Report gives money managers pause

Money managers are nervously watching to see whether a Financial Stability Oversight Council report sets the stage for further scrutiny and regulation.

The review, conducted by the Treasury Department's little-known Office of Financial Research, was designed to help regulators on the multiagency council gauge how much systemic risk could exist in the $53 trillion money management industry.

The report, acknowledging an incomplete picture of the asset management world, offered no conclusions but did identify factors that could make those money management firms vulnerable to financial shocks, including:

na reach for yield, driven by competition, performance fees and other factors that increase risks that might not be fully recognized by investors;

n”herding” or going after similar assets, particularly in less liquid assets, including exchange-traded funds of fixed-income securities or emerging market assets, or mutual funds of hedge fund and private equity managers using alternative strategies;

nredemption risk in mutual funds and similar vehicles, which “have little ability to impose restrictions to prevent heavy redemptions in times of stress.” The report noted that during the financial crisis, sophisticated investors tended to react more quickly to deteriorating market conditions and perceived liquidity shortfalls to the detriment of retail investors;

nleverage obtained through borrowing, derivatives, securities lending and repurchase agreements, that can increase the risk of fire sales; and

nfailure risk of the money manager itself, depending on its size, complexity and level of interaction among diverse investment strategies. “Instability at a single asset manager could increase risks across the funds that it manages or across markets,” the report stated, especially if firm managers “fail to understand or anticipate” the financial stability implications of those risks.

The report said there are data gaps that hinder regulators' ability to “fully analyze the nature and extent of financial stability risks relating to the asset management industry.” The biggest data gaps, the report said, come from a lack of transparency in separate accounts, “their counterparty and other risk exposures, and amounts of leverage” especially related to securities lending, and the repo market. While acknowledging the added expense of gathering such information, the report suggests regulators “could consider” the costs and benefits of additional reporting requirements for these less-understood practices.

Part of a broader effort to see which other financial firms are “systemically important financial institutions,” this latest review of asset managers was “to better inform (OFR's) analysis of whether — and how — to consider such firms for enhanced prudential standards and supervision,” the report said.

Despite the inconclusive tone of the report, “it clearly signals that two important but little appreciated regulatory bodies — the OFR and, by proxy, the FSOC — are actively examining the extent to which alternative funds, such as hedge funds, pose systemic risk,” said Deborah Prutzman, CEO of the Regulatory Fundamentals Group LLC in New York, which consults on regulatory due diligence for private equity and hedge fund managers. “I would not underestimate them.” Institutional investors might also be under consideration, she said, because the OFR report mentions the need to learn more about managed accounts.

“FSOC wants to designate asset management firms as systemically significant, which means the Federal Reserve would regulate them,” Jaret Seiberg, managing director and financial services policy analyst of Guggenheim Securities' Washington Research Group, wrote to clients of the political intelligence firm. While some regulators might be truly concerned about the risks, “we also believe regulators realize that the safer course politically is to designate more firms, not fewer.”

The Financial Stability Oversight Council, which was created by the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010 and given broad authority to identify and monitor excessive risks to the U.S. financial system, already has deemed three non-banks — American International Group, General Electric Capital Corp. and Prudential Financial Inc. — as systemically important financial institutions.

The likeliest money management firm to get the FSOC's attention is BlackRock Inc., which tops OFR's list of the 20 largest asset managers by assets under management, at $3.8 trillion, and has widespread and diverse investment operations, including money market funds, which are currently getting more scrutiny from regulators. Also on the Top 20 list, which is based on Pensions & Investments' data, are The Vanguard Group Inc. with $2.2 trillion, State Street Global Advisors with $2.1 trillion, Fidelity Investments with $1.9 trillion and Pacific Investment Management Co. with $1.6 trillion.

Mr. Seiberg considers BlackRock and PIMCO the likeliest to get FSOC designation, but he cautioned “this report casts a wide net, and many of the other large asset managers may face more risk than they previously realized.” Whether the risks warrant it, “at least a few asset managers will get tagged,” he predicted.

While spokesmen at most firms declined to comment, others in the industry were not shy about questioning the report's facts and ultimate purpose. “We learned the hard way that vague insinuations and incorrect data can lead to bad public policy,” Karrie McMillan, general counsel of the Investment Company Institute, said at a capital markets conference in New York Oct. 10, where she noted the report's “many flaws.”

Vanguard, which disputes OFR's description of the firm as a non-deposit trust company, said in a statement it already operates “within a highly effective regulatory structure governed by the SEC. As an asset manager (not an asset owner), and our enterprise-wide risk management functions, we do not believe that Vanguard and other highly regulated asset management firms pose systemic risk.”

Federated Investors, in a statement, called the report “misleading and inaccurate.”

Critics of the report are quick to point out that it comes with several caveats, including the wide variety of asset manager classifications and the lack of data from hedge fund and private equity funds. OFR officials do acknowledge that asset managers differ from other financial institutions in that they act as agents and any losses are borne by clients, not the managers themselves.

An analysis of the OFR report done by the New York law firm Sullivan & Cromwell LLP noted that the lack of data on more than 50% of the total assets involved “substantially undercuts the OFR's analysis and the utility of the report for its stated purpose.” The lack of discrimination among asset managers and classes “may produce unreliable conclusions,” while assumptions about risks, including institutional first-mover tendencies are “unwarranted.”

Those shortcoming and more are expected to come up in comment letters due Nov. 1. In light of the largely negative reaction to the report, the Securities and Exchange Commission, whose chairwoman is one of 10 voting FSOC members, created the opportunity to comment. FSOC officials also will use information from the SEC's Form PF to learn more about manager assets, leverage and trading practices.

“I don't think the asset management business is well understood,” said Timothy Cameron, New York-based managing director and head of the asset management group at the Securities Industry and Financial Markets Association, which represents money managers, securities firms and banks. “OFR has indicated that they want to engage with the industry, and we continue to be engaged with them to talk them through the results.”

In addition to firm-specific information, Ms. Prutzman of Regulatory Fundamentals Group thinks an industry-wide response is warranted. “Now is the time to respond — before positions are set,” she said.

The council, whose other voting members include the secretary of the Treasury and the Federal Reserve chairman, “will review the study closely as its reviews potential next steps” for the asset management industry, said a Treasury spokeswoman who declined to be identified, but there is no time frame for dealing with the concerns raised in the report.

Still, said Richard Heller, a partner with law firm Thompson Hine LLP in New York who represents hedge funds, while the report is more of “a homework assignment, in this overly regulated environment, it's a real possibility” that it could lead to more oversight.