A major conference sponsored by the U.S. Financial Stability Oversight Council (FSOC) on May 19, 2014, has sharpened debate on the question whether large U.S. asset management firms should be designated as “Systemically Important Financial Institutions” (SIFIs), which would open them to heightened supervision based on a potential threat to stability of the U.S. financial system that the failure of one of them could pose. The debate has been prompted by a September 2013 report by the FSOC Office of Financial Research, suggesting that very large asset management firms may present systemic risk in the same way that major banks and other financial institutions may do so. All of this comes in the wake of the financial crisis, and the congressional initiative in the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) to address the interdependency of institutions in global financial markets and the systemic vulnerabilities and domino effect that could be triggered by the failure of a single or handful of financial institutions.
The suggestion that very large asset management firms are systemically significant, such that the failure of one could put the entire U.S. financial system at risk is vigorously challenged by the asset management industry. Lately, the industry has been joined by a top financial regulator, who has strongly criticized the notion put forward in the September 2013 report that asset management firms should be viewed in the same systemic context as major banks. The FSOC emphasized at the May 19 conference that no decision has been made whether to accept conclusions of the September 2013 Report, or to proceed with SIFI designation for any asset managers. This is, however, a quintessential post-Dodd-Frank Act debate, and there is clearly more to come.
The FSOC and Nonbank Financial Firms
In the wake of the financial crisis, the FSOC was created by Congress as part of the Dodd-Frank Act to establish accountability for identifying “systemic risks” to the U.S. financial system, and to respond to emerging threats to financial stability. The FSOC is a collaborative body chaired by the Secretary of the Treasury that brings together federal and state financial regulators, along with an independent insurance industry expert appointed by the President, with the statutory mandate to identify and constrain excessive risk in the financial system. With that mandate, the FSOC has authority to designate banks and non-bank financial firms as Systemically Important Financial Institutions, and to require tough new consolidated supervision to help minimize the risk that the failure of such a firm would threaten the stability of the entire financial system. The FSOC also has a significant role in determining whether action should be taken regarding SIFIs that are deemed to pose a grave threat to the financial stability of the United States.
Non-bank financial firms meeting certain screening criteria fall within the authority of the FSOC to designate SIFIs. In its current initiative, the FSOC has undertaken an assessment of the asset management industry, and what risks it may pose across the broader financial system. In its September 2013 Report, the FSOC Office of Financial Research identified factors that it perceived as making the industry vulnerable to financial shocks, and which could transmit risk throughout the financial system. As addressed in the Report, the failure of a large asset management firm could be the source of systemic risk depending on its size, complexity, and the interaction among its various investment management strategies and activities,
“The September 2013 report noted that distress at a large asset manager could amplify or transmit risks to other parts of the financial system.”
and interconnection with other market participants. The report noted that distress at a large asset manager could amplify or transmit risks to other parts of the financial system. Concentration of risks among funds or activities within a firm, for example, could pose a threat to financial stability by increasing risks across the funds that it manages or across markets through its combination of activities. Risk managers, the report suggested, could fail to understand or anticipate risks with financial stability implications. Moreover, the report cautioned that material distress at the firm level, or a firm failure, could increase the likelihood and magnitude of redemptions from a firm’s managed assets, possibly aggravating market contagion or contributing to a broader loss of confidence in markets.
At the FSOC Conference on Asset Management held May 19, 2014, with the September 2013 report as an anchor, a panel of industry and academic experts examined many facets of asset management in relation to systemic risk in the financial system. Participants addressed the unique characteristics of the asset management industry in comparison to banks and other types of financial institutions, with several urging that designating asset management firms as SIFIs could have severe negative consequences for an industry in which asset managers do not make risky decisions that could potentially imperil the entire financial system. For its part, the FSOC recognized that large asset management firms differ from banks, and it has made no decision whether to accept conclusions of the September 2013 report. As the debate sharpens, it is important to examine the context in which it is happening.
Nonbank Firms as Systemically Significant Financial Institutions
In simplest terms, a SIFI is one whose failure could have significant impacts throughout the financial system. Although major banks quickly come to mind, one of the FSOC statutory mandates is to identify risks to financial stability that could arise from the material financial distress or failure, or ongoing activities, of nonbank financial firms. A nonbank financial firm subject to the FSOC designation authority is one that is “predominately engaged in financial activities,” such that: (1) annual gross revenues derived by the company and its subsidiaries from financial activities, or from ownership and control of insured depository
institutions, represent 85 percent or more of the company’s consolidated annual gross revenues; or (2) the consolidated total financial assets of the company and its subsidiaries related to financial activities and to ownership or control of insured depository institutions represents 85 percent or more of the company’s
total assets. If designated by FSOC, a SIFI is subjected to heightened supervision by the Federal Reserve in addition to the firm’s primary regulator, and to additional prudential standards.
Under the Dodd-Frank Act, after determining that a nonbank financial firm meets the “predominately engaged” criterion, the FSOC must make one of two further predicate determinations before subjecting the firm to supervision as a SIFI. There must be a determination that either:
- Material financial distress could pose a threat to the financial stability of the United States; or
- The nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the nonbank financial company could pose a threat to the financial stability of the United States.
The Dodd-Frank Act prescribes several considerations in making either of these determinations with regard to a non-bank financial firm and FSOC has itself implemented a three-stage process for evaluating the firms. The first stage establishes size thresholds to narrow the universe to a smaller set of companies that merit further evaluation. There are six quantitative thresholds:
- $50 billion in total consolidated assets;
- $30 billion in gross notional credit default swaps outstanding for which a nonbank financial company is the reference entity;
- $3.5 billion of derivative liabilities;
- $20 billion of total debt outstanding;
- 15 to 1 leverage ratio of total consolidated assets (excluding separate accounts) to total equity; and
- 10 percent short-term debt ratio of total debt outstanding with a maturity of less than 12 months to total consolidated assets (excluding separate accounts).
A nonbank financial firm meeting both the total consolidated assets threshold and any one of the other thresholds listed above will then be further evaluated under the second and third stages, which apply qualitative standards. As noted, being designated as an SIFI means that a non-bank financial firm becomes subject to heightened supervision by the Federal Reserve (alongside the existing primary regulator), and to prudential standards in accordance with the Dodd-Frank Act and as FSOC may itself direct for implementation. Once identified, a SIFI will thus be regulated differently from other financial institutions, but precisely how is yet to play out, as only three nonbank financial firms have so far been designated by the FSOC as SIFIs. That said, the asset management industry justifiably offers an apples- and-oranges argument. The industry has been joined by SEC Commissioner Daniel Gallagher, who ahead of the May 19 Conference offered: “Applying bank regulatory principles to capital markets regulation is a fatally misguided approach, the regulatory equivalent of trying to jam a square peg into a round hole.”
Asset Management Firms as SIFIs?
At the May 19, 2014, FSOC Conference on Asset Management, the Director of the SEC Division of Investment Management presented information on the size and scope of asset management firms in the context of SIFI assessment based primarily on two products types: mutual funds and private funds. As of September 2013, mutual funds registered under the Investment Company Act of 1940 and advised by SEC registered investment advisers held assets of $16.2 trillion. And in May 2014, private fund regulatory assets, reported by all SEC registered investment advisers, is approximately $11 trillion. The FSOC Office of Financial Research reported in 2013 that overall, the U.S. asset management industry oversees the allocation of approximately $53 trillion in financial assets, and that the firms and funds they manage transact with other financial institutions to transfer risks, achieve price discovery, and invest capital globally through a variety of activities. The sheer size, scope and interconnectedness of the industry, however, do not answer the baseline inquiry.
Are There Legitimate Systemic Risk Concerns for Asset Managers?
Only three nonbank financial institutions have so far been designated as SIFIs: American International Group, Inc., General Electric Capital Corporation, Inc. and Prudential Financial, Inc. In its SIFI designations so far, the FSOC has analyzed potential effects of material financial distress at these nonbank companies in terms of “channels.” In the case of Prudential Financial, Inc., for example, the FSOC considered “Transmission Channels” -- how material financial distress at the firm could be transmitted to other firms and financial markets in terms of:
- Exposures of counterparties, creditors, investors and other market participants to Prudential;
- The liquidation of assets by Prudential, which could trigger a fall in asset prices and thereby could significantly disrupt trading or funding in key markets or cause significant losses or funding problems for other firms with similar holdings; and
- The inability or unwillingness of Prudential to provide a critical function or service relied upon by market participants, and for which there are no ready substitutes.
Firm-specific assessments of transmission channels make sense. Looking to asset managers, as a whole, however, in the September 2013 report the FSOC Office of Financial Research identified general “vulnerabilities” -- factors making the entire industry vulnerable to financial shocks, and which could transmit systemic risk. They are:
- Reaching for Yield and Herding: Portfolio managers seeking higher returns by purchasing relatively riskier assets than they would otherwise for a particular investment strategy, or by crowding, or herding, into popular asset classes or securities regardless of the size or liquidity of those asset classes or securities.
- Redemption Risk: Unrestricted redemption rights giving rise to the risk of large redemption requests by investors in a stressed market in which investors believe that they will gain an economic advantage by being first to redeem, and resulting in an increasingly less liquid portfolio whose net asset value may fall at an accelerating rate as liquidity premiums rise.
- Leverage: Funds may obtain leverage through derivatives and derivative products that magnify risk. The report noted that registered funds markedly expanded their exposure to credit derivatives in the run-up to the financial crisis. Sixty percent of the 100 largest U.S. corporate bond funds, for example, sold credit default swaps, and the use of derivatives resulted in significant losses for some funds.
- Firms as Sources of Risk: The failure of a large asset management firm could be a specific source of risk, depending on its size, complexity, and the interaction among its various investment managers, strategies and activities. Concentration of risks among funds or activities within a firm may pose a threat to financial stability, and instability at a single asset manager could increase risks across the funds that it manages or across markets through its combination of activities. Large asset managers may also be interconnected with or linked to other financial market segments directly or indirectly through business connections within the firm.
The report also concluded that asset managers could transmit risks across the financial system and cause disruptions to financial markets by exposure of creditors, counterparties, investors or other market participants to an asset manager’s activities; or by “fire sales” of assets that temporarily depress market prices.
As noted earlier, the reported vulnerabilities of asset managers, and conclusions based upon them have been characterized as fundamentally flawed by SEC Commissioner Gallagher, who offers that they were the inevitable result of the deeply unsound process followed by Office of Financial Research in performing its analysis. It offers up speculative conclusions of systemic risk, he says, and is simply a “botched analysis that grossly overstates indeed, in many cases simply invents without supporting data -- the potential risks to the stability of our financial markets posed by asset management firms." Such an indictment by a principal financial market regulator does not portend well for acceptance
of the 2013 report as the basis for proceeding down a new avenue of systemic risk regulation. The baseline premise that the asset management industry plays a major role in
the U.S. financial market system is not assailable, however. The sharp debate underway now, and which will continue in the wake of the May 2014 conference, is entirely consistent with the commitment to understanding, identifying and addressing systemic risk in the financial system that is the FSOC reason for being. The action step will undoubtedly be, as it should be, more careful study and assessment.
Bob handles financial market regulatory and complex litigation matters for a wide range of market participants and financial intermediaries. He is a noted author and teacher on law, theory and practice in financial markets.