In recent months, both the U.S. Financial Stability Oversight Council (FSOC or Council)1 and the international Financial Stability Board (FSB)2 have taken actions signaling their continued interest in evaluating the potential for investment funds and asset managers to be deemed systemically important financial institutions (SIFIs) by the FSOC, or non-bank non-insurer (NBNI) global systemically important financial institutions (G-SIFIs) by the FSB.
On December 24, 2014, the FSOC issued a Notice Seeking Comment on Asset Management Products and Activities (FSOC Notice). As discussed below, the FSOC Notice invited commenters to address concerns the FSOC identified regarding the potential systemic impacts cause by the holdings, activities and structure of a variety of types of investment vehicles and asset managers. Subsequently, on February 4, 2015, the FSOC announced that it had adopted supplemental procedures regarding SIFI determinations.
Against this U.S. backdrop, on March 4, 2015, the FSB and the International Organization of Securities Commissioners (IOSCO) issued a second consultation addressing the potential designation of NBNI financial entities (including investment funds and asset managers) as G-SIFIs.3 This consultation establishes a framework for identifying G-SIFIs and seeks comments on proposed sector-specific methodologies.
This article discusses key takeaways from the FSB’s and FSOC’s recent activities.
FSOC Notice Invites Comments from Asset Management Industry
The issuance of the FSOC Notice followed the September 2013 release of the Office of Financial Research’s (OFR) Report on Asset Management and Financial Stability (OFR Report), which suggested that the asset management industry could pose a threat to financial stability under certain circumstances.4The OFR Report was sharply criticized by many asset management industry participants, who argued, among other things, that the OFR Report failed to adequately distinguish among a range of different types of asset management vehicles, as well as the regulatory and risk characteristics associated with various types of vehicles, and had failed to take adequate steps to obtain public input. Following the release of the OFR Report, the U.S. Securities and Exchange Commission took the unusual step of soliciting public comment on the report.
In contrast to the OFR Report, the FSOC Notice indicated that the FSOC had not reached any conclusions regarding the potential financial stability impacts of the asset management industry. The FSOC indicated that it wished to take account of public comment that had discussed the special attributes of various types of asset management vehicles, in connection with the FSOC’s evaluation of this sector.
The FSOC Notice sought comments on four broad categories of concern, each of which was accompanied by a series of eight or nine specific (and often multi-part) questions. The four broad categories were:
- Liquidity and redemptions. The FSOC expressed concern that the redemption features of certain types of investment vehicles could influence investors’ redemption behavior and could potentially incentivize runs during periods of market stress.
- Leverage. The FSOC asked commenters to address the ways in which investment funds’ use of leverage could increase the potential for forced asset sales or expose their counterparties to market risk, as well as the potential impact these factors could have on the broader financial system.
- Operational Risk. The FSOC sought comments on potential risks relating to inadequate or failed processes or systems, particularly in connection with the transfer of large amounts of client assets and situations where multiple asset managers rely on a small number of third parties to perform important services.
- Resolution. The FSOC sought commenters’ views on the potential impact that the failure of an asset manager could have on its clients or the broader financial system.
The comment period for the FSOC Notice closed on March 25, 2015, with 59 commenters having submitted comments.
FSOC Adopts Supplemental SIFI Designation Procedures
Following a series of meetings with industry participants and significant Congressional attention regarding the FSOC’s SIFI designation processes and level of transparency, on February 4, 2015, the FSOC announced the adoption of supplemental procedures relating to its designation of entities as SIFIs.5 These supplemental procedures included:
- Increased transparency with companies under consideration for SIFI designation;
- Enhanced interaction with a company’s primary regulator or home country supervisor;
- Enhancements to the annual reevaluation process; and
- Increased transparency with the public.
It remains to be seen how these changes to the FSOC’s SIFI designation procedures will impact future designation proceedings and any legal challenges arising out of such proceedings.
FSB/IOSCO Issue Second Proposal on G-SIFI Designation Methodology for Investment Funds and Asset Managers
On March 4, 2015, the FSB and IOSCO issued their second “Consultative Document,” entitled Assessment Methodologies for Identifying Non-Bank Non-Insurer Global Systemically Important Financial Institutions: Proposed High-Level Framework and Specific Methodologies” (2015 Consultation).6 The 2015 Consultation serves as a re-proposal of FSB’s and IOSCO’s January 2014 Consultation (2014 Consultation), which laid out the organizations’ proposed methodology for designating NBNI G-SIFIs and attracted more than 50 comments from trade organizations, asset management firms, and others. The 2015 Consultation sets forth, among other things, the parameters the FSB and IOSCO are considering for assessing the systemic risk of asset managers and investment funds.
The 2015 Consultation identifies the same three systemic risk and transmission mechanisms (exposure/counterparty channel; asset liquidation/market channel; and critical function or service/substitutability) and the same five basic impact factors that apply across all NBNIs (size; interconnectedness; substitutability; complexity; and global/cross-jurisdictional activities) as did the 2014 Consultation.
The 2014 Consultation had identified four potential asset management-related categories of entities to which NBNI G-SIFI status could be applied – individual funds, families of funds, asset managers on a stand-alone basis, and asset managers collectively with the funds they manage. The 2015 Consultation, in contrast, focuses on two categories – investment funds and asset managers – and proposes distinct methodologies for assessing systemic risk for each. Under the more recent approach, asset managers and the funds they advise are assessed independently of one another, and designation of one will not in itself trigger designation of the other. In addition, under this approach, the proposed methodology for assessing investment funds features a heightened focus on leverage and the increased interconnectedness experienced by funds that take on higher leverage due to borrowing. The methodology for assessing asset managers will focus on those engaged in activities with the potential to generate systemic risk and entities whose disorderly failure could disrupt the financial system.
The 2015 Consultation also set forth proposed thresholds for identifying investment funds and asset managers that are to be evaluated for potential G-SIFI designation. These proposed thresholds, with respect to public investment funds, are:
- $30 billion in net asset value (NAV) and balance sheet financial leverage of three times NAV, with a size-only backup of $100 billion in net assets under management (AUM).
- $200 billion in gross AUM, unless there is a demonstration that the fund is not a dominant player in its markets.
The proposed threshold, with respect to private investment funds, is $400 billion of gross notional exposure, which the 2015 Consultation indicates is intended to capture highly leveraged private investment funds.
With respect to asset managers, the proposed eligibility thresholds are:
- $100 billion (or another specific value) in balance sheet total assets.
- $1 trillion (or another specific value) in AUM.
The 2015 Consultation indicates that once the methodologies are approved, the FSB will submit to the relevant national authorities a list of entities that meet the applicable criteria. Those authorities will, in turn, create a list of entities that are recommended for G-SIFI assessment. Ultimately the various national authorities and the FSB will agree on a list of investment funds and asset managers from throughout the world that will be designated as G-SIFIs. During this period, the FSB and national authorities will develop policy measures that would be applied to designated investment funds or asset managers.
The FSB and IOSCO invited public comment on the 2015 Consultation. The comment period closed on May 29, 2015, with 48 commenters having submitted comments.
On June 17, 2015, IOSCO announced that it would shift its immediate focus to performing a full review of asset management activities in order to identify potential systemic risks and vulnerabilities, prior to continuing its work on developing methodologies for identifying asset management G-SIFIs. As of the publication of this article, the FSB had not publicly addressed this development.7