The re-regulation agenda set by the G20 aims beyond banks. It includes policing the alleged contribution to financial instability of the global fund management industry. The logical conclusion is the regulation of major fund management houses by central banks, in much the same way as the global banks, and a number of regulatory initiatives mean that threat is not that far away.

Ever since the Financial Stability Board (FSB) invented them in its notorious list of November 2011, shared with world leaders at the G20 meeting in Cannes that month, systemically important financial institutions (SIFIs) have provoked discussion about which banks count, and which should not – for being on the list entails paying an additional capital tax. The G20 was so impressed it asked the FSB to extend the concept to fund managers and insurance companies.

In the United States, Congress had by late 2011 identified as a SIFI any domestic or foreign bank holding company with more than $50 billion in assets. It assigned to the Financial Stability Oversight Council (FSOC) - the government agency set up under the Dodd-Frank Wall Street Reform and Consumer Protection Act to monitor the stability of the American financial system – the task of deciding exactly which bank holding companies should receive this dubious honour.

That threshold was always low enough to threaten to extend beyond the banking industry into the so-called “shadow banking” industry, where fund managers interact with broker-dealers in what central bankers increasingly read as a de facto banking business. As Paul Tucker, a former deputy governor of the Bank of England, put it in a seminal speech on shadow banking in April 2012, “anyone holding a securities portfolio can build themselves a shadow bank using the securities lending and repo markets. One simply lends out the securities at call for cash, and then one employs that cash by making loans or buying credit-assets with a longer maturity. This is leverage and maturity mismatch.”

Tucker did not identify insurance companies as part of the shadow banking nexus, but they also tend to qualify for the FSOC watch list – on the face of it, with rather more justification than fund managers. American taxpayers forked out $182 billion to rescue American International Group (AIG) in the great financial crisis, after its AIG Financial Products subsidiary over-extended itself in the credit default swap market. This is one big reason why users of derivatives now have to report them to trade repositories.

Non-bank, non-insurance (NBNI) financial companies are also on notice. A paper by PricewaterhouseCoopers (PwC) warns farm credit unions, stock exchanges, central counterparty clearing houses (CCPs), swap execution facilities (SEFs), derivative trade repositories, speciality lenders, broker-dealers, futures commission merchants (FCMs), fund managers and hedge fund managers that the FSB as well as FSOC might one day get around to designating them as SIFIs.

Fund managers are at particular risk. FSOC is considering whether to label certain asset managers as SIFIs, which would make them subject to supervision by the Federal Reserve. However, recent reports suggest FSOC is refocusing its scrutiny towards the type of products being sold by asset managers.

The FSB, which is housed by the central bank to central banks – the Bank of International Settlements (BIS) in Basel – issued in conjunction with the International Organisation of Securities Commissions (IOSCO) a consultative paper on 8 January 2014 on “assessment methodologies for identifying non-bank, non-insurer global systemically important financial institutions” or G-SIFIs. It followed a request from the G20, meeting in St Petersburg in September 2013, to do exactly that.

In essence, the FSB-IOSCO paper of 8 January 2014 proposes that any large, complex and global financial institution whose activities are hard to replicate quickly, and whose failure would undermine the stability of counterparties, prompt fire-sales that damage asset prices or lead to the loss of a critical service, is a potential G-SIFI. In the fund management industry, the FSB-IOSCO paper reckons a number of funds, fund families, fund managers and fund managers running large numbers of funds pose counterparty and asset price risk large enough to make them candidates for G-SIFI status.

The paper sets a “materiality threshold” for funds of US$100 billion in net assets under management (AuM) that is to say, the amount of capital investors could lose, excluding leverage, or, in the case of a hedge fund, $400-600 billion in gross notional exposure (that is to say, the absolute sum of all long and short positions, which includes both orthodox and synthetic leverage via the notional value of derivatives). In other words, hedge funds with at least US$100 billion in net AUM, or between US$400 and US$600 billion in gross notional exposure, would be assessed annually by national regulators for G-SIFI status.

The proposals attracted 47 public responses, which were published by the FSB on 25 April 2014. The respondents included the major several of the largest fund managers in the world (BlackRock, Capital Group Fidelity, PIMCO, SSgA and Vanguard) and a major hedge fund manager (Brevan Howard) as well as the leading trade associations. A sampling of these suggests that the approach taken by the FSB and IOSCO is not popular in the fund management industry.

In a 41 page submission whose length come close to matching the 44 page FSB-IOSCO paper, BlackRock argues forcefully that leverage is more important than size and that, as agents rather than principals, fund managers are not a source of systemic risk. It adds that fund managers disappear regularly through failure or acquisition without causing problems. In its submission, Vanguard agrees leverage is a better indicator of riskiness than size. Brevan Howard argues against the use of gross notional exposure for hedge funds, describing it as “a fundamentally flawed metric.”

In its submission, the Alternative Investment Management Association (AIMA) also argued that asset managers (unlike banks, insurers and broker-dealers) are agents, and the assets belong to the investors. It added that the great financial crisis had proved hedge funds in particular were not systemically dangerous: “Prior to and during the recent financial crisis, thousands of funds have been liquidated or failed without causing systemic disturbances and we therefore do not consider that is it necessary to impose additional regulation to that which has already been imposed on the industry with the aim of mitigating systemic risk.”

Ironically, the FSB-IOSCO accepts in its original paper many of the arguments advanced by fund managers. It agrees that investors (who accept risk, but also collect rewards) are not analogous to depositors (who assume risk but collect no rewards), that fund managers are agents and not principals, that managers start, get taken over and even fail all the time without causing systemic problems (LTCM and the Reserve Fund are the exceptions). In fact, the FSB-IOSCO paper specifically excludes “substitutability” as a problem in fund management failure. It even acknowledges the systemic risk benefits of redemption gates, payments in kind and side-pockets.

The concerns of the FSB and IOSCO arise from other considerations. The paper lists a variety of “individual indicators” (see Table 1) would be taken into account in an assessment of whether a fund manager that cleared the “materiality threshold” is a G-SIFI or not. In terms of detail, they certainly include leverage, but also extend to re-hypothecation, correlated trades, use of derivatives, access to unencumbered cash, portfolio liquidity, high frequency trading, cross-border activities, and especially the impact of disorderly fund failures on counterparties (notably the investment banks, and especially the prime brokers).

This last point is a material one, based on memories of what happened in 2008. In the United Kingdom, the Financial Services Authority (FSA) – the precursor to the Financial Conduct Authority (FCA) – published a study in 2012 arguing that hedge funds did not pose a systemic risk, but that fire-sales of hedge fund assets in distressed market conditions were bound to affect asset prices and liquidity. The risk of a concentration of counterparties, and especially counterparties which supply a G-SIFI with finance, is also raised in the FSB-IOSCO paper.

The methodologies for determining a G-SIFI outlined in the FSB-IOSCO paper bear an unsurprisingly close resemblance to the methodologies favoured by the FSOC in the United States, in order to fulfil its obligation under Section 113 of the Dodd-Frank Act to decide which non-bank financial companies need to be regulated by the Federal Reserve. This means FSOC is somewhat ahead of the FSB-IOSCO, in the sense that it has adopted (on 3 April 2012) and published a final rule setting out how it will select the non-bank financial firms that must submit to supervision by the Federal Reserve as SIFIs.

Any business which derives 85 per cent of its revenues or assets from financial services is a contender, and the final rule sets out a three stage process by which those that count as SIFIs will be selected (see Table 2). The first stage sets six quantitative thresholds. Any financial institutions which pass those thresholds will be analysed in a second stage according to six criteria not unlike those selected by the FSB-IOSCO paper, on the basis of publicly available information. Worrisome entities will then be further evaluated in a third stage, in which the regulator will demand further data from the institution itself to assess its systemic riskiness not only by the same six criteria as in stage two but also qualitative criteria.

The final rule outlines the “determination process” by which a fund manager will be assessed at the third stage. A notice of consideration will be sent, giving the manager the opportunity to contest the investigation in writing within 30 days. If the regulator still decides to go ahead, a written notice will be sent, explaining the basis of the proposed determination. This written notice will not be made public, and the manager can request a hearing to contest the proposed determination, again within 30 days. Any manager deemed to be a SIFI will be informed at least one business day before a final determination is made public.

Any firm that reaches that point will by definition have failed to satisfy FSOC that it is not a threat to the financial stability of the United States, and be regulated like a bank, by the Federal Reserve. Quite what information the manager will then have to make available to the Federal Reserve will be decided by the Federal Reserve after the fact. After that, the only hope for managers dismayed by the outcome is an annual “re-evaluation and rescission” process, in which the FSOC will re-evaluate and occasionally rescind a determination that a fund manager is a SIFI.

The decision-making process leading to “determination” as a SIFI is clearly more judgmental than either of the first two stages. As FSOC conceded in its final rule, “the Council does not believe that a determination decision can be reduced to a formula.” It does, however, mention five considerations en passant (see Table 2). In a paper reviewing the impact of the final rule, Deloitte warned that a stage three investigation was likely to probe the complexity of the funding, legal and operational structures of a firm, its dependency on intra-group transactions and funding, its ability to break itself up successfully and preserve value if it failed, the likelihood of continuing to provide critical services while being resolved, and its overall complexity and opacity.

Not many hedge funds are going to be caught by the thresholds proposed by either the FSB-IOSCO paper or FSOC. A 15:1 leverage ratio was a rarity even in the golden age of hedge fund investing – the great exception, LTCM, was leveraged 25:1 at the time of its demise in 1998 - and is now almost unheard of among managers, if not among the investment banks which service them (and broker-dealers are one of the non-bank categories at which the FSB-IOSCO measures are aimed, complete with their own “indicators” of systemic importance). The FCA, the regulator of the fund management industry in the United Kingdom, found in its March 2014 annual survey of the domestic hedge fund industry that leverage averaged 4.2 times Net Asset Value (NAV).

However, there is plenty of mutual and money market funds which will not struggle to clear thresholds of $50 billion or even $100 billion (see Table 3), though the rapid alterations in the league table of the biggest mutual funds bear witness to the ability of the industry to cope with substantial inflows and outflows without causing ban-style runs. The exception to this is the Reserve Management Company money market fund, whose investments in Lehman Brothers paper caused it to “break the buck” in 2008, but it had much less than $100 billion invested at the time, suggesting size is not the most appropriate criterion of riskiness.

However, fund size is not the only criterion by which the FSB-IOSCO paper proposes to assess systemic risk in fund management. It also identifies fund families and stand-alone fund managers as potential sources of problems. This puts firms such as BlackRock (with $4.3 trillion in AuM), Vanguard ($2.9 trillion) and Fidelity ($1.9 trillion) in line for special regulatory treatment. However, the FSOC recently retreated on that front, announcing it had directed its staff to move away from evaluating the systemic risks posed by large asset managers to focus on the particular funds and investment strategies they offer investors, and their other activities. The conclusions of the FSB-IOSCO consultation, which closed in April, have yet to be published.

However, the risk that large asset managers will be designated SIFIs and G-SIFIs has not gone away. If so, they might find themselves subject to bank-style capital, leverage, liquidity and reporting rules. “If an asset manager is designated as a SIFI, it may be subject to strict reporting, monitoring and capital requirements,” says Bibb Strench, counsel in the investment management practice at Seward & Kissel in Washington DC. “Large asset managers presently complying with securities regulations could be further burdened by a new regulator imposing bank holding company type regulations on it.”

The implications for a fund manager of being designated a SIFI or G-SIFI are undoubtedly significant. Regulation by the Federal Reserve would probably require a manager raise additional capital, observe a debt to equity limit, and file a FR Y-9C report, which includes off-balance assets. Given the diversity of asset management companies, a standardised reporting template such as Y-9C could prove challenging.

In its study, SIFI designation and its potential impact on nonbank financial companies, Deloitte predicts that SIFIs would also be subject to liquidity risk management standards, requiring them to conduct internal liquidity stress tests and set internal quantitative limits to manage liquidity risk in line with the Basel III regime. Single counterparty credit exposures will be further tightened. Stress tests on a company-wide basis would have to be undertaken annually, the results of which would be made public. Restrictions on growth and capital distributions, not to mention executive remuneration, could also be imposed.

Deloitte adds that, like banks, SIFI-designated fund managers would have to implement “living wills,” outlining in detail how they would wind down their businesses in the event of failure. “This will involve both a risk management framework outlining a set of actions to maintain sufficient capital and liquidity levels in order to prevent a company from failing in the event of a severe distress and a resolution framework designed to ensure orderly wind-down, expediting actions by authorities and minimising impact to the overall financial system,” says Deloitte.

One concern is that fund managers regulated as SIFIs will prompt a “fight to quality” with assets flocking to managers deemed to be “too big to fail.” This would exacerbate the fact that fund management – notably hedge fund management – increasingly conforms to the 80:20 rule: 20 per cent of the managers control 80 per cent of the assets. The failure of one or more of these managers would already damage institutional investors, and possibly create systemic consequences. On that basis, it would be logical for regulators to investigate the systemic risk posed by the largest pension funds, endowments and sovereign wealth funds as well. As BlackRock pointed out in its submission to the FSB-IOSCO paper, the top 25 institutional funds – which range from the Government Pension Fund of Japan to Previ in Brazil – control over $10 trillion of assets. That is unlikely to happen yet.

What will happen, however, is the designation of some managers as SIFIs and/or G-SIFIs. Richard Frase, a partner at Dechert in London, says the subsequent imposition of bank-style regulation on major fund managers will be highly disruptive. “Were regulators to impose bank-style rules to asset managers, it would present enormous challenges as these firms simply do not have the financial resources to deal with such requirements, unlike the banks,” he says. “The damage would be severe. It has already been suggested that funds should be required to deliver guaranteed returns, similar to the return payable on a bank deposit. If the fund failed to match the benchmark, the manager would have to make good the difference itself. The capital cost of having to cover liabilities of this sort would be enormous. Another trend is to seek to impose capital requirements on the funds themselves – something which has already happened under the Alternative Investment Fund Managers Directive (AIFMD) in relation to self-managed funds.”

Regulators will only be emboldened by possession of the data they are now receiving from regulatory reports such as Form PF, Form CPO-PQR and Annex IV of the AIFMD. Managers warn the data should not be read out of context or it will exaggerate the risks posed by the industry. The Annex IV report, for example, incorporates the gross notional value of outstanding derivatives and leverage into its calculation of Regulatory Assets under Management (RAuM). This is in stark deviation to the tradition AuM figures provided by managers to their clients in their investor reports and prospectuses, which do not account for leverage or outstanding derivatives positions.

A fund manager filing Annex IV might deliver an investor report stating its AuM stands at $2 billion, while the same manager might file his RAuM in Annex IV as closer to $15 billion. Form PF, which is submitted to the Securities and Exchange Commission (SEC) poses a similar challenge, in that it too incorporates leverage into RAuM. The annual report to Congress on Form PF, which stated SEC-registered hedge funds collectively controlled $4.04 trillion is a far cry from the $2.7 trillion put out by data provider Hedge Fund Research in Chicago, which is widely considered to be the industry benchmark. Regulators are therefore reading data that inflates the AuM of managers and presents them as being more systemically important than they actually are.

“There is a possibility that the inflated RAuM numbers being digested by regulators could facilitate further regulation if the authorities deem certain fund managers to be systemically more risky and important than they actually are,” says Grant Lee, a director at PricewaterhouseCoopers (PwC) in London. Richard Frase agrees. “There is an on-going risk of bank-style regulations being imposed on fund managers,” he says. “If reliance was placed on the RAuM figures outlined in regulatory reports it could be much easier for regulators to classify some asset managers as being SIFIs. Initiatives of this sort could pose enormous challenges for the industry.” They already are.