Asset Managers Do Not Pose Systemic Risk

On Thursday, Jacob Lew, Treasury Secretary and head of the FSOC, will testify before the House Financial Services Committee to talk about systemic risk in the international financial system.  It’s vital that this discussion address the unique characteristics of asset management firms and how they are different from banks.

In April of 2012, the FSOC published a rule on the process for designating non-bank financial institutions as systemically important – so called SIFI designation. This framework – which was essentially a list of factors most pertinent to the banking industry – was not supported by extensive research, nor did it contain an approach tailored toward the targeted entities’ business model. SIFMA’s Asset Management Group is very concerned with the notion that asset managers and/or the funds they manage could be designated as SIFIs and, therefore, subject to prudential or bank-like regulation that could stifle their ability to serve individual investors.

Many have seen the flawed OFR report on Asset Management and Financial Stability.  While we appreciate that the regulators have begun to take a deeper look at the asset management industry before enacting further regulation, we were surprised by the reports’ noticeable lack of extensive research and failure to reflect the fundamental characteristics of asset managers. The OFR appears to have used only a small fraction of available data to support its conclusions about marketplace risk and thereby deprived the FSOC of a comprehensive view of the industry and its relevance to the financial stability of the U.S. and our capital markets.

The most effective way to mitigate risk posed by the financial industry is through market-wide regulation on activities which pose a systemic risk. In other words risk, if it’s truly systemic, is not housed exclusively in a firm or a fund.

In fact, current reform initiatives reflect an activities-based approach to regulation in order to address the types of risky behavior that could impact financial stability.  In particular, we’ve seen, or are in the process of seeing, regulatory reforms in the derivatives, tri-party repo and money market spaces. The FSOC should allow our primary regulators, the SEC and the CFTC, to complete these initiatives and evaluate their cumulative impact on the mitigation of systemic risk, prior to moving forward with any sort of SIFI designation.

It’s important to note the unique characteristics of asset managers when considering their impact on financial stability, as they are very different from other financial institutions. Asset managers invest money on behalf of their investor clients. They serve as fiduciaries with a legal obligation to invest assets according to guidelines set by clients. In this capacity, asset managers actively manage risks and, therefore, function as risk mitigators, not risk takers. Asset managers do not rely on their balance sheets to achieve success, unlike other financial firms.  Assets under management are owned by clients, NOT the firm and, therefore, are not a part of a firm’s balance sheet.

The success or failure of an asset management firm does not impact investor assets.  In other words, there is a legal separation between a firm’s assets and the assets of its customers. Additionally, asset managers do not guarantee positive investment returns, and do not back-stop investment losses. Asset managers are highly regulated and, subject to extensive public disclosure requirements and reviews.

Further, Asset Managers are highly substitutable.  It is relatively simple for investors to transfer control of assets to a new manager. These moves are common and are unlikely to encourage widespread redemptions in other products or managers. And, lastly, in this agent-client relationship, the asset manager does not retain custody of client (investor) assets. Thus, taken together, these collective considerations support the notion that, in the rare event of distress or failure of an asset manager, investor assets are not impacted – they are certainly not impacted in a fashion which would require tax payer support or a government bailout.

In an effort to help steer regulators down the most effective regulatory path, SIFMA’s Asset Management Group has been actively engaged. By way of example, the OFR has indicated that it lacks sufficient information on separate accounts required to assess their impact on financial stability. Separate accounts, despite not having the same level of transparency as funds, are managed with the same intensity and fiduciary care and oversight as that applied to funds and, in some cases, are subject to additional regulatory requirements such as ERISA.

We recently completed a survey of buy-side firms to help the FSOC gain insight into their risk profile. The results of the survey underscored the fact that separate accounts do not pose a specific or unique threat to financial stability and, that separate accounts do NOT generally engage in excessive risk taking – i.e., leverage.

Specifically, the survey found that for large separate accounts: 99% of large account assets are invested in long-only strategies, with 53% invested in passively managed index strategies, based on total assets under management in these accounts. Less than 4% of these accounts employed leverage and, the average leverage reported for these accounts was modest.  Less than 2% of these accounts held illiquid securities and less than 2% engage in securities lending. Additionally, 100% of respondents robustly monitor counterparty risk and employ comprehensive risk management procedures.

Certainly, none of this data comes as a surprise to anyone in the asset management industry. So, to the extent that there remains unaddressed risk, systemic or otherwise, it would be wise to acknowledge that market-wide regulation to address specific activities which are deemed to pose the risk is the only fair and effective manner to preserve the usefulness of our capital markets for all investors.

Timothy W. Cameron
Managing Director and Head of SIFMA’s Asset Management Group