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Do asset managers pose a risk to the global economy?

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In the aftermath of the financial crisis, policymakers have been wrestling with one major question: how to ensure it never happens again?

The Financial Stability Board and International Organisation of Securities Commissions have proposed extending regulation beyond banks and insurance companies to other financial institutions and deem asset managers systemically important.

But do asset managers actually pose a risk to the global economy?

International law firm Hogan Lovells partner Nicholas Holman, who is responsible for the investment funds team, says regulators don’t have to impose additional burden on asset mangers.

He adds: “Are investment funds going to be treated like shadow banks? Are they going to be treated as global systemic important institutions? “What we need is new measures to smoothen things up, but we don’t need further regulations.

Holman says the FSB has “no evidence” that asset managers are systemically risky – a view shared by investment giant Fidelity.

“The FSB uses the words ‘may,’ ‘might,’ ‘could,’ ‘potential’ and ‘potentially’ an astounding 402 times in the second consultative document, which is only 57 pages long,” says Fidelity in its official response to the consultations.

It adds: “The FSB attempts to support its proposal by imagining a series of hypothetical circumstances in which an investment fund or asset manager could somehow create heavy losses for counterparties or experience disorderly asset liquidation.

“By continuing to pursue a designation approach the FSB is wasting scant regulatory resources that could be utilised to identify and address genuine systemic risks.”

Angus Canvin, senior adviser regulatory affairs at the Investment Association, says the FSB came out with the “wrong framework” to analyse the risks posed by asset managers. He says: “They’ve approached the problem with a banking hat on.

“Though we agree there is a legitimate question to ask on financial stability, particularly in the light of the growth in our industry.”

Canvin says the FSB needs to look at the market as a whole, including “market function and malfunction”.

According to consulting firm McKinsey the asset management industry is responsible for managing 25 per cent of the investments going into financial markets. The other 75 per cent is made up of DIY investors, McKinsey says.

Dr. Christopher Sier, managing director UK at KAS Bank, argues AMs are “absolutely systemically important”, especially in the UK, as “they own everything”.

“Pension funds, insurance funds, life funds and retail funds in the UK totally manage £4.5trn approximately. The size of the FTSE is only £1.4trn; the size of the entire listed market in the UK is closer to £3trn so, in another words, the £4.5trn of assets is exercising this leverage across the entire listed market. It is absolutely systemically important,” says Sier.

“These funds own absolutely everything and the people who are managing these assets are asset managers so the duty of care is enormous.”

But Holman argues fund managers are fundamentally different to banks.

He says: “It is hard to see how a fund manager or an asset manager of itself could be globally systemically important. I think there is a real danger that the fund management industry could be dragged into a regulatory regime which is not designed for that industry because they are doing a fundamentally different job to a bank or an insurance company.”

A multitude of structural, economic and regulatory factors also make it impossible for the “failure” of any fund or manager to damage the global financial system or economy, states Fidelity.

This includes the existence of many easy substitutes for any mutual fund or asset manager, the ability of investors to manage their own assets, the fact that each fund and each manager has its own distinct assets and liabilities, and the requirement that mutual funds use independent custodians, which are heavily regulated.

But Sier says: “The custodians who keep all these records on behalf of asset managers, do they provide an insurance policy if they fall over?

“Is there true client segregation, a true insurance policy? I don’t think there is.”

The FSB has also come under fire for using size of firm as a proxy for risk, an approach which the IA considers “useless”.

While the ‘too big to fail’ mentality may work in the banking industry, it is not applicable to asset managers, the trade body says.

The IA also argues that as assets are owned by clients, rather than being held on the manager’s balance sheets, their fate is separated from the firm’s as the investments in a fund remain segregated and can be transferred elsewhere “without clients’ money ever being at risk”.

“[The too big to fail] designation serves no purpose unless a company can fail and its failure would disrupt global financial and economic activity so severely that policy makers and regulators are unwilling to allow it to fail through normal processes, ” states Fidelity.

“Mutual funds and their managers do not meet this test. Most operate with little or no leverage and are not susceptible to sudden failure like a bank and the evidence proves that they enter and exit the business regularly through normal processes with no systemic impact even during financial crises.”

Sier says a firm’s reputation could also be a factor in determining systemic risk.

“Another definition of systemic importance is the performance of the UK economy or other countries. asset managers are some of the biggest earners in the UK, contributing huge amounts of GDP and taxation. If the asset manager shrinks or suffer a massive reputation shock or other damages there could be significant impacts on the economy.”

Canvin believes the FSB and other authorities should add an “additional work stream” on market liquidity and how to move from the current extremely loose monetary policy conditions to more “normal” monetary policy.

He says: “It is a huge job and a very complex analysis needs to be done, a vast amount of data needs to be assessed and all these things are missing in the current process the FSB is on.”

BlackRock’s response to the FSB paper also argues that products have become safer since the financial crisis. “Many of the reforms implemented since the financial crisis have made the system in 2015 much safer than it was in 2008.

“Any additional reform measures should factor in the reforms that have already been taken or are in process.”

How the “systemic importance” of asset managers will be assessed

Complexity
– Impact of the organisational structure
– Difficulty in resolving a firm

Cross-jurisdictional activities (global activity)
– Number of jurisdictions in which an asset manager has a presence

Size
– Net assets under management
– Balance sheet assets

Interconnectedness
– Leverage ratio
– Guarantees and other off-balance sheet exposures

Substitutability
– Measured by a percentage of the asset manager’s revenues as compared to the total revenues attributable to the relevant business

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