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The Dodd-Frank Act created significant 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” and threaten financial stability, it can assign a SIFI designation and require the firm to satisfy enhanced capital, leverage, liquidity, and supervision requirements similar to those Dodd-Frank prescribes for large banking institutions.
Dodd-Frank skeptics warned that such a setup would encourage regulators to expand their SIFI powers beyond large banks to virtually any large financial firm. That’s the case because there is no clear definition of what constitutes “systemic risk” and no framework for assessing a non-bank financial firm’s impact on financial stability.
These warnings now look prescient. The Council has already designated AIG, GE Capital, and Prudential Financial as non-bank SIFIs. Metlife is under the Council’s microscope and some members are reportedly considering SIFI designation for the largest asset management companies such as BlackRock, Fidelity and PIMCO.
In September, the Treasury’s Office of Financial Research issued a study that encourages a further expansion of the Council’s role. The study will guide the Council’s deliberations on non-bank SIFI status for asset management firms–firms that manage the investments of stock and bond mutual funds, 401K retirement and corporate pension fund investments. The study excludes money market, hedge, and private equity funds which have received their own special studies.
The Treasury study paints an alarmist portrait of an industry that channels consumer savings directly into investments in growing companies. The industry has never caused the failure of a large bank, let alone a systemic financial crisis, and so it is unclear why it should be the target of increased Council scrutiny.
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.
Despite a history of industry stability, the Treasury report makes disturbing allegations that the industry introduces large systemic risks. To do so, it rehashes dated arguments and recycles existing research about risks that arise in bank-depositor relationships, not potential risks in the asset management industry.
A key example of overreach in the study, for example, is the claim that asset managers create “fire sale” externalities when they sell assets. “Fire sales” arise when banks experience a loss of confidence and their depositors run. Banks are forced to sell illiquid assets even at a loss to enable banks to honor their fixed-value liabilities and avoid failure. Some highly levered hedge funds have had similar experiences, but it is misleading to apply such a model to asset managers that have a very limited ability to use leverage. Outside of money market funds, asset managers do not issue fixed value claims, and they are never pressured to dump assets to avoid a default.
When mutual fund net redemptions are large, fund managers must sell assets and asset prices may fall. It is simple supply and demand. Most people would not think of this as “systemic risk,” and yet the Treasury report suggests that it is. The academic studies Treasury uses to support this claim also show that large mutual fund inflows cause stock price gains, but Treasury forgot to mention that. Evidence of simple supply and demand at work–not systemic risk.
If large investor redemptions generate illiquidity costs, fund investors bear these costs. Outside of money market funds that are not the focus of the Treasury report, there is no threshold net asset value or redemption volume that will trigger a mutual fund investor run and require asset managers to dump assets at “fire sale” discounts to avoid a fund default.
Worse yet, the Treasury report suggests that fund “fire sale risk” could be eliminated if asset managers are required to hold large liquidity buffers. Larger liquidity buffers will surely mean lower expected returns for fund investors, but with no tangible benefit to fund stability. Liquidity buffers or not, faced with large investor redemptions, fund managers must sell assets.
The report also raises a number of red herring issues, including suggestions that there are potential SIFI-level risks generated by specific industry activities such as securities lending, exchange-traded funds. These issues have already been extensively studied and national regulators findings are summarized in two recent Financial Stability Board reports. Domestically, the SEC has also undertaken a number of steps to improve regulation and disclosure in these areas.
One wonders whether the real issue with securities lending is market share. Section 165(e) of the Dodd-Frank Act limits banks’ counterparty risk exposures which includes the guarantees extended through securities lending. Bank-SIFIs are subject to even stricter limits. Not so for asset managers who are not subject to this rule unless they are designated as SIFIs.
Should asset manager securities lending generate serious financial stability concerns (which is doubtful), the Council can require the SEC to impose additional capital requirements or other rules to mitigate the risk. There is no need for a SIFI designation.
Regulators must be extremely cautious when they assign a SIFI designation. The Treasury report does not develop the framework that is needed to seriously analyze asset managers’ potential for creating financial instability. Instead of doing this hard work, the report sounds multiple alarms that are music to the ears of regulators seeking to expand their reach.
Paul Kupiec is a resident scholar at the American Enterprise Institute.
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