The Office of Financial Research (“OFR”), an office of the U.S. Department of the Treasury, recently issued a report that may provide a roadmap for future designations by the Financial Stability Oversight Council (“FSOC”) of asset management companies for supervision as systemically important financial institutions (”SIFIs”).1 The release, “Asset Management and Financial Stability” (“Report”), describes how in the view of the OFR the U.S. asset management industry may be vulnerable to financial shocks and may contribute to the amplification or transmission of such shocks, which, in turn, may pose threats to U.S. financial stability.
When the FSOC in April 2012 issued a final rule regarding how it would exercise its authority to designate nonbank financial companies as SIFIs, it indicated that, with the assistance of the OFR, it was in the process of analyzing the extent to which asset management companies presented potential threats to financial stability. The final rule left open significant questions as to how asset managers would be evaluated under the SIFI designation process.2
The Report suggests that various aspects of asset managers operations may present systemic risks to financial stability. The Report, when read together with the FSOC’s first three SIFI designation decisions, could lead to increased scrutiny of asset management firms by the FSOC.
SEC Request for Comments
On the day the Report was issued, the Securities and Exchange Commission (“SEC”) announced that it would accept comments from the public on the Report. The SEC’s comment period will be open through November 1, 2013. The SEC comment process offers an important opportunity for persons interested in asset management activities to provide their views regarding the analysis and concerns contained in the Report, and to impact what findings are required to be part of the record when the FSOC considers asset managers for possible designation as SIFIs, among other things.
Key Aspects of the Report
Noting that the U.S. asset management industry oversees the allocation of approximately $53 trillion of financial assets, the Report briefly presents certain data regarding the sources of managed funds, the distribution of assets in the asset management industry, and the asset vehicles and asset categories of assets in which customer funds are invested. However, the more significant part of the Report is the OFR’s discussion of what it describes as the “vulnerabilities” of the asset management industry to financial shocks and how the industry may affect U.S. financial stability.
According to the Report, there are four categories of industry vulnerability:
- Reaching for Yield and Herding Behavior. Portfolio managers may in certain situations “reach for yield" by seeking higher returns in riskier assets than they otherwise would select for a particular investment strategy. Competitive pressures may also cause asset managers to take on extra risks, and some risks (such as the difficulty of disposing of assets in less liquid markets) may be aggravated by numerous managers crowding into the same asset class. If investors do not understand or appreciate the risks, particularly in newer investment products that expose investors to alternative investment strategies, they may seek to disinvest, further worsening any financial shock.
- Redemption Risk and Liquidity Management. Collective investment vehicles offering unrestricted redemption rights could face large redemption requests in a stressed market if investors believe that they will gain an economic advantage by being the first to redeem. Asset sales in response to redemption requests could spread the stress from one asset type to another type within the same portfolio and to additional market segments. Increased redemptions may also create a perception that the asset manager is itself at risk of failure.
- Use of Leverage. Leverage through derivatives contracts, securities lending and repurchase agreements may magnify both gains and losses compared to an investment in the underlying asset or index alone.
- Asset Managers as a Source of Risk. A large asset manager or an asset manager that is part of a large complex organization may expose its investors to liquidity risk or operational risk. For example, an asset manager of a number of funds could employ strategies that turn out to be correlated in unanticipated ways, or an asset manager could be linked to other companies that provide an array of services to the asset management industry, creating interconnections and dependencies that increase the asset manager’s importance in financial markets. These vulnerabilities and other risks inherent in asset management may be transmitted across the financial system through two primary channels: (i) direct exposure of creditors, counterparties, investors and other market participants to an asset manager or its affiliates; and (ii) disruptions caused by asset “fire sales.” The Report suggests, without providing any examples or explanation, that a concentration of service providers and interconnections between asset managers and other financial services firms increases the potential that risks originating among asset managers could be transmitted to or amplified through other market sectors, and vice versa.
The Report notes that there are significant gaps in available data for several areas of the asset management industry, particularly with regard to the administration of separately managed accounts and practices followed in securities lending. This conclusion may suggest that the OFR will embark upon a process of gathering relevant data from the industry.
Interestingly, while the Report describes itself as providing only “a brief overview” of the asset management industry, it does not expressly caution the reader regarding the conclusions that may be drawn based on this limited review. From an administrative law perspective, the admittedly summary nature of the Report, among other matters, contributes to undermining the potential reliance that the FSOC could fairly place on the Report.
It should be a particular concern that the “findings” of the Report — consisting of a general taxonomy of risks from which numerous hypothetical cause-and-effect relationships are drawn, with little discussion of their likelihood, severity or amenability to preventive or corrective measures — so closely resemble the methodology that the FSOC has used in its three SIFI designation orders to date. This similarity suggests that the Report may provide the analytical foundation for the FSOC's future review and possible designation of asset managers as SIFIs, notwithstanding the many issues related to the Report. This emphasizes the importance of public comments to the SEC that provide other perspectives on the operations of asset managers and the risks to financial stability that asset managers may or may not pose.