Asset managers and SIFIs: why regulated funds do not threaten financial stability

Author: | Published: 18 Mar 2015
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Dan Waters of ICI Global discusses the important role that asset management firms play in the financial markets, and argues for appropriate regulation

As regulators around the world seek ways to make the financial system more resilient, attention has turned to the asset management industry. Debate over whether funds or asset managers pose any threat to the financial system emerged quickly and has evolved rapidly. In this article we closely examine the role of the asset management industry and regulators' concerns. Unfortunately, many of those concerns appear to be based on the notion that asset managers or funds are "shadow banks"– a notion that overlooks the distinct features and robust regulation of this sector, particularly regulated funds. We explain why regulated funds and their managers are unlike banks and do not occasion systemic risk, and why applying bank-like regulation is unnecessary and would be harmful. Instead, we set out the reasons for a superior approach to addressing systemic risks that regulators may perceive in asset management – regulation of market-wide activities and practices by capital markets regulators.

In September 2013 the US Treasury's Office of Financial Research (OFR) issued its report Asset Management and Financial Stability. The Financial Stability Board (FSB) released its consultation on "assessment methodologies" for investment funds and other non-bank, non-insurer financial institutions in January 2014.

In response, the Investment Company Institute (ICI), ICI Global, and a wide range of stakeholders have provided the US Financial Stability Oversight Council (FSOC) and the FSB with considerable information about the operation and regulation of asset management, particularly such regulated funds as US mutual funds and Undertakings for Collective Investment in Transferable Securities (Ucits). Thanks in part to this growing public record, it appears that the FSOC and FSB are not inclined to rush to judgment on any potential risks in asset management or potential remedies. Instead both bodies are engaging in a more focused examination of potential risks in the markets, activities, and products associated with asset management.

On 18 December 2014 FSOC issued a request for comment on a range of questions about the liquidity, leverage, operations, and resolution of asset managers and their products. Importantly, the FSOC notice pointed out that the Council is focusing its examination on "products and activities" – a shift from the FSOC's emphasis in banking and insurance on designating firms as "systemically important financial institutions", or SIFIs.

The FSB is preparing a second consultation on standards for designating non-bank, non-insurer SIFIs, expected early in 2015. This appears to mark a reconsideration of the FSB's initial approach of focusing solely on the large funds that met the threshold of the FSB's first consultation (those with assets exceeding US$100 billion).

"We have long stated that if regulators believe specific activities or practices pose threats to financial stability, they should use their considerable authority to address those"

The regulated funds that ICI and ICI Global represent, in the United States and in other jurisdictions, welcome opportunities to bring the fund industry's data and expertise to discussions of systemic risk. We believe that such examinations will clearly demonstrate that regulated funds and their managers do not pose threats to financial stability.

After all, even the world's largest registered fund accounts for just 0.19% of worldwide stock and bond markets – and all mutual fund assets amount to less than 15% of those markets. We have long stated that if regulators believe specific activities or practices pose threats to financial stability, they should use their considerable authority to address those – an approach that would be far more effective in enhancing the resilience of the financial system than designating individual managers or funds as SIFIs.

Still – a note of caution

Yet these hopeful signs must be viewed with great caution. Even as the FSOC and FSB acknowledge the need for more data and understanding of asset management, banking-oriented analysts at OFR, the International Monetary Fund (IMF), and bank regulatory agencies continue to speculate about unproven risks based on conjectures that are grounded in neither historical evidence nor plausibility – including risks that are unlikely to rise to a systemic level, even in the very worst crisis.

This approach has prompted one economist to define systemic risk as a "grab bag of scenarios", however improbable, "that are supposed to rationalise" more and more intervention by banking regulators in capital markets.

We believe – and the evidence shows – that neither the largest regulated funds nor their managers pose systemic threats to the financial system.

We do not say this to avoid regulation. Indeed, the fund sector around the world has thrived under sound regulation that addresses risks to investors and the capital markets. In particular, since the global financial crisis, ICI, ICI Global, and our members around the world have actively supported efforts to address abuses and close regulatory gaps exposed by that upheaval.

Instead, we want to encourage a debate over where and how risks to the financial system at large may occur and what the most effective tools are to address such risks, out of the many tools that regulators have at hand. And we want to ensure that regulation does not undermine the unique role that asset management plays in financial markets. None of today's economies, anywhere in the world, can afford to burden capital markets with inappropriate rules to address speculative risks.

Putting the blame on the "shadows"

Much of the search for systemic risk in asset management stems from banking regulators' fixation with shadow banking. Let's step back for a few seconds and examine that.

In the six years following the bankruptcy of Lehman Brothers, which ignited the worst financial firestorm in generations, banking regulators seem to have reached an agreement to blame that crisis on shadow banks. They define shadow banking so broadly that the term could apply to almost any financial activity done without a banking charter. And they imply that such activities are inappropriate, and motivated primarily by the desire to engage in banking functions while avoiding banking regulation.

In the fund industry, the term shadow banks was first applied to money market funds. But now it is used more broadly, to sweep in all investment funds – not just money market funds, but all regulated funds, including Ucits and US mutual funds that invest in stocks and bonds.

However, asset managers and their funds are not banks. Applying the framework of bank-style regulation to regulated funds or their managers would harm these funds, their investors, and the capital markets.

And we reject the notion that our funds operate in shadows. Regulated funds are the most well-lit and transparent of all financial products. As we have told the FSB, shadow banking is a pejorative term that mis-states the activities, the importance, and – in the case of regulated funds – the strong regulation that governs our practices.

Instead of dealing in speculation and labels, ICI, ICI Global, and our members have worked to assemble a large, growing body of hard data and analysis, and to educate policymakers about the structure and experience of regulated funds globally. Our emphasis, based on our mission, has been on regulated funds. Yet many of the principles we discuss apply to other funds and their managers as well.

Funds are not banks

As the FSB recognised in its 2014 consultation on investment funds, regulated funds have a very different risk profile from the banks and other financial institutions that are the focus of systemic risk considerations.

These funds typically make little use of leverage, and leverage has proved to be the essential fuel of financial crises. Virtually all major financial crises have involved debt that has grown dangerously out of scale. That most certainly includes the great financial crisis we all just experienced.

The largest US banks, those that have been designated as global SIFIs, carry about $10 in debt for every $1 of their own equity. For the world's 11 largest stock and bond funds (all of which are US funds), the comparable figures are about four cents in debt for every $1 of their own equity.

Banks invest for their own accounts, as principals, and put their own money at risk. That is one reason why banks need to have capital on hand: to absorb losses that could bankrupt them.

In contrast, fund managers invest for their funds, as agents. The gains or losses in the fund belong to the fund's investors. In short – banks are exposed to investment risks and hold capital to protect depositors and taxpayers from losses. Fund managers leave risk-taking to their end investors. That is why fund managers do not need capital as banks do.

Another implication of the shadow banking epithet is that non-bank institutions are unregulated, or that capital markets regulation is inferior to banking regulation. This, too, is untrue.

Strict regulation and no disorderly failures

Regulated funds operate under strict regimes that limit their potential to cause broad systemic effects. Under many fund regimes, including Europe's Ucits directives and the US regulations under the Investment Company Act of 1940, funds are subject to rules governing transparency; diversification of their portfolios; liquidity to meet demands for redemptions; and frequent, if not daily, valuation of their holdings. Their use of leverage is also limited. A custodian holds all the assets of the fund, and neither the fund's manager nor its creditors has any claim on those assets.

This comprehensive regulation of funds protects fund investors, while serving to limit risks that could have broader effects on the financial system.

Regulated funds differ from banks in another key way: these funds do not fail in the same way as banks. At highly leveraged banks, losses can wipe out their capital and leave them bankrupt: unable to repay depositors and other creditors. Regulators' fears about "disorderly failure" are based on that experience with banks and other highly leveraged institutions, and don't apply to regulated funds.

"We want to ensure that regulation does not undermine the unique role that asset management plays in financial markets"

Banks guarantee customers that they will get their money back plus interest. Funds have investors, and make no such promise. They don't promise any gain on investments. They do not even guarantee that investors will get their principal back. If a fund's investments prosper, fund investors share the gains, on a pro rata basis.

And if the fund's investments lose value, the investors know and expect that the losses are theirs. In most regimes, regulated funds keep score on the ups and downs of their portfolios frequently, even daily, calculating the market value of all their holdings and disclosing their net asset value.

With little or no debt and frequent mark-to-market valuation, funds aren't likely to become insolvent. And when a fund does close, those same features mean that it is relatively easy to unwind. In the United States, funds that do close follow an orderly process.

Literally hundreds of stock and bond mutual funds and dozens of fund managers exit the US market every year. Not one requires government intervention or taxpayer assistance. Contrast that to banks.

Real-world "stress testing"

Even when confronted with all these reasons why regulated funds do not create systemic risk, banking regulators cling to one notion: the idea that fund investors are subject to panics and de-stabilising runs that can create "fire sales", drive down markets, and spread damage to other investors and institutions. They fear that the ability of investors to redeem fund shares could create severe liquidity pressures on markets.

These concerns are misplaced, for two reasons.

First, regulated funds offer investors the ability to redeem shares on a regular (usually daily) basis. This is a defining feature of these funds, and one around which many of the regulatory requirements and operational practices for these funds are built. In particular, these funds maintain much of their portfolios in liquid investments. US mutual funds, for example, must maintain 85% of their assets in liquid securities.

Fund managers also may have liquidity management tools at their disposal that can be used on a temporary basis. In the United States, for example, a mutual fund has up to seven days to pay proceeds to redeeming investors and may reserve the right to redeem in kind – to provide redeeming shareholders with portfolio securities, rather than cash. Fund managers in other jurisdictions have other tools, including temporary gates, to manage redemptions.

Second, the notion that investors in regulated funds are prone to flight simply does not withstand closer scrutiny, certainly not for regulated funds that invest in equities and bonds.

Modern US mutual funds have been through a lot of what bank regulators call stress testing, in the real world of markets, during their 75-year history. The evidence is consistent and compelling: US stock and bond funds have never experienced the de-stabilising runs that regulators and the media imagine. In every period of market turmoil since World War II, stock and bond mutual fund investors did not run; fund sales of stocks or bonds accounted for a modest share of total trading; and fund sales had a minimal impact on asset prices.

Take, for example, 2008. It was the second-worst year for the US stock markets since 1825. From October 2007 to February 2009, the S&P 500 index fell by more than 50%. In the midst of this turmoil, US stock fund investors withdrew, on net, 3.6% of assets: less than $1 in every $25.

Proponents of the myth of the flighty investor are persistent; they keep trying out new theories. Yet in every case they raise – high-yield bond funds, emerging-market funds, and so forth – we have examined the data for US funds, and have never found evidence to support the speculations that stock and bond fund investors move en masse and de-stabilise markets.

The stakes are high

So regulated funds and their managers are not at all like banks. They employ little to no leverage. The managers operate as agents, not principals, and the funds are subject to comprehensive regulation. These are some of the reasons why we can say confidently that regulated funds and their managers do not occasion systemic risk.

Why are ICI and ICI Global so persistent in driving that message into the public debate? Because the stakes for our funds, their managers, their investors – and our economies – are so high.

The model that some regulators have in mind for regulated funds or their managers is banking regulation or, in the term that is en vogue with central bankers, macro-prudential regulation.

That could mean applying bank-like capital standards to regulated funds – a change in the basic model of fund investing. Funds don't need capital buffers because they pass gains and losses through to their investors. But setting aside a percentage of a fund's assets for capital could severely undercut that fund's performance and competitive standing. The costs would fall on the fund's investors: at least, until those investors saw the harm and took their assets elsewhere.

Funds subjected to bank-style regulation could also face higher fees and taxes to pay for their own regulation. And in the United States, a designated fund could be subject to assessments to help bail out other financial institutions. Under the Dodd-Frank Act, if a big bank fails and its assets won't cover its debts, the government can assess all other SIFIs – including any designated mutual funds – to make up the difference.

SIFI designation also would be likely to render regulated funds subject to prudential supervision by central banks or other banking regulators. That could give regulators broad power that would even reach to the fund's portfolio management. In the United States, the Federal Reserve could substitute its prudence for the fiduciary judgments of a SIFI-designated fund's investment adviser.

All of these costs and burdens would fall uniquely on those funds designated as SIFIs: likely to be the largest and most successful funds or fund families. In the competitive markets in which regulated funds operate, designation would not make a fund "too big to fail" – it would render it too burdened to succeed.

A better approach to risk in capital markets

Fortunately, there is a better way to approach any risks that regulators might perceive in funds and asset management. That approach is to regulate activities or practices that authorities perceive as risks to financial stability, and to regulate them across markets and participants.

An activity-based approach is more comprehensive: it is more likely to address all of the market participants engaged in an activity that could pose threats to stability, in a way that singling out one or a few large firms or funds for designation would not. For example, ICI is participating in an industry-led initiative to shorten settlement cycles for a wide range of US securities – work that will help address settlement risks for all market participants, not merely for the narrow slice of activity represented by funds.

Just as important, activity-based regulation starts with identified activities and practices that pose demonstrable risks. That is in stark contrast to the hypothetical and improbable scenarios that have dominated much of the discussion to date.

Finally, targeting activities and practices will engage primary regulators that have deep experience and expertise with specific industries and markets. For regulated funds, those are the capital market regulators – rather than the banking regulators that have thus far dominated and largely driven systemic risk discussions. Given the vast differences between banks and regulated funds, it makes sense to call upon capital markets regulators.

In fact, the primary regulator of US regulated funds and their managers, the Securities and Exchange Commission (SEC), has laid out a specific agenda to enhance its already extensive regulation of asset management. In a speech in December, chair, Mary Jo White discussed: potential recommendations to enhance and modernise data reporting by funds and managers; referred to Commission plans to examine liquidity management and the use of derivatives in mutual funds and exchange traded funds (ETFs); and described a possible requirement for managers to develop "transition plans" to help weather any major business disruption. She also mentioned that the SEC is considering ways to implement requirements under Dodd-Frank for annual stress testing by large investment advisers and large funds, and is considering how to tailor the requirements, which also apply to other types of large financial companies, for asset management.


Dan Waters
Managing director

ICI Global
35 New Broad Street
London, EC2M 1NH, United Kingdom
T: +44 203 009 3100

But even as she spoke about ways to bolster asset management regulation, chair White emphasised that the SEC's objective is not to eliminate all risk. She said that investment risk is "the engine that gives life to new companies and provides opportunities for investors" and called for "preserving the principle of 'reward for risk' that is at the center of our capital markets.".

Such a balanced view is sorely overdue in the debate over financial stability. According to the International Investment Funds Association (IIFA), regulated funds worldwide manage almost $31 trillion in assets. They are a large and growing source of finance for economies around the world. They are a key mechanism for investors to save for retirement and other long-term goals.

For ICI and ICI Global, preserving the unique role of these funds, under a regulatory regime administered by those who know the capital markets best, is our goal.