Systemic risk designation threatens major new costs for large asset managers.
[This article originally appeared on our sister site, IndexUniverse.eu.]
After the financial crisis regulators first targeted the banks in an attempt to ensure future financial stability. Then insurance companies found themselves in the spotlight. Now it’s the asset managers’ turn.
Two years ago global regulators issued a list of banks whose failure would threaten outsized costs to the global economy. The list identified 29 systemically important financial institutions (“SIFIs”) as distinct from other banks as a result of their size, complexity and interconnectedness.
The SIFI designation carries higher capital requirements for the firms concerned, as well as more intrusive scrutiny from supervisors and heavier reporting requirements.
Earlier this year US regulators extended the SIFI label to three non-bank financial institutions: two insurance companies (AIG and Prudential) and the financial arm of a major conglomerate (GE Capital). Certain large financial market utilities like central clearing counterparties (CCPs) and central securities depositaries (CSDs) have also been deemed systemically important.
In a sign that their investigations are broadening, regulators are now taking a close look at the asset management industry, aiming to work out if certain firms or activities within the sector also merit the systemic label.
In June, the European Parliament’s Economic and Monetary Affairs Committee issued a warning of the potential increase in financial market risks as a result of the activities of fund managers.
“We are now seeing the growth of much larger asset management firms, many of whom are exploring new business opportunities that could fundamentally change their business models and over time increase their systemic importance,” the Committee’s rapporteur, Kay Swinburne, wrote.
Two weeks ago the US Treasury’s Office of Financial Research (OFR) published its own report on the fund management sector. The OFR says it aimed to analyse “how asset management firms and the activities in which they engage can introduce vulnerabilities that could pose, amplify, or transmit threats to financial stability”.
For banks, the pros and cons of SIFI designation may seem surprisingly balanced: some even argue that the cachet of being officially “too big to fail” outweighs the cost of holding more capital than non-SIFI competitors.
But for asset management firms, which are much more thinly capitalised than banks, systemic status could be highly disruptive.
“US asset managers are deeply worried about being defined as a SIFI and suffering a huge capital hit as a result,” one market observer told IndexUniverse.eu, speaking on condition of anonymity.
The debate over systemic importance carries extra resonance for the index fund and ETF business.
The three largest global players in the ETF market by assets under management (BlackRock, State Street and Vanguard) are also the three largest asset managers mentioned in the OFR’s report.
The OFR devotes a section to ETFs in its report. ETFs, says the OFR, “may transmit or amplify financial shocks originating elsewhere”.
But the systemic risk debate, the OFR makes clear, is about fund liquidity in general.
“Any collective investment vehicle offering unrestricted redemption rights could face the risk of large redemption requests in a stressed market if investors believe that they will gain an economic advantage by being the first to redeem,” the OFR goes on.
The OFR identifies funds with money-like characteristics, such as money market funds, as presenting the greatest risk of an uncontrolled redemption stampede. But the US Treasury’s researchers argue that mutual funds, including ETFs, could also cause market contagion, particularly in thinly traded asset classes like fixed income.
Even if asset managers may have no legal obligation to support their funds financially during a crisis, the OFR says, many specifically reserve the right to do so in their regulatory filings. And the OFR notes that “investors may believe that they can rely on [such] sponsor support…because of the way a product was marketed or because such support has been granted in the past.”
Sponsor support of funds is common in the ETF market: for example, when issuers provide indemnities to investors in funds involved in securities lending activity; or when issuers pay market makers to support trading activity in their funds.
Fund management activities that give rise to particular systemic risk concerns include securities lending, repo and reverse repo and the leveraging of fund assets, for example via the use of derivatives, the OFR says.