In the epilogue to her excoriating treatment of the misguided and corrupt response of the American regulatory authorities to the financial crisis, Sheila Bair, the former chairman of the Federal Deposit Insurance Corporation (FDIC), confirms what we all know about how regulation really works. “The problem is that the financial regulatory system is so insular,” she wrote. “Regulators start to confuse what is best for large financial institutions with what is best for the broader public. They are not the same.”
Today, new and emerging fund managers are spending half or more of their management fees on compliance with regulations that are designed to drain financial markets of systemic risk. This is putting their commercial viability at risk. Yet it is hard to sustain the argument that even the largest fund managers, let alone the smallest, represent a systemic risk that is comparable to that posed by any one of the six most important banks in America. Start-up and emerging fund managers, which are the principal source of innovation in any market, are becoming collateral damage in an unworkable regulatory endeavour immune to its own absurdity.
Entrepreneurial activity in fund management is being suppressed as an inadvertent by-product of regulatory measures built on the irreconcilable contradiction that banks which are too big to fail are also too big to be unprofitable. This is public policymaking at its worst. The result is not just a growing concentration of financial assets and liabilities with a small number of giant banks whose systemic importance is greater than ever. The burden of regulation, including frequent and detailed reporting, is also leading to a concentration of investment capital at a diminishing number of giant institutional fund managers.
In the American mutual fund industry, the top five firms now control two out of every five dollars invested in mutual funds. The top 10 manage more than half the assets of a $15 trillion industry, and the biggest 25 three quarters of them. In the hedge fund industry, the 100 largest managers control at least two thirds of assets under management (AuM). The Financial Conduct Authority (FCA) estimated that the 12 largest hedge fund managers in the United Kingdom control 82 per cent of net AuM and 94 per cent of gross notional exposure.
Regulation is infamous for its ability to generate unintended consequences, but an acceleration of concentration within the fund management industry of this kind was entirely foreseeable. Every schoolboy economist, let alone Carmen Segarra or Brooksley Born, knows that regulators are invariably the captives of powerful interests. Incumbents habitually use regulation to raise barriers to entry, while simultaneously purchasing relief for themselves from its most onerous provisions. In a financial system as fragile as the one which currently prevails, the benefits of regulatory capture even include the subsidisation of funding costs and implicit profit guarantees.
For buyers of fund management services, the consequences of this Potemkin regulation for giant corporations are dire. Innovative fund managers armed with new insights or technologies are being thwarted by the heavy costs of regulation before they even have a chance to enter the market.
This is deleterious to the long term health of the investment management industry, and injurious to the savings of the public, who are the ultimate consumers of its products. If it is harder for start-up fund managers to establish themselves, and emerging managers to grow, investors will have less choice, and pay higher prices for worse performance. Unfortunately, if regulators are the captives of the regulated, the institutional intermediaries that allocate the savings of the public have succumbed to Stockholm syndrome. They shun any manager which cannot demonstrate an operational and compliance infrastructure capable of withstanding any conceivable due diligence or regulatory test. Fortunately, there is a force powerful enough to break this drive to uninspired gigantism in fund management. It is the sheer pretension of the regulations. If regulators are not overwhelmed by the quantities of information they are seeking, they will certainly be defeated by the impossibility of basing sensible decisions upon it.