By Ingrid Goodspeed, Governor of the South African Institute of Financial Markets
1. Introduction
The phrase “too-big-to-fail” came into widespread use in the aftermath of the 2007/08 global financial crisis. It defines the dilemma facing regulators when dealing with the recovery and resolution of systemically important financial institutions 1 (SIFIs) that are in distress. In 2010 the G20 Leaders endorsed a comprehensive framework developed by the Financial Stability Board to reduce the risk to the global financial system posed by SIFIs. The framework includes standards for recovery and resolution regimes; intensive, effective supervision; and requirements for higher loss-absorbency capacity and cross-border cooperation in resolution and recovery. The focus for implementation at that stage was on SIFIs that were banks or insurers, with thirty banks and nine insurers designated global SIFIs 2.
However in 2011 the G20 Leaders called on the Financial Stability Board and International Organization of Securities Commissions (IOSCO) to find ways to identify systemically-important non-bank non-insurer financial institutions such as asset managers. In 2015 the Financial Stability Board jointly with IOSCO published their consultation paper. Asset managers lobbied strongly against being designated SIFIs and being subject, amongst other things, to bank-style capital requirements. It would appear that their arguments held sway. In addition regulators in the US and UK said they did not intend to single out individual asset managers as SIFIs, instead they would focus on analytical work to ascertain market liquidity and leverage risks linked to asset managers. In July 2015 the Financial Stability Board announced that its analysis of possible financial stability risks arising from asset managers and asset management activities is not yet complete and that once completed it will finalise the assessment methodologies.
The objective of this article is to consider whether asset managers could be systematically important in view of their potential to introduce vulnerabilities to the financial system that threaten financial stability.
2. The asset management industry
In 2013 the global asset management industry3 managed assets of about USD 76.4 trillion (2012: USD 68 trillion), which is roughly three quarters the size of the banking industry and about 40% of global financial assets.
The top 20 international fund managers manage USD 35.4 trillion assets, roughly 41% of the global industry. The largest fund manager is BlackRock with USD 4.3 trillion assets under management. Of the top 20 asset managers, 9 are independent, 8 are bank owned and 3 are owned by insurers.
In 2013 the five largest South African-related asset managers ranked by Towers Watson were Old Mutual (UK) placed 53 out of 500 with USD 327.1 billion assets under management, Investec Asset Management ranked 135 with USD 110.2 billion assets under management, Sanlam ranked 172 with USD 73.5 billion assets under management, Coronation Fund Managers ranked 216 with USD 49.8 billion assets under management; Stanlib ranked 248 with USD 37.4 billion assets under management and Allan Gray ranked 254 with USD 36.5 billion assets under management.
3. Historic asset manager failures
History is not filled with evidence that asset management activities create or contribute to systemic risk. The only examples generally offered are Long Term Capital Management (LTCM) and money market funds.
The distress and eventual failure of LTCM shows that highly-leveraged hedge funds can cause systemic problems. At the end of 1997 LTCM was holding about USD 30 debt for every USD 1 of capital. Using this excessive leverage the firm looked for profits in a broad range of markets – government bonds, mortgage-backed securities, and equities and derivatives contracts. In its first two full years of operation it produced 43% and 41% return on equity. In August 1998, when Russia declared a moratorium on its debt, nervous investors fled into superior credit quality and higher liquidity and credit spreads widened in markets around the world, creating losses for market participants including LTCM, which lost 44% of its value in August alone. The Federal Reserve Bank of New York, concerned about possible systemic implication of a rapid and disruptive liquidation of LTCM, facilitated a capital investment of USD 3.6 billion into the firm by a group of fourteen banks and brokerage firms. This forestalled a fire sale of LTCM assets into already turbulent markets and allowed for an orderly liquidation of the firm’s holdings.
The potential systemic impact of money market funds became evident during the financial crisis when the failure of Lehman triggered an investor run on such funds. When Lehman collapsed in September 2008, a large and the oldest US money market fund, Primary Reserve Fund “broke the buck”. In the US money market funds, unlike banks and mutual funds, promised to return USD 1 for every USD 1 invested with them. No capital cushion or government guarantee such as deposit insurance stood behind this promise. Primary Reserve held 1.2% of its assets in Lehman debt with a face value of USD 785 billion that was worth zero. As a result the fund could no longer hold to its promise and at best investors would be returned USD 0.97 for every USD 1 invested. Investors lost money. The result was a run on money market funds, which put many funds in danger of failure. Only an injection of emergency liquidity into markets to replace money market funds and a decree by the US federal government to support the industry stopped the run.
On a much smaller scale; in August 2014 African Bank was placed under curatorship by the South African Reserve Bank (SARB). Investors expressed concern regarding the exposure of money market funds to African Bank. SARB acted decisively to resolve African Bank and sooth market jitters. The Financial Services Board (FSB) too took action and announced that “a very little” of the total assets of money market funds were exposed to African Bank debt, only 1.3% of assets of R270 billion with 43 money market funds, although 10 of these funds “broke the buck”.
4. What asset managers do
Asset managers act almost exclusively as agents, not principals. The core function of an asset manager is to manage assets as an agent on behalf of investors in accordance with a specified investment mandate or the investment strategy defined in the fund prospectus. The asset manager’s discretion to invest assets is also subject to a number of regulatory and legal constraints and limits.
Investors have a direct interest in and perhaps legal ownership of the underlying securities and can establish virtually on a daily basis the value of the interest. Generally investors can also trade their interest on a daily basis.
Since the core function of asset managers is to manage assets as agents, they tend to have small balance sheets in relation to their assets under management. In addition since asset managers take no investment risk (other than in respect of their seed capital) they generally need little capital to support the risk they are exposed to.
Other activities of asset managers comprise securities-lending agency services (including indemnifying securities lenders), provision of risk management systems or valuation and pricing services, and consulting and advisory services. These activities may present systemic risk if they are relied upon by investors and are difficult to substitute.
5. Possible vulnerabilities that may have systemic implications
There are four possible risk-transmission mechanisms or channels4 through which the financial distress or failure of an asset manager could be transmitted to markets and other financial institutions and potentially cause or amplify significant disruption to the global financial system.
Exposures/counterparties channel
This channel encompasses the risk that banks, brokers, creditors, investors and other market participants could suffer losses or impairments through their exposures to a distressed or failed asset manager as counterparties. This would include having direct trading links with the asset manager. It has been argued that since asset managers, as agents for the investor, do not act as counterparties to financial transactions, this risk cannot arise from the distress or failure of the asset manager.
However such exposures could result from leverage when market participants such as banks extend financing to asset managers (subject where applicable to regulatory caps). While it has been argued that asset managers; with the exception of hedge and private-equity funds, do not use leverage, a recent study5 has found that leverage on the buy side differs depending on the type of fund. Equity funds tend not to use borrowed money. On the other hand fixed-income funds do use debt, and sometimes extensively.
Counterparty risk could also result from asset managers’ securities-lending agency services to market participants. These services may include indemnifying securities lenders, including their own clients, against losses if borrowers fail to return securities, which could pose significant counterparty risk.
Asset liquidation / market channel
This risk-transmission channel stems from the mismatch between the liquidity of fund investments and redemption terms and conditions for fund units in that the units or shares of a fund are usually redeemable or tradable on demand while fund assets are generally less liquid and can be illiquid. Any fire-sale or forced sale of fund assets following heavy redemptions by investors could mimic a banking “run” i.e., one round of asset fire sales inducing further rounds in an amplifying cycle. The impact of this market liquidity risk may be exacerbated by excessive leverage and margin calls.
Given the small size of an asset manager’s balance sheet relative to its assets under management, it is unlikely that the forced liquidation of its own assets would disrupt the financial system. However there may be a major impact on the financial system if such liquidation results in significant redemptions by nervous investors. In addition there may be operational risk as a result of the transfer of investment mandates from thefailing asset manager under stressed conditions. This may further distress investors and disrupt the financial system.
A further question is whether asset managers could aggravate a market panic if a large number of them simultaneously sold off certain types of assets while uneasy investors were trying to exit. This happened with asset-backed securities in 2008. Recent events such as the October 2014 Treasury bond flash rally in the US and the April 2015 German Bund yield instability in Europe are reminders that market liquidity is unpredictable and associated volatility can impact even the most liquid assets. Several solutions have been mooted by regulators and the industry to deal with this scenario including requiring funds to hold more cash to meet redemptions and installing “gates” to suspend or limit investor withdrawals at times of market stress. Many fixed-income asset managers have been increasing their credit lines to protect themselves against the possibility of a wave of redemptions by edgy investors.
The critical function or services substitutability channel
The systemic impact of an asset manager’s distress or failure is generally negatively related to its degree of substitutability as both a market participant and service provider. Thus it could have a systemic impact if a particular asset manager were unable to provide a critical function or service relied upon by market participants or clients and for which they could not find a suitable and ready replacement.
Asset managers are generally considered highly substitutable since investors are free to switch their assets to a different manager, investment strategy or investment fund and third-party custody arrangements facilitate such switching.
However if an asset manager has specific skills which makes its business not easily substitutable in the event of its distress or failure, the resulting disruption may be large, perhaps even systemic, in terms of both service gaps and reduced flow of market liquidity.
Delegation / industry conventions channel
The fourth risk-transmission mechanism relates to the delegation of the investment decision and associated industry practices and incentives.
Investors delegate the day-to-day management of their investments to an asset manager and agree upon incentives for the managers to act in their interests. These are generally based on manager performance relative to its peers or to benchmarks.
Since asset managers are generally highly substitutable, this form of evaluation may lead to portfolio decisions that result in increased volume and volatile price movements that may have systemic implications. Examples are (i) intense buying and selling to avoid unfavourable short-term performance; (ii) higher correlations between and price volatility of securities included in benchmarks (iii) herding i.e., mirroring the behaviour of peers as it is safer to be wrong collectively than individually and (iv) excessive risk taking when fund performance falls behind that of its competitors.
6. What are regulators doing / planning to do?
The possibility that asset managers and their investors might destabilise financial markets is highly relevant for financial-sector regulators. The current regulation of the asset management industry focuses mainly on investor protection with some consideration of micro-prudential issues. Macro-prudential policy perspectives such as assessing sector vulnerabilities, particularly its leverage and market liquidity risks are still in a formative stage. Of course asset management companies that belong to financial groups that have been identified as global SIFIs are already included in the prudential regulation of their parent company and subject to specific requirements to cover these risks.
Recently both the Bank of England and the US Federal Reserve announced that they do not intend to single out individual asset managers as SIFIs. Instead they will focus on analytical work to ascertain market liquidity and leverage risks linked to asset managers. The view of the UK Financial Conduct Authority is that it is not asset managers that are systemic but rather the markets they operate in and “big questions” need to be answered before labelling asset managers as SIFIs.
The US Securities and Exchange Commission announced several initiatives to reduce risk in the US asset management industry including subjecting mutual funds and exchange-traded funds (EFTs) to stress tests to ascertain if they can survive a market crisis and requiring them to specify how they could be resolved should there be a major disruption in their business.
The Financial Stability Board announced in September 2015 that it too is working on identifying risks associated with market liquidity and the activities of asset managers. It encouraged funds to stress test their ability to individually and as an industry meet redemptions under stressed market liquidity conditions. In addition it, together with IOSCO, will continue to work on identifying sources of vulnerabilities including (i) the mismatch between the liquidity of fund assets and their redemption conditions; (ii) leverage within funds; (iii) operational risk associated with transferring investment mandates under stress; and (iv) securities lending activities of asset managers.
Reforms are currently underway globally to address the systemic risks associated with the high leverage and complex strategies of hedge funds and the vulnerability to runs of money market funds. South Africa too has introduced hedge fund regulations. However these focus mainly on market conduct and investor protection mechanisms rather than on prudential requirements. Under the proposed Twin Peaks regulatory framework the prudential regulation and supervision of money market funds as well as financial conglomerates, banks, insurance companies, securities exchanges and central counterparties will be assigned to the Prudential Authority a statutory entity within the South African Reserve Bank. The market conduct regulation and supervision of financial institutions, including money market funds, will be given to a separate dedicated statutory entity – the Financial Sector Conduct Authority, which will incorporate the Financial Services Board.
The International Monetary Fund’s (IMF’s) financial sector assessment programme (FSAP) of South Africa end 2013 noted that the reliance of South African banks on money market funds for short-term wholesale funding makes South Africa susceptible to contagion and recommended that systemic liquidity risk be reduced by introducing variable net asset value for money market funds. In addition the IMF recommended that South Africa enhance the regulation and supervision of asset managers. South Africa is still to implement these reforms.
7. The age of asset management?
In a speech in 2014 Andrew Haldane said “It is often said that banks are special. Compared to banks, asset managers generate a completely different risk and opportunity set. But they, too, are special both for the financial system and the wider economy. As they grow in scale and importance, that specialness is likely to increase further. The Age of Asset Management may be upon us. Academics, practitioners and regulators have been studying banks, their behaviour and failure, for several centuries. Analysing and managing the behaviour of asset managers is, by contrast, a greenfield site.”
Fears about possible financial stability risk posed by the asset management industry have increased recently as a result of the sector’s growth, its investments in less liquid assets and the multitude of investment products offered to the general public. It is generally agreed that oversight of the industry should be strengthened in respect of both micro-prudential and investor protection supervision. However it is also important that regulators implement a macro-prudential view of the industry to assess the factors that make the industry vulnerable to financial shocks and how the industry could transmit systemic risks across financial markets and the financial system.
Bibliography
Fernando Avalos, Ramon Moreno and Tania Romero, October 2015, BIS Working Papers No 517: Leverage on the buy side, www.bis.org/publ/work517.pdf. Accessed October 2015
Bloomberg. 26 June 2015. A perfect storm brews for bond funds. www.bloomberg.com. Accessed October 2015
Economist. 2 August 2014. Assets or liabilities? www.economist.com. Accessed October 2015.
Economist. 2 August 2014. Regulators worry that the asset management industry may spawn the next financial crisis. www.economist.com. Accessed October 2015.
Financial Stability Board. March 2015. Assessment Methodologies for Identifying Non-Bank Non-Insurer Global Systemically Important Financial Institutions. www.financialstabilityboard.org. Accessed October 2015.
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End notes
[fusion_builder_container hundred_percent=”yes” overflow=”visible”][fusion_builder_row][fusion_builder_column type=”1_1″ background_position=”left top” background_color=”” border_size=”” border_color=”” border_style=”solid” spacing=”yes” background_image=”” background_repeat=”no-repeat” padding=”” margin_top=”0px” margin_bottom=”0px” class=”” id=”” animation_type=”” animation_speed=”0.3″ animation_direction=”left” hide_on_mobile=”no” center_content=”no” min_height=”none”][1] Systemically important financial institutions cause major disruption to the financial system and economic activity when distressed or if they fail in a disorderly way. Sources of systemic risk relate to their size, complexity, interconnectedness, substitutability and cross-jurisdictional activity.
[2] The list of global SIFIs can be found at: http://www.financialstabilityboard.org/2014/11/2014-update-of-list-of-global-systemically-important-banks/ and http://www.financialstabilityboard.org/2014/11/2014-update-of-list-of-global-systemically-important-insurers-g-siis/.
[3] For purposes of this article, the asset management industry includes collective investment schemes such as mutual funds, unit trusts, exchange-traded funds, money market funds, private equity funds and hedge funds.
[4] The first three channels were highlighted by the Financial Stability Board in its second consultative document “Assessment Methodologies for Identifying Non-Bank Non-Insurer Global Systemically Important Financial Institutions”.
[5] Fernando Avalos, Ramon Moreno and Tania Romero, October 2015, BIS Working Papers No 517: Leverage on the buy side, www.bis.org/publ/work517.pdf accessed October 2015.[/fusion_builder_column][/fusion_builder_row][/fusion_builder_container]
