Are asset managers becoming systemically dangerous?
SHOULD WE BE worried about the latent power of the US$76.7trn held in the asset management sector – 40% of global financial system assets – to wreak havoc on the world and unleash an unforeseen buyside catastrophe?
Are the dozen or so asset managers above, at, or nearing the trillion-dollar mark systemically dangerous? What risks does BlackRock, with more than US$5trn under management, pose where the likes of, say, Allianz Global Investors with an AUM haul smaller by a factor of 10, doesn’t?
Can fund managers ever be as systemically dangerous as banks?
These questions have been in the ether for some time. The Financial Stability Board thinks at the very least authorities should be concerned about and alert to certain risks in asset management, hence the 14 final recommendations it unveiled in its report last week, “Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities”, a follow-up to last June’s draft.
It’s all innately sensible stuff, to be honest. It’s not that most people – and I’m among them – believe that fund managers or fund management unduly pose immediate systemic risks that could require massive taxpayer bailouts or cause chronic financial system disorder. The fund structure kind of protects fund managers from group-wide implosion, while for the biggest firms elements such as asset-allocation and currency overlays, investment diversification and cash segregation typically offer protection from the toxic effects of pro-cyclicality, correlation concerns or any other dangers that might emerge during times of distress.
To be sure, though, there’s nothing wrong with thinking about the riskiness and the kinds of risk posed by fund managers.
What does strike me as a sensible step forward in this area stems from a function of prior and ongoing policy actions: actions that are pushing pools of non-bank capital into areas traditionally occupied by the banks.
POLICYMAKERS CONTINUE TO bang the drum – as indeed the FSB did in its most recent report – of reduced reliance on bank funding in favour of market-based intermediation via asset management companies. That has been the bias behind the broad push towards Capital Markets Union.
More recently, the European Central Bank’s ‘steer’ to banks, as a risk-mitigation matter, to limit their involvement in leveraged finance to deals that have less than 6x debt-to-EBITDA leverage is tantamount to a free pass to non-bank institutional capital to dominate lending to that space. (While I’m mentioning the ECB, the public hearing on its leveraged finance draft guidelines takes place on January 20 in Frankfurt and the consultation ends a week later on January 27. Not long to go – you’ve been warned.)
On the basis of the duck analogy (if it swims like a duck…), if asset managers replicate and increasingly engage in banking activities, particularly below the investment-grade space, they should be monitored, supervised and regulated like banks, regardless of the fact that to date they haven’t created financial stability concerns in recent periods of stress and heightened volatility (a point made by the FSB).
As the debt alternatives space catches on, incorporating everything from real estate and infrastructure lending to mezzanine debt to non-performing loans, distressed and restructuring to direct lending, it’s clear a series of bank-like risks are being created in the financial system away from the banks in (for the asset managers) non-traditional areas. This needs scrutiny.
Such risks require a bank-like skillset at the front end and through the deal life cycle as well as through the monitoring and supervisory process.
Given the explosion of activity in the alternatives space, you have to wonder about the level of risk that’s being created and how it’s understood and is being managed – particularly in a cycle of covenant erosion.
There’s another dimension that needs to be borne in mind. Monetary policy actions have made bank deposits a disastrous value-preservation option, forcing a wall of yield-seeking retail savings into the securities markets into things like ETFs and other schemes not protected by deposit insurance (retail hybrids, anyone?).
Because this movement is being powered by public policy, should it be creating in parallel a set of questions around investor protection and the elasticity of protection schemes? Does it call for more stringent licencing or even ring-fencing within asset management groups of bank-like and non-banking activities?
The FSB’s recommendations are a sensible starting-point. They are grouped around liquidity and leverage.
The former honed in on information gathering by national authorities and the appropriateness of liquidity risk-tools (including system-wide stress-testing inter alia to capture the effects of collective selling, contagion and volatility) and the broader adoption of risk-management tools by open-ended funds. They covered reporting and disclosure requirements, and better consistency between investment strategies and redemption language and what happens in exceptional circumstances.
Leverage recommendations focused on authorities having consistent measuring and monitoring capabilities and collecting data, with an eye on the use of leverage by funds not subject to limits and/or which might pose significant risks to the financial system.
Operational risk recommendations were about ensuring managers have robust risk management frameworks and practices, especially with regards to business continuity and transition plans to secure orderly transfer of clients’ accounts and investment mandates in stressed conditions.
The recommendations will be operationalised this year and next by IOSCO – liquidity by the end of this year; leverage by the end of 2018. The FSB said it will regularly review progress.