Asset managers: Too big to fail?

Global regulators have become increasingly worried about the growth of the asset-management industry and the risk that it could pose in terms of contributing to a future financial crisis. Estimates on the total size of the global market differ, but one firm alone, New York-based BlackRock Inc., reported assets under management of US$4.6 trillion at the end of 2014.

A primary concern of both regulators and oversight bodies is liquidity risk, a topic addressed by Carolyn Wilkins, senior deputy governor of the Bank of Canada, as part of a speech she gave in May on the broader issue of liquidity and the economy.

“The salient question here is what happens if many funds see large numbers of investors asking to redeem at the same time,” Wilkins said. “The worry is that fund managers may not have enough cash holdings and may be forced to incur large losses as they sell assets to cover redemptions.”

Both the Switzerland-based Financial Stability Board (FSB)on the global stage, and the Financial Stability Oversight Council (FSOC) in the U.S., are contemplating designating certain asset-management firms as “global systemically important financial institutions” (G-SIFIs), as has been done with large banks, and possibly imposing capital-holding requirements, as well as other conditions, on these firms.

There is concern that designating asset-management firms as G-SIFIs would be inappropriate and that investment funds operate in a markedly different manner than do banks and insurers: asset-management firms make little or no use of leverage; they don’t fail in the same way as banks and insurers do; their structure and existing regulatory framework limits systemic risk; and investment funds and their unitholders have not demonstrated behaviours that might pose systemic risk.

Capital reserves

If asset managers are required to hold capital reserves, individual unitholders will bear the costs. “[And] any capital reserves that are sitting in a mutual fund are not generating returns in the stock or bond market,” wrote Bill McNabb, chairman and CEO of U.S.-based Vanguard Group in an opinion article published in May in the Wall Street Journal.

Asset managers believe the size of the industry does not present a risk in itself to the global economy. “[Total assets] are really still quite small compared to the capitalization of markets out there and institutional assets,” says Howard Atkinson, chairman of the Canadian ETF Association and president of Horizons ETFs Management (Canada) Inc., both of Toronto.

Three risks

In a consultation document released in March, the FSB, which is charged with promoting international financial stability, identified three risks associated with certain non-bank, non-insurance financial entities, including the asset-management industry. The risks are: the effect of a failure of an entity; the inability of an entity to provide a critical function required by the market; and the forced liquidation of assets.

There also is concern that a significant portion of the assets flowing into investment funds in the past several years is being directed toward index-investing or passive-investing vehicles, which may lead to unintended distortions in the market.

“The whole idea of financial markets is that there are many different investors with a heterogenity of beliefs, and that’s how trading happens,” says Saurin Patel, an assistant professor of finance at Ivey Business at the University of Western Ontario in London, Ont. “If everyone is a passive investor, then you have less trading [and] the price discovery mechanism of a particular stock is inefficient – and that leads to bubbles and busts.”

The risk of too many investors in index strategies is overstated, says Atkinson, arguing that if price discovery were compromised, assets inevitably would flow back into active-management strategies.

“It’s self-correcting.” Atkinson says. “Active management would have a huge advantage in those situations.”

The regulation of the asset-management industry should be left to capital markets regulators, as it is in Canada, rather than to bank or prudential regulators, IFIC argued in a letter to the FSOC dated March 25: “We urge the council to adopt a similar approach and allow the [Securities and Exchange Commission] to pursue its mandate of overseeing the U.S. securities market.”

Although some new regulatory oversight of the asset-management industry at a global level is likely, the industry hopes that regulators proceed carefully.

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