BIS report warns rise of asset managers presents potential market risks
The growing clout of asset managers could present risks to market stability, according to a report by the Bank of International Settlements (BIS).
The report argues portfolio managers are evaluated on the basis of short-term performance while revenues are linked to fluctuations in customer fund flows. “These arrangements can exacerbate the pro-cyclicality of asset prices, feeding the market’s momentum in booms and leading to abrupt withdrawals from asset classes in times of stress,” read the report.
It warned growing concentration in the asset management space could weaken the market’s ability to deal with stress. “Another concern arising from concentration is that operational or legal problems at a large asset management company may have disproportionate systemic effects,” it read.
Nonetheless, the same paper is not wholly negative and points out asset managers can bring about market stability by “strengthening market based financial intermediation (which) can provide a complementary channel to bank-based funding for businesses and households. In fact, the growth in asset management company’s portfolios mirrors the rebalancing of funding of the real economy away from banks and towards markets. Greater diversity in funding channels can be a strength to the extent that one might compensate for supply problems in the other,” read the report.
The $60 trillion asset management industry is facing a number of regulatory challenges with industry experts expressing alarm that some large firms could be labelled as systemically important financial institutions or SIFIs. The Financial Stability Oversight Council (FSOC), the US government agency mandated under Dodd-Frank to monitor systemic risk, has proposed that some asset managers including hedge funds, be designated as SIFIs in what could lead to further heavy-handed regulations.
FSOC is reportedly assessing whether Blackrock and Fidelity in particular should be classed as SIFIs. Critics point out that the failure of an asset manager would most likely only hurt its investors while a bank default would harm depositors, borrowers and others dependent on a source of liquidity. If the FSOC adopts a tough approach, it could see large asset managers subjected to bank-style capital, leverage, liquidity and reporting rules at a time when operational costs are rapidly mounting for the industry.
Regulators globally are analysing the potential systemic risks within the shadow banking system. A consultation paper by the Financial Stability Board (FSB) and the International Organisation of Securities Commissions (IOSCO) recommended “materiality thresholds” to identify SIFIs. The FSB and IOSCO set a threshold of $100 billion in assets and an alternative threshold between $400 billion and $600 billion gross national exposure for hedge funds it deemed as SIFIs.
Both the Alternative Investment Management Association (AIMA) and Hedge Fund Standards Board (HFSB) have both opposed the FSB and IOSCO findings and have reportedly suggested the US definition of a major swap participant under Dodd-Frank be used to identify SIFIs instead.
Hedge fund surveys conducted by the UK’s Financial Conduct Authority (FCA) and its precursor the Financial Services Authority (FSA) have long said hedge funds individually are unlikely to pose a systemic risk although one paper in 2012 warned a rapid fire-sale of hedge fund assets in distressed market conditions would impact liquidity and efficient pricing, which could potentially be a systemic risk. Long Term Capital Management (LTCM), which spectacularly blew up in the late 1990s is often cited as evidence that hedge funds pose a systemic risk, although managers’ use of leverage has diminished markedly since then. The FCA, for example, found the median leverage at most hedge funds to be 4.2 times their Net Asset Value (NAV).
While hedge funds should not be deemed SIFIs, the largest managers are gaining the lion’s share of investor assets, which could lead to concentration risk. The FCA’s survey of hedge fund managers in March 2014 found the 20 largest hedge funds in the UK controlled 82% of the $470 billion in assets managed out of the country. A default by one or more of these managers could hurt a number of institutional investors although this would unlikely alarm markets more broadly.