FSOC proposals on SIFIs could hurt large asset managers

20 May, 2014

The proposals by the Financial Stability Oversight Council (FSOC), the US government agency mandated under Dodd-Frank to monitor systemic risk, to label some asset managers including hedge funds as “systemically important financial institutions” (SIFIs) would be detrimental, and could lead to further heavy-handed regulations.

The FSOC is reportedly assessing whether Blackrock and Fidelity should be designated as SIFIs.  One lawyer warned the FSOC’s remit could potentially be extended to large or highly leveraged hedge fund managers. “Even though there are some sizeable asset managers, size alone does not mean that a hedge fund or mutual fund poses systemic risks. The key differentiator between an investment fund and a bank is that the impact of a failure of the former is generally limited to its investors, while a failure of the latter impacts its depositors, borrowers and others dependent on a source of liquidity,” said Bibb Strench, counsel in the investment management practice at Seward & Kissel in Washington DC.

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. “If an asset manager is designated a systemically important financial institution or SIFI, it may be subject to strict reporting, monitoring and capital requirements. Large asset managers presently complying with securities regulations could be further burdened by a new regulator imposing bank holding company type regulations,” commented Strench.

Regulators globally are analysing the potential systemic risks posed by 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/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 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 mangers 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.  

FSOCSeward & KisselSIFIFSBIOSCOAIMAHFSBFCAFSABlackRockFidelityshadow banking