Possibly one of the most important post-Dodd-Frank reports impacting asset managers was released this week by the Office of Financial Research (OFR). Asset managers have argued long and loud that they did not cause the “great recession” and should not have been regulated as a result. The OFR has provided a response: yes, they should be and more reports and regulations may be required.
The OFR was created by Dodd-Frank to support the Financial Stability Oversight Council (FSOC). In that capacity, it has written a report to the FSOC discussing whether asset management firms are systemically important and thus worthy of oversight by the FSOC—as it is now doing for bank holding companies and certain other large financial services companies.
A few takeaways from the Asset Management and Financial Stability report are as follows:
1. The regulators need more information. There are data gaps that need to be filled about:
Managed accounts, the types of assets they hold, their exposures and leverage;
Securities lending and repo markets and collateral arrangements generally; and
Financial stability and soundness of the asset management firms themselves.
2. Separate accounts seem to be squarely in the line of regulatory scrutiny. Those with complex strategies are of particular interest to the OFR.
3. Asset management firms may be asked to disclose more about their financial condition. The OFR also noted that in the US (as opposed to the UK) firms do not need to maintain liquidity or capital reserves and are not required to have chief risk officers.
4. The report discussed several combinations of fund and/or firm activities which could pose, amplify or transmit threats to the financial system.
Firms and funds that imbed alternatives in retail products.
Funds holding less liquid assets (such as CLOs, emerging markets equities or thinly-traded fixed-income).
Firms and funds that offer an implicit guarantee of support in the event of a crisis.
Firms and funds that engage in securities lending, repo and other leveraged transactions.
Asset management firms that have multiple lines of business and engage in business across multiple countries or markets.
Those managers or funds with a large market position in a particular asset, sector or strategy—especially if informational or other barriers might prevent an inflow of other investors during a crisis.
Those that participate in crowded markets or trades that exhibit “herding.”
Funds with funding mismatches.
Funds of funds with investments in both liquid and illiquid funds.
It’s unclear which of these will ultimately make their way onto the regulator’s wish lists…but you can be sure they are noodling about this right now. In fact, the SEC opened a webpage asking the public to provide feedback on the study. Those who feel strongly about the issues should consider commenting now.
Systemic risk posed by investments funds is not just a focus in the US. Across the pond, UK regulators have recently zeroed in on whether hedge funds are ready to fall as interest rates rise.
Earlier this year the UK officially established the Financial Policy Committee (FPC), a body designed to identify and monitor systemic risk—just like FSOC in the US. In June, an FPC report called for an investigation into the impact on UK financial institutions from a rise in interest rates. The FPC revealed its preliminary thoughts—hedge funds are particularly vulnerable due to their use of leverage. As a result, UK regulators are in the process of gathering additional information about hedge funds so that “a more complete assessment of risks to financial stability can be made.”
Precisely where the will chips fall on systemic risk oversight is yet to be seen; what is becoming obvious is that the regulators, on a worldwide basis, are beginning to marshal their arguments that some segments of the asset management industry should be brought into the fold.