October 31, 2013
SEC Comment on the OFR Report, Asset Management and Financial Stability
Paul H. Kupiec, Ph.D.
Resident Scholar, The American Enterprise Institute
These comments are the opinion of the author alone. They do not represent the opinions of the American Enterprise Institute.
The Dodd-Frank Act created regulatory uncertainty when it gave the Financial Stability Oversight Council the power to designate financial firms as systemically important financial institutions or SIFIs. If the Council finds that financial firms create systemic risks that threaten financial stability, it can designate the firm a SIFI and require it satisfy capital, leverage, liquidity, and enhanced supervision processes that are similar to those Dodd-Frank prescribes for the largest banking institutions.
Non-bank SIFI designation is a contentious issue because there is no clear definition of what constitutes systemic risk and no framework for assessing a non-bank financial firms impact on financial stability. Moreover, there is no economic analysis that demonstrates that FSOC-designated non-bank financial SIFIs will pose reduced financial stability risks if they are required to follow the enhanced capital, leverage, and supervisory standards similar to those required by bank SIFIs under Dodd-Frank.
To date, the Council has designated AIG, GE Capital, and Prudential Financial as non-bank SIFIs. Dodd-Frank allows the Federal Reserve to modify the enhanced prudential standards for bank SIFIs to better accommodate specialized industry characteristics of any non-bank financial SIFIs the Council designates, and yet the Federal Reserve has not yet specified any specific alterations to the enhanced prudential standards it will apply to bank SIFIs. Until it does, non-bank SIFI designees must prepare to comply with Basel III regulatory capital rules and liquidity standards, orderly liquidation planning, and Federal Reserve designated stress testing even though these rules were specifically designed for banks, not for insurance, finance or asset management companies.
Some Council members are considering SIFI designation for the largest asset management companies like BlackRock, Fidelity or PIMCO, even though the Council lacks a framework for assessing whether these asset managers create financial stability risk. Moreover, it is unclear what SIFI designation would accomplish as it has never been discussed how requiring asset management Institutions to satisfy the enhanced bank-centric safety and soundness standards will accomplish any specified policy goal.
In September, the Treasurys Office of Financial Research issued a study to guide the Council in its deliberations on non-bank SIFI status. The report excludes analysis of money market funds, hedge funds and private equity funds, and so these activities are also excluded from this commentary.
The OFR study provides no evidence that an asset manager SIFI designation would improve financial market stability, and yet the study paints an alarmist portrait of the industry that is designed to encourage designation. Unlike bank holding companies, mutual funds do not go bankrupt. They do not borrow funds they cannot repay. They will not be resolved in the new special Dodd-Frank Title II resolution. Losses, while never welcome, are fully absorbed by fund shareholders. There is no possibility that mutual fund losses will trigger a systemic banking crisis.
When Lehman Brothers failed, its asset management subsidiary survived and it operates even today as an independent company. If mutual fund management companies stumble, the Security Investor Protection Corporation rules already shield investors from fallout.
The OFR report offers no new framework for assessing the systemic risk potential associated with asset manager operations. It rehashes dated arguments and recycles existing research about risks that arise in bank-depositor relationships, not potential risks in the asset management industry.
One particularly misleading issue raised by the OFR study is the claim that asset managers create fire sale externalities when they sell assets. A fire sale externality arises in banking models when banks experience a loss of confidence and their depositors run. Banks are forced to sell illiquid assets even if the sale generates losses so they are able to honor their fixed-value liabilities and avoid failure. Outside of money market funds, asset managers do not issue fixed value claims, and so they are never pressured to dump assets to avoid default.
Still, it is true that when enough people want to sell a stock, the stock price may fall. Similarly, when mutual fund net redemptions are large, fund managers must sell assets, and asset prices may fall. It is particularly true if the assets being sold are illiquid. Its simple supply and demand. Most people would not think of this as systemic risk, and yet the Treasurys study suggests that it is.
To be fair, the OFR study does not do any new research on the topic, but instead relies on academic studies that show when many mutual funds experience large redemptions that require fund managers to sell similar assets, asset prices may decline. These studies also find that the reverse is true: large mutual fund inflows may cause mutual fund managers to purchase similar assets, and these asset prices may rise. The academic studies label the former fire sales but they do not coin a pejorative term for the symmetric case when large fund inflows cause asset prices to rise. Moreover, the OFRs clearly reveals its intention to skew the debate towards asset manager SIFI designation when it only mentions the fire sale results from this literature.
Large mutual fund purchase or redemption demands may generate illiquidity costs, but outside of money market funds that are not covered in this report, there is no threshold net asset value or redemption volume that will trigger an investor run. Fund investors bear the cost of illiquid fund asset sales.
Worse yet, the OFR report suggests that this fire sale systemic risk could be eliminated if asset managers held large mandatory liquidity buffers. Larger liquidity buffers will surely mean lower expected returns for mutual fund investors, but with no tangible benefit to fund stability. Liquidity buffers or not, faced with large permanent investor redemptions, fund managers must eventually sell assets.
What about the symmetric case? Should asset managers be required to build large liquid asset buffers when they experience fund inflows to avoid bidding up asset prices? If asset price declines linked to mutual fund sales are an externality requiring regulation, then surely it follows that mutual fund purchases that trigger asset price increases must also be an externality in need of regulation. The logic is exactly the same and yet most people would probably not identify the positive return is an externality that should be regulated away. The idea that either of these investor demand-generated price impacts is an externality in need of new regulation or a SIFI designation is misguided.
A SIFI designation will bring new required capital and liquidity buffers that could lead fund investors to expect their funds will be supported by the management company in the next market correction. What happens when a fund tries to buffer large redemption demands by avoiding the sale of assets experiencing illiquidity discounts but instead finds that asset price declines were permanent and not merely a temporary liquidity discount? Such a regulation would essentially lock in mutual fund investors in SIFI-designated funds from selling their assets until prices bottom out. Investors incentive to run a SIFI-designated fund would be enhanced. In this case, SIFI designation and mandatory liquidity buffers would be counterproductive and actually increase systemic risk.
The report also suggests that there are potential risks associated with specific asset management industry products and activities. If any of these risks rise to a level that justifies new regulations, the Securities and Exchange Commission has jurisdiction. In another example of OFR study bias, the report fails to highlight the fact that the specific issues it raises have already received extensive regulatory attention both domestically in the Dodd-Frank Act and internationally through Financial Stability Board deliberations.
The stability risks of exchange-traded funds and securities lending have been extensively studied. The findings of national regulators appear in a recent Financial Stability Board reports. Domestically, the Securities and Exchange Commission has issued guidance on the risks of investing in exchange traded funds and is required to increase securities lending disclosures by Section 984 of the Dodd-Frank Act.
Regarding the issue of securities lending, I wonder whether the real unspoken issue is the potential competitive disadvantage Section 165(e) of the Dodd-Frank Act may create for bank SIFIs. This provision limits banks counterparty risk exposures which must include indemnities extended through securities lending. SIFIs will be subject to even stricter counterparty lending limits. While the industry argues indemnity risks are limited, when added to bank SIFIs other exposures, Section 165 rules could limit bank SIFIs ability lend securities. Not so for asset managers who are not subject to this rule unless they are designated as SIFIs.
If securities lending activities of asset managers are really generating financial stability concerns (which is doubtful), the Council could require the SEC to impose supplementary asset-lending capital requirements on asset management firms. There is no need for SIFI designation.
Regulators must be extremely cautious when they designate institutions as systemically important. A SIFI designation may increase systemic risk as customers may be less diligent managing their SIFI exposures given the institutions explicit systemic importance. The Treasurys OFR report does not develop the framework that is needed to seriously analyze asset managers potential for creating financial instability. Judged on this basis, the OFR report falls far short. It would be shocking if the Council found value in this report. It would be more shocking still if the report were used to justify an industry SIFI designation.