Forget Dodd Frank, AIFMD, FATCA and MiFID: this is the regulatory threat that matters

28 Apr, 2014

The closure on 7 April of the Financial Stability Board (FSB) and International Organisation of Securities Commissions (IOSCO) consultation on the methodologies required to identify non-bank, non-insurer global systemically important financial institutions (NBNI G-SIFIs) may not sound exciting. But it is hard to think of an issue more important to the future of the fund management industry, which is now being subject to the same game-changing forms of regulatory interference as the banks and investment banks have endured since 2009.

The authors of the FSB-IOSCO paper are asking exactly the same question of fund managers as they have asked of banks for the last five years: would the distress or disorderly failure of an institution like this disrupt the global financial system? True, the consultation paper, published on 8 January[1], acknowledges that fund managers are agents not principals, that they can dampen systemic volatility as the last takers of risk even in distressed financial markets, and that they often close without damaging anyone except their investors, and often not even them.

But the fact a consultation paper addressing investment management and systemic risk was issued at all – and at the ultimate behest of the G20 three years ago - marks the defeat of efforts to persuade regulators that fund managers are not dangerous to the financial system in anything like the same way as banks and investment banks. In fact, the paper states explicitly that asset management firms owned by banks will not be regulated as NBNI G-SIFIs solely because they are already regulated in exactly the right way by the assessment of major banks as G-SIFIs.

Such distinctions make no difference. The FSB-IOSCO paper applies to fund managers not owned by banks much the same tests as it applies to banks and investment banks: size (as measured by assets under management, or the sum of long and short positions), leverage ratios (measured as size over NAV), counterparty credit exposures (measured by number as well as size), liquidity ratios (measured as weighted average number of days to liquidate a portfolio) and reliance on collateralised funding in general and re-hypothecation in particular.

The fact the paper adds to the regulatory mix a handful of factors specific to the investment management industry, such as pursuing a high frequency trading or esoteric strategy, or exposure to multiple markets or thinly traded assets, is not reassuring. At bottom, the FSB-IOSCO paper treats the investment managers it has in its sights as little more than investment banks in disguise, in much the same way as it implicitly treats certain investment banks as little more than giant hedge funds in disguise. In short, the FSB-IOSCO initiative is rich in dismal portents for the investment management industry.

One otherwise obscure portent particularly worth noting is the dismay expressed by the authors about the lack of data available by which to gauge which fund managers are systemically important. They attribute this to a misguided reliance on regulating investment managers from an investor protection perspective instead of from a systemic risk perspective. The corollary is implicit criticism of regulators for taking seriously the claim by fund managers that they cannot disclose information to regulators because client confidentiality forbids it.
This is the answer to that oft-posed question: what are the regulators going to do with all the information they are now gathering from fund managers? As the FSB-IOSCO paper points out, data on the size of funds and their leverage and liquidity ratios is now being collected through Form ADV, Form PF, Forms CPO PQR and PQF and Annex IV of the Alternative Investment Fund Managers Directive (AIFMD).

This is the principal reason why the FSB-IOSCO consultation paper departs from previous official pronouncements on the subject of investment management and systemic risk by focusing on funds rather than fund managers. Its logic is not only that funds are separate legal entities from management companies, or that economic exposures are built up at the level of the fund rather than the management company, but the fact that data is becoming available at the fund level.

Every type of fund is in scope too, not just the hedge and private equity funds that make use of leverage, or a lot of leverage, or which are unregulated (not that there are many left in the wake of the passage of the Dodd Frank Act and AIFMD). Potential NBNI G-SIFIS now include mutual funds, money market funds, exchange-traded funds and real estate funds. Even separately managed accounts, which are not actually collectively invested funds at all, have yet to be excluded from the scope of the exercise.

The thresholds proposed are not that high either. $100 billion in net assets under management (that is to say, the amount investors stand to lose) on a global basis is enough to capture an individual fund. Any hedge fund manager running a fund with somewhere between $400 and $600 billion in gross notional exposure (GNE) – the sum of all long and short positions, including derivatives - is also captured.

“Reference lists” of institutions affected, including any on the cusp of the proposed “materiality” thresholds, are now being prepared by national regulators. Information will be sought from the organisations on those lists to gauge if they are NBNI G-SIFIs or not. Since information of the right kind is already being collected via Form ADV, Form PF, Forms CPO PQF and PQR and Annex IV of the AIFMD, this will at least spare managers any further burden.

With the FSB-IOSCO consultation having closed as recently as 7 April, the concrete proposals that will be advanced by the two bodies will not be revealed until the FSB reports back to the G20 later this year. The most important revelation – which managers will be deemed systemically important – is eagerly awaited. At this point nothing can be ruled out, including a focus on managers with AuMs and GNEs far lower than $100 billion or $400-600 billion. Particular investment strategies may be at risk. After all, the FSB-IOSCO paper expressly states that size is only a proxy, pending the delivery of more detailed information.

Nor is the FSB-IOSCO paper an isolated symptom of a direct regulatory assault on the investment management industry. The Office of Financial Research (OFR) of the US Treasury Department published a paper in September 2013, entitled Asset Management and Financial Stability[2], whose explicit goal was to explore whether regulation of the $53 trillion US investment management industry under the Dodd Frank Act needed to be intensified. The Securities and Exchange Commission web site so far sports 49 separate responses to the paper (albeit five of them from Barbara Novick, the vice chairman of BlackRock).

The OFR paper noted that investment managers act primarily as agents rather than principals, but nevertheless argued that “some types of asset management activities are similar to those provided by banks.” It warned that investment managers “may create funds that can be close substitutes for the money-like liabilities created by banks; they engage in various forms of liquidity transformation, primarily, but not exclusively, through collective investment vehicles; and they provide liquidity to clients and to financial markets.”

The paper singled out the bank-like activities of leverage, maturity transformation, repo borrowing and reinvestment of cash collateral (following recent disasters in that field, of which AIG was the most prominent) as areas of particular concern. Like the FSB-IOSCO paper, the authors of the OFR paper bemoaned the lack of data about the investment management industry, and look forward to the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) reading the contents of Form PF and forms CPO PQR and PQF. It even echoed the FSB-IOSCO paper in noting that separately managed accounts need further scrutiny.

But the OFR paper also attempted a macro analysis of how investment managers can create and exacerbate systemic risk. It fingers the incessant hunt for yield, adding leverage in the cash and derivatives markets, and failure to maintain sufficient liquidity in the face of redemptions, leading to fire sales of assets in distressed markets. The paper also pointed to the herd-like behaviour of investment managers, alluding to the growth of indexed funds and ETFs as the prime exhibits.

The OFR noted the level of concentration in the industry too. After all, just five managers run half the total AuM of the US mutual fund industry. That concentration risk alone seems to many regulators to argue for treating large asset managers as systemically important financial institutions. The OFR paper may have attracted only 49 responses, a third of them from a small group of enormous fund managers, but it has certainly attracted a following in Congress and the Office of the Comptroller of the Currency (OCC), which is trying to build a reputation for being hard on the investment banking industry, and especially its "shadow banking" relationships with investment managers.

In the United Kingdom, the second most important investment management centre in the world, the sentiments of the OFR paper were closely echoed in a recent speech by Andrew Haldane, director of financial stability at the Bank of England. Since Andrew Haldane is not only in charge of financial stability but the man who in a just world will become the next governor of the Bank of England - assuming Goldman Sachs do not find a way of holding on to the job - his views are of more than usual importance in this field.

In the speech, quizzically entitled “The age of asset management?,” Haldane expatiated on all of the themes raised in the OFR paper. He noted the worryingly large size of the investment management industry. It was managing $87 trillion in assets worldwide last year, making it bigger than global GDP and giving it command of assets whose value is only one quarter below those of the global banking industry. Haldane also pointed out that investment management was growing fast on the back of economic growth and demography, doubling in size in the last decade. So size is an issue for British regulators too.

Indeed, Haldane pondered directly the question whether the biggest managers are “too big to fail.” While he accepted that, as agents, investment managers assume none of the credit risks taken on by banks, he still worried about asset disposals at fire-sale prices by distressed managers. He thought this could lead to a systemic crisis if investors panicked. He says the Bank is worried enough to have put work in hand to establish how to measure the “pro-cyclical” effects of buy-side behaviour. Haldane thinks it is driven by investment return benchmarking, mark-to-market valuation rules and pension and insurance company solvency ratios, as well as passive investing.

All this, thought Haldane, drove cycles of over-investment and under-investment in equities and government bonds. Haldane also noted that investment managers were taking investors increasingly into illiquid (hedge funds, private equity, real estate, infrastructure, high yield and commodities) and passive strategies. This combination of illiquidity and passivity he judges rich in potential for (note the central bankerly formulation) “correlated market movements.” Coupled with a shift to defined contribution pension plans invested mainly in funds, Haldane argued a rising proportion of these “correlated” assets are now in the hands of “trigger-happy investors.”

But Andrew Haldane has not acquired a reputation for thoughtfulness by accident. In the same text, he openly criticises regulation and accounting rules for forcing investors to jettison equities for government bonds, in order to meet official solvency ratios and minimise the impact of volatile asset prices on the balance sheets of corporate plan sponsors. “Equity,” he said, “does a much better job than debt of sharing risk between borrowers and lenders as repayment terms adjust automatically with servicing capacity. Equity is also better able to support the financing of long-term investment projects because it is perpetual. So a world without equity is likely to be one with poorer risk-sharing and weaker long-term investment.”

There is much to be applauded in that observation. Andrew Haldane may agree that “we are in the intellectual foothills when it comes to understanding and scaling the transmission channels through which asset managers could generate systemic risk,” but clearly some decision have been made already. Central bankers want greater patience and less speculation in investing and investment management. They want, in short, less debt and more equity. As it happens, there is no industry more in need of more equity than the first targets of the regulators: banking and investment banking.

Accordingly, no fund manager can afford to be indifferent to the fact that the FSB-IOSCO consultation paper identifies prime brokers as sources of systemic risk, primarily through their reliance on short term debt financing in the repo markets. The paper advises national regulators to tot up the on and off-balance sheet liabilities of broker-dealers; client assets in custody, or re-hypothecated, or simply under management by the asset management arm; their connections with fund managers and banks through stock borrowing and lending, repo, reverse repo and swaps; their counterparty concentrations; their out-of-the-money derivatives positions; and the collateral they have in hand or must post to central counterparty clearing houses (CCPs) and counter-parties.

The FSB-IOSCO document even defines how the leverage (total shareholder equity divided by the sum of on balance sheet assets and off-balance sheet exposures) and liquidity (debt with a maturity of less than one year over total consolidated assets) ratios of an investment bank should be calculated. Coupled with measures to ensure the customer assets broker-dealers hold are protected from the failure of the firm – most obviously, segregation of assets in custody and collateral – it is obvious that the traditional, full re-hypothecation, borrow-overnight-and-lend-for-90-days model of prime brokerage is now unworkable.

In short, an extravagant era in investment banking, which began in the 1980s, is being drawn deliberately to a close. The modern investment management business, which was in so many ways an outsourced arm of the investment banking industry, is going to have to change or shrink with the investment banking industry. The journalistic and regulatory assaults on high frequency trading may have garnered the headlines of late. But the steady and deliberate asphyxiation of shadow banking, as the pejorative terminology has long had it, is of greater consequence.


[1] Financial Stability Board and the International Organization of Securities Commissions (IOSCO), Consultative Document Assessment Methodologies for Identifying Non-Bank Non-Insurer Global Systemically Important Financial Institutions Proposed High-Level Framework and Specific Methodologies, 8 January 2014.

[2] Office of Financial Research, Asset Management and Financial Stability, September 2013.

Dominic Hobson