In marked contrast to the emerging U.S. deregulatory climate, the G-20’s Financial Stability Board (FSB) has issued Policy Recommendations for the regulation of four “structural vulnerabilities” in the asset management industry:1
Liquidity mismatch between fund investments and redemption terms and conditions for open-end funds;
Leverage utilized by investment funds;
Operational risks and challenges faced by asset managers in stressed conditions; and
Securities lending activities of asset managers and funds.
The FSB states that liquidity mismatch and fund leverage are its key concerns. This OnPoint reviews the FSB’s suggested regulation of fund leverage, discussing how the risks identified by the FSB with respect to fund finance may be overstated and why additional regulation may be unwarranted.
Two Types of Leverage
The FSB classifies fund leverage in two ways: balance sheet and synthetic leverage.
Balance Sheet Leverage
Balance sheet leverage refers to traditional cash financings through bank lines of credit, prime brokerage margin finance and similar direct financings. The FSB suggests calculating balance sheet leverage by dividing a fund’s total on-balance sheet leverage by the fund’s net asset value. This is a standard assets-to-equity financial ratio. Balance sheet leverage can be further divided into redemption/cash-management facilities and term/structural leverage. The FSB is concerned with the latter type of longer-dated structural leverage.
The FSB defines synthetic leverage as financing obtained through total return swaps and other types of derivatives transactions. As the FSB states, however, funds use derivatives for many different reasons, including for hedging portfolio risks and establishing more cost-efficient investment positions. The FSB is focusing on derivatives used primarily to amplify asset returns.
Fund Finance and Systemic Risk
The FSB is concerned that fund leverage, in the form of balance sheet or synthetic leverage, can amplify risks to the global financial system through the impact of such leverage on lenders, investors and asset prices.
First, the FSB states that leverage can increase the risk of a fund encountering financial distress, which can then be transferred to the fund’s balance sheet lenders or derivatives counterparties. The FSB cites the failure of Long Term Capital Management in 1998 as an example of this risk. Second, leveraged funds, which can have more volatile swings in net asset value, can also transfer risk to sponsors and investors. The FSB refers to the collapse of two Bear Stearns funds in 2007 and the financial support provided by Bear Stearns as an example of a leveraged fund transferring risk to a sponsor. Third, falling asset prices and increased margin calls can result in a repetitive cycle of fire sales of assets.
It is obvious that leverage increases financial risks. That is the purpose of leverage: to increase investment due to the assumption of greater investment risk. The FSB, however, does not offer an argument in its Policy Recommendations as to why these risks merit yet additional regulation of the fund industry.
It is notable that after the most severe global financial crisis since the Great Depression – when the S&P 500 plummeted 37% and volatility reached historic highs – the FSB is able to identify only one fund insolvency nearly two decades ago and the Bear Stearns fund closure in 2007 as examples of systemic financial harm caused by leveraged funds in a global asset management industry, which as the FSB notes, had $77 trillion AUM as of 2015.
Regulating Systemic Risk
Nevertheless, the FSB believes that perceived risks arising from investment fund leverage warrant a globally coordinated regulatory response.
Global Monitoring of Fund Leverage
First, the FSB recommends that the International Organization of Securities Commissions (IOSCO) develop methods of calculating fund leverage to allow “monitoring” for financial stability purposes across jurisdictions. IOSCO is currently assessing what types of information regulators are unable to obtain regarding a fund’s operations and investment activities. The FSB would like IOSCO to identify methods of measuring fund leverage to include in IOSCO’s assessment by the end of 2018.
Consistent Measures of Fund Leverage
The FSB is particularly concerned about consistently measuring leverage across balance sheet fund financings, derivatives and securities financing transactions. With a consistent method of measuring leverage, the FSB believes regulators could better aggregate this information and make direct comparisons across most funds “at a global level.” The FSB also suggests that regulators may benefit from using measures of leverage that are comparable to quantifying leverage in banks and other financial entities.
Risk-Based Measures of Fund Leverage
The FSB states that IOSCO should also consider developing more risk-based measures (such as value-at-risk calculations) to allow regulators to better understand how funds use leverage. Further, the FSB would like IOSCO to consider how to identify risks from “interconnectedness” between leveraged funds and other parts of the global financial system.
The FSB cautions, however, that risk-based measurements of leverage must take into account several additional factors:
- Synthetic leverage: The FSB indicates that calculations of synthetic leverage should: capture the risk of derivatives exposures that will change in the future; distinguish between positions in different asset classes; and take into account specific differences between derivatives contracts.
- Derivatives used for netting and hedging: The FSB states that the netting and hedging benefits of derivatives “require careful consideration” to avoid underestimating risk from synthetic leverage (such as when a hedge may not perform as expected during market distress) or overestimating risk (such as when a fund is not given credit for the full benefits of using derivatives for netting and hedging purposes).
- Directionality of positions: The FSB cautions that not all derivatives that increase investment exposure also increase fund leverage, and that regulators should consider the directionality of positions to distinguish between long and short positions. A written credit default swap presents much greater leverage risk than a purchased credit default swap.
- Model risk: With an eye on the 2007-9 financial crisis, the FSB recommends that measures of leverage be designed to limit “model risk.” For example, the FSB indicates IOSCO should avoid overly detailed specifications for required regulatory inputs and for reliance on estimated risk parameters and sensitivities.
Measuring Risk Across Regulated and Private Funds
The FSB further recommends that regulators monitor the use of leverage by funds that are not subject to leverage limits (e.g., funds not registered under the Investment Company Act) or which may pose leverage-related risks to the financial system. The FSB would like regulators to develop systems for aggregating and analyzing information across different types of funds subject to different regulatory schemes (e.g., private funds and U.S. registered funds).
Potential Regulatory Action
More ominously, the FSB recommends that, on the basis of this newly aggregated information across fund types, regulators should “take action when appropriate.” The FSB does not elaborate further on what action regulators should take or when such action would be appropriate.
The FSB’s call for yet more regulation of the asset management industry will clearly not be embraced in the new U.S. deregulatory climate. Republican members of Congress have already gone on record that the FSB has no binding authority in the United States. And there is scant evidence, in any event, that investment leverage was a contributing cause of the financial crisis or even meaningfully exacerbated the crisis.
Moreover, existing bank regulation has constricted the fund finance markets. Some funds report having difficulty locating long-term structural leverage. Bank balance sheets are subject to their own more stringent regulations, and some banks have been increasingly reluctant to allocate scarce capital to investment funds or other borrowers. In addition, new derivatives regulations requiring the exchange of initial and variation margin will significantly increase the cost, and will in turn limit the use, of total return swaps and other types of synthetic leverage.
Given the impact existing regulations have had on the availability and use of fund leverage, as well as the lack of compelling evidence of related systemic risks, the FSB may wish to reconsider whether fund leverage is a profound global risk warranting the imposition of additional regulatory costs and burdens on investment funds, their managers and their investors.