Is Asset Management the Next Frontier in Systemic Risk?
The Financial Stability Board consultation on the regulation of asset managers ended last week and some recommendations on the subject can be expected by the end of the year. To build on MI’s program on systemic risk and financial stability, our new report “The Asset Management Industry and Systemic Risk: Is There a Connection?” examines the potential catalysts within the industry that could trigger a crisis.
The regulators’ interest in nonbank financial intermediaries is a natural evolution of their policy stance. In the aftermath of the financial crisis, new legislation and regulation have pressured banks (and insurance companies) to reduce their size, leverage and riskier lines of business to avoid another too-big-to-fail debacle. Nonbank financial intermediaries have naturally taken up some of that slack, hence the regulatory scrutiny. The regulators’ goal is to evaluate whether these intermediaries could pose similar risks to financial stability that banks presented pre-crisis. The focus centers on asset managers, which include firms offering mutual funds, exchange-traded funds (ETFs), hedge funds, and private-equity funds.
In contrast with the banking and insurance industries, the asset management industry has historically benefited from limited regulatory oversight of its activities, which range from traditional asset management to alternative investing and direct lending. Therefore, identifying if and how asset managers could trigger the collapse of an entire market or of the financial system is a challenge.
The recent expansion of regulation from institution-based to activity-based scrutiny is an acknowledgment of the industry’s specificities. Yet the debate driven by Basel III guidelines and the Dodd Frank Act in the U.S. focuses primarily on adapting and/or extending banking regulations to other market participants. The stress tests are an interesting illustration because they rely on a clear understanding of the risk mechanism or transmission channel in question. So far, there is no consensus on how to define and measure the concepts of liquidity and leverage, which matter in the context of systemic risk buildup within the asset management industry.
In the report, we provide insights on how asset management might act as a catalyst or contributor to systemic risk. We look at the structure of the industry, at asset managers’ role as fiduciary agents and at some factors, such as illiquidity and herding, commonly associated with systemic risk.
Let us first focus on some of the key issues. It is important to keep in mind that there is a difference between systemic risk and run-of-the-mill financial or operational risk when determining whether a sector poses a threat to the broader financial system, and holds the potential for negative spillovers into the real economy. A closer look at asset managers’ business model shows that they do not take on nearly the same level of leverage and do not guarantee balances on customer accounts as banks do with deposits. Hence, it is unlikely that the industry creates systemic risk. Yet, the potential to transmit or amplify systemic risk based on unique factors such as herding and liquidity mismatches — created when firms offer highly liquid investment terms for their funds while investing in highly illiquid assets — is a major regulatory concern. If we focus on the role of high-yield debt markets we can see that major disruptions to the sector’s funding environment could have a significant impact on the real economy. However, even during periods of acute investor outflows, high-yield mutual funds have managed liquidity risk effectively to-date, and high-yield ETFs have actually been a supplemental liquidity source for institutional investors.
The lack of evidence of a clear connection between the asset management industry and systemic risk does not mean it cannot be a contributing factor. However, it also argues against a system-wide approach and in favor of a regulation by function. This means imposing similar regulations for institutions performing similar tasks (for example, depository institutions and money-market funds) and for having requirements set consistently across markets and institutions.
It also seems necessary to take a step back and remind ourselves, first and foremost, that prudential policies are complements to — not substitutes for — proper macroeconomic policies (monetary, fiscal, structural). The current global monetary policy stance with pervasive low or negative interest rates and continued divergence among major central banks could generate financial instability that prudential policies would be unable to fix. Furthermore, many financial markets and actors are international. As a result, successful toughening of prudential requirements necessitates international coordination. Yet, the recent G7 and G20 summits show that such coordination remains a challenge, especially now that the memory of the crisis grows weaker.
Finally, when it comes to the financial world itself, it is important to keep in mind that it is still adjusting to the post-crisis regulatory framework (for example, the full implementation deadline for Basel is 2019) and it is an extremely reactive and complex environment. Hence, the rules or policies should be targeted sufficiently to strengthen resilience of the desirable economic functions (such as lending to firms) but simple enough to limit regulatory avoidance. Ultimately, it seems rather unlikely that any data sets will provide a complete understanding or mapping of all the risk profiles, and these limitations should be clearly accounted for when designing regulations and their goals.