On April 18, 2016, the Financial Stability Oversight Council (FSOC) released a statement providing an update of its ongoing review of asset management products and activities. The statement, Update on Review of Asset Management Products and Activities (Update), provides FSOC’s views regarding the risks to financial stability posed by asset management with respect to five areas: (i) liquidity and redemption, (ii) leverage, (iii) operational functions, (iv) securities lending and (v) resolvability and transition planning. As described by Treasury Secretary Jacob J. Lew, Chairperson of the Council in a Wall Street Journal Op-Ed published April 19, 2016, the first two risk areas – liquidity and redemption, and leverage – are the “key” areas of FSOC’s focus in this context.
FSOC and Its Members
FSOC was established by the Dodd-Frank Wall Street Reform and Consumer Protection Act to identify risks to the financial stability of the U.S., promote market discipline, and respond to emerging threats to the stability of the U.S financial system. FSOC has nine member agencies: the Board of Governors of the Federal Reserve System, the Commodity Futures Trading Commission (CFTC), the Federal Deposit Insurance Corporation, the Federal Housing Finance Agency, the National Credit Union Administration, the Office of the Comptroller of the Currency, the Securities and Exchange Commission (SEC), the Treasury Department, and the Consumer Financial Protection Bureau. The head of each member agency is a voting member of FSOC. Secretary Lew’s Op-Ed notes that the Update reflects the collaboration and collective expertise of all its member agencies.
Focus on Asset Management Products and Activities
The Update follows a May 2014 public conference on asset management and a July 2014 directive to FSOC staff to undertake a more focused analysis of industry-wide products and activities to assess potential risks associated with the asset management industry. In December 2014, FSOC also issued a request for public comment regarding whether and how certain asset management products and activities could pose potential risks to U.S. financial stability. FSOC received 59 comments from a range of interested parties, either encouraging or opposing enhanced regulatory oversight of asset management products and activities. The comments were due in March 2015. Now, a little over a year later, the Update details FSOC’s views on the five risk areas noted above as well as proposed next steps to respond to these potential risks.
The Update indicates that FSOC sees significant potential risks to financial stability associated with the two “key” risk areas identified by Secretary Lew – liquidity and redemption, and leverage. The liquidity and redemption risk is associated largely with runs on mutual funds shares in a crisis, where funds, particularly those that invest in illiquid assets, can be forced to sell at distressed prices, hurting shareholders and potentially threatening financial stability. FSOC’s focus on leverage risk is associated with hedge funds’ ability to unwind highly leveraged positions in a time of crisis. The Update’s discussion of these two key risk areas provides some indication of what mutual funds, hedge funds and other asset management companies can expect from FSOC moving forward.
Liquidity and Redemption Risk
With respect to liquidity and redemption risks, FSOC believes that concerns may arise in pooled investment vehicles, particularly where investor redemption rights and underlying asset liquidity may not match. In light of this risk, FSOC will consider the following mitigation measures:
- Adoption of robust liquidity risk management practices for mutual funds, particularly with regard to preparations for stressed conditions by funds that invest in less-liquid assets;
- Establishment of clear regulatory guidelines addressing limits on the ability of mutual funds to hold assets with very limited liquidity, such that holdings of potentially illiquid assets do not interfere with a fund’s ability to make orderly redemptions;
- Enhanced reporting and disclosures by mutual funds of their liquidity profiles and liquidity risk management practices;
- Steps to allow and facilitate the use of tools by mutual funds to allocate redemption costs more directly to investors who redeem shares; and
The Update also urges regulators (e.g. the SEC and the CFTC) to consider whether these or other measures may be appropriate for reducing potential liquidity risks in collective investment funds and similar pooled investment vehicles subject to their respective jurisdictions.
FSOC believes that leverage is concentrated in larger hedge funds, but that individual regulators lack access to the data necessary to develop a comprehensive understanding of the risks such leverage may pose. FSOC concludes that further analysis is needed to determine the extent of the risk that asset management leverage poses to the financial system. To undertake this analysis, FSOC will establish an interagency hedge funds working group to address the lack of information. The hedge funds working group will:
- Share and analyze relevant regulatory information in order to better understand hedge fund activities and further assess whether there are potential risks to financial stability;
- Use regulatory and supervisory data to evaluate the use of leverage in combination with other factors – such as counterparty exposures, margining requirements, underlying assets, and trading strategies – for purposes of assessing potential risks to financial stability;
- Assess the sufficiency and accuracy of existing data and information, including data reported on Form PF, for evaluating risks to financial stability, and considering how the existing data might be augmented to improve the ability to make such evaluation;
- Consider potential enhancements to and the establishment of standards governing the current measurements of leverage, including risk-based measures of synthetic leverage; and
- Seek to report its consolidated findings to the Council by the fourth quarter of 2016.
Other Areas of Risk
The Update’s discussions of the two key risks areas also identify and propose steps to address resolvability and transition planning risks. With respect to the other risk areas, FSOC believes that further data collection and analysis is warranted for operational functions and securities lending.
In his Op-Ed, Secretary Lew pledges that FSOC will continue to gather information and undertake the analysis necessary to better understand the expanding asset management sector and determine whether further action is needed. In this regard, the Update “welcomes ongoing engagement with stakeholders as this work moves forward.”
Given Secretary Lew’s commitment that “data and thorough analysis continue to guide FSOC’s work” it is imperative that mutual funds, hedge funds and other asset management companies weigh in with FSOC via comment letter and with in-person meetings. FSOC must have all data and information necessary to understand the implications of further regulation. The asset management sector is already subject to significant oversight from the SEC, which at both the Commissioner and staff level, best understand this industry. However, with only three out of five sitting Commissioners currently at the SEC, FSOC may look to take on a greater regulatory role absent demonstration by stakeholders that SEC oversight adequately addresses concerns raised by the Update.