed a framework for determining whether an asset manager is a global SIFI.
The question itself is highly controversial. The asset management industry naturally opposes “bank-like” supervision. Its traditional U.S. regulator, the Securities and Exchange Commission, views the FSOC and the Fed as encroaching on its turf. Politicians who disapprove of the expanded regulatory apparatus under the Dodd-Frank Act tend to view SIFI designation as an illustration of regulatory overreach.
From our perspective, there are two key economic questions we need to answer before considering whether a specific asset manager should be designated a SIFI. First, in what sense can the asset management industry pose risk to the financial system as a whole? And, second, if investment practices that potentially pose systemic risk were properly regulated, are there still circumstances under which an asset manager would be worthy of a SIFI designation?
Top 10 Asset Managers by Assets Under Management
(in trillions of dollars, as of December 31, 2012)
|Vanguard Group Inc.||2.2|
|State Street Global Advisors||2.1|
|Pacific Investment Management Company LLC||1.6|
|J.P. Morgan Asset Management||1.4|
|BNY Mellon Asset Management||1.4|
|Deutsche Asset and Wealth Management||1.2|
|Capital Research & Management Company||1.0|
|Source: “Asset Management and Financial Stability,” Treasury Office of Financial Research, September 2013, Figure 2 (original cites Pensions and Investments)|
The largest asset managers today are not banks. They typically serve as agents who act on behalf of principals, the ultimate investors. Unlike banks and hedge funds, these managers’ balance sheets themselves are relatively small and not highly leveraged. For example, BlackRock, the world’s largest asset manager with more than $4 trillion under management at the end of 2013, has a balance sheet (adjusted for “separate account” assets and for collateral held under securities lending agreements) that is only about $40 billion against more than $26 billion in shareholder equity. Critically, funds under management are not on the balance sheet of the manager, but on the balance sheet of the investors who own them.
Aside from money market mutual funds (MMMFs) – which we analyzed in an earlier post – equity and bond mutual funds have a floating net asset value (NAV), so the investors bear losses directly, rather than diminishing the capital of the fund managers. In most cases, the funds themselves are separate legal entities that rise and fall on their own. So, too, do the firms that manage them.
Some observers see this agency role alone as sufficient to exclude the asset management industry from being systemic. But does it? Probably not.
Starting with the funds themselves, the preponderance are open-ended, so there can exist a first-mover advantage that triggers a run and fire sale. For example, in bad times, investors in an open-end fund with illiquid assets – such as bank loans – have an incentive to run while the fund still has some liquid assets left to sell. In such circumstances, the daily quoted NAV will not fully reflect the inability of the fund to redeem all its shares. One empirical analysis found that, when mutual fund performance has been poor, illiquid funds are indeed subject to greater redemptions (so long as they are not held primarily by large investors). Another study (co-authored by one of us) found evidence of mutually amplifying swings in prices and flows for selected categories of bonds funds (but not for more liquid categories like Treasuries or equities) that appear to be associated with “market tantrums.”
Are these pro-cyclical effects large enough to be systemic? Could they trigger a credit crunch with adverse feedback to the economy? Possibly. But even so, aside from actively managed funds (where managers’ relative performance concerns can lead to herding and pro-cyclicality), the source of this risk is the legal structure of the funds themselves (open- vs. closed-end), not the managers per se. It is a consequence of the activity at the level of the fund, rather than at the level of the asset management firm.
The September 2013 report of Treasury’s Office of Financial Research (written at FSOC’s request) on “Asset Management and Financial Stability” identified several activities of investment vehicles (including, but not limited to, mutual funds) that could be disruptive. These include serving as MMMFs, engaging in repurchase agreements (repo), acting as securities lenders, taking on leverage, and buying and selling of derivatives.
Imagine that U.S. and international regulators were to agree on and implement reforms that addressed the systemic risks from each of these (and any other potentially systemic) activities. Regulating broadly by function rather than by legal form would eliminate or at least sharply diminish the related run and fire sale risks.
In this brave new and safer financial world, would there still be risks at the asset management level? Possibly, but the burden of proof will be high. One key question is, “Would one huge asset manager – measured by assets under management – pose greater risk to the financial system than an array of small managers with identical funds and strategies?” It might. But the focus of supervisors’ attention would then be on operational risks (such as the information technology platform, software, protocols for risk measurement, and physical structure), not on the balance sheets of the managers themselves or on their assets under management.
Perhaps the greatest concern at the management firm level is a scenario in which the lender of last resort would someday be called on to lend to an array of solvent, but illiquid open-end funds run by a common manager. One might scoff at this notion today because it did not happen even in the financial crisis of 2007-2009. But as the provision of private funds shifts further away from banks toward asset managers, it is plausible to think that a credit crunch will become a nonbank phenomenon. Indeed, households’ direct holdings of mutual funds already rival their bank deposits, while asset managers now play a central role in managing pension assets, which dwarf these alternatives (see chart below). As we have argued elsewhere, the “know your customer” rule applies to the lender of last resort. Here, that means supervising the asset manager.
Household Financial Assets: Relative Shares (Percent) of Mutual Funds (including MMMFs), Deposits, and Pension Assets