Two significant developments last week shed light on the issue of how U.S. regulators may address systemic risk. The Office of Financial Research—the R&D arm of the Financial Stability Oversight Council—released a working paper that discussed an “agent-based model” for analyzing vulnerability of the financial system to fire sales and the FSOC announced that staff will “undertake a more focused analysis of industry-wide products and activities to assess potential risks associated with the asset management industry.”
At last we have official responses to the position taken by money managers who were concerned that they might be deemed SIFIs (that is, systemically significant firms). Those in the line of fire countered that they are “only” agents and thus do not create systemic risk in the same manner as banks, which trade on their balance sheet. Their arguments appear to have made an impact; the FSOC seems to be shifting away from its earlier suggestion that specific asset management firms may be systemically important.
The question now is, “where are the regulators going?” The answer, although it is still too early to say for sure, appears to be that they are adopting a different approach, which could impact a wider group of participants in the financial service markets.
As the OFR report highlights, systemic risk brought on by a crisis is not a repeat of the past but represents the unleashing of new forces. It also notes that subsequent shock waves can exceed the initial triggering event in importance. For this reason OFR and the FSOC are considering whether agents (or at least the activities they engage in) play a role in transmitting shock waves. One example of such possible transmission is through asset-based fire sales by investors with leverage. Think hedge funds.
The OFR and FSOC seem to be laying the groundwork to claim that numerous players engage in activities that could impact the stability of the markets. The working paper seeks to build detailed maps of the flows from shock waves. What might they do next? Collect even more information to get more of the picture seems a likely first step. But over the longer term, the scope of the regulations (while perhaps less targeted on the governance of particular large asset managers) could cut a wider swath throughout the financial markets themselves. We are a long way from being done with the process of regulating the markets.