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
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
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
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
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
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
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
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
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
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
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
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,
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
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
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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
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.