Money managers remaining vigilant against FSOC

Money managers watching the Financial Stability Oversight Council grapple with systemic risk breathed more easily after being given a chance at a recent Washington conference to explain what they do. Still, they're not letting down their guard or putting away potential weapons just yet.

Panelists representing money management heavyweights such as BlackRock Inc., State Street Corp., Pacific Investment Management Co. LLC, AQR Capital Management LLC, Citadel LLC and Fidelity Investments explained it is investors, not money managers, who decide in which sectors they want to be invested. “The major takeaway was that run risk (the risk of a run on a particular fund or firm that could affect other participants) is idiosyncratic; it's not systemic,” said Timothy Cameron, Washington-based managing director and head of the asset management group at the Securities Industry and Financial Markets Association. “The more that all of the regulators learn about the role performed by asset managers, it is our hope they will recognize that asset managers aren't systemic in and of themselves.”

The FSOC 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.

Under Dodd-Frank, bank holding companies with $50 billion or more in assets are automatically deemed systemically important financial institutions, or SIFIs, and subject to additional supervision by the Federal Reserve. A non-bank financial institution can be designated if two-thirds of voting members find it could pose a threat. The council already has designated three non-banks — American International Group, General Electric Capital Corp. and Prudential Financial Inc. — as SIFIs.

The spotlight turned on money managers last September when an FSOC report prepared by the Treasury Department's Office of Financial Research identified activities of 20 of the largest U.S. money managers as possible sources of risk. The list, which was based on Pensions & Investments' data, includes BlackRock with $4.3 trillion in assets under management; Vanguard Group Inc. with $2.8 trillion; State Street Global Advisors with $2.3 trillion; Fidelity Investments with $2.2 trillion and PIMCO with $1.5 trillion.

Since then, anxiety levels among money managers have continued to rise, largely because of a lack of insight — and input — into the FSOC process for designating systemically important financial institutions. Nervous money managers and industry groups like the SIFMA have let their many concerns be known on Capitol Hill, leading to bipartisan pressure from House and Senate members to rethink the FSOC's mandate. House Financial Services Committee Chairman Jeb Hensarling, R-Texas, has twice called on the FSOC to “cease and desist” until Congress learns more about the process.

To help ease those fears, the Treasury Department convened a public conference May 19 to hear from academics and to let the money managers explain their business models.

Norm Champ, director of the SEC investment management division, pointed out at the start of the conference that the money management industry is both diverse and unique, but governed by several levels of fiduciary responsibility and third-party custodians, and “highly regulated” by the SEC.

The industry also has done more to manage risk, panelists at the conference said.

“Idiosyncratic jumps in default risk” stemming from external factors such as market shifts, sector risk or investors' asset reallocations are continually subject to managers' own “deep-down analysis,” said panelist William De Leon, managing director and global head of portfolio risk management at PIMCO, Newport Beach, Calif.

Giving money managers a forum provided some reassurance that FSOC officials will look at specific activities by money managers — such as securities lending and the repurchase agreement market — rather than just the firm's size, SIFMA's Mr. Cameron said.

Money managers also took comfort from remarks by SEC Chairwoman Mary Jo White at an Investment Company Institute gathering May 22 that FSOC members “ought to be looking very closely at what is it (they) are trying to achieve. What does it actually accomplish?”

Ms. White, one of 10 voting FSOC members, said managers were not “overreacting” in their complaints of a lack of transparency and a banking regulator bias at the council. “I think it is enormously important for FSOC to make certain that it has the requisite expertise” for scrutinizing money managers, she said.

Mary Miller, Treasury undersecretary for domestic finance, stressed at the May 19 conference that the FSOC “clearly recognizes that asset managers are different,” and will continue to engage the asset management industry before coming to any conclusions. “It is indeed possible that we will take no action,” said Ms. Miller, a former fixed-income director at T. Rowe Price Group Inc., Baltimore.

A better approach, conference participants said, is more scrutiny of the problems seen during the financial crisis, such as too much leverage or illiquid assets that present redemption risk for money market funds, which are being revisited by the SEC. “The message is, allow the primary regulators to finish the work they have in process and then look to see if anything else makes sense,” SIFMA's Mr. Cameron said.

A SIFI designation brings with it the threat of additional oversight by the Federal Reserve and more rules that could include risk-based capital reserves, leverage limits, liquidity rules, stress testing and increased reporting demands. That has managers hedging their bets, joining with other critics to convince FSOC officials to slow things down. One of the most vocal critics is SEC Commissioner Daniel Gallagher, who on May 15 filed his own comment letter on the OFR report, which he said “reflects a severe lack of understanding of the asset management industry.” Illustrative of the FSOC's “unprecedented and extraordinary regulatory powers” Mr. Gallagher said was a November 2012 FSOC recommendation that led the SEC to restart efforts to reform money market mutual funds.

If the critics don't prevail, it will be time to bring in the lawyers to legally challenge the FSOC process, said an industry lobbyist who declined to be identified.

Eugene Scalia is a partner with Washington law firm Gibson Dunn & Crutcher LLP who specializes in challenging financial regulators over their rule-making procedures. Mr. Scalia warned during a House hearing May 20 that Dodd-Frank dictates 11 factors for the FSOC to consider when deciding to designate a firm as systemically important, including leverage and off-balance sheet exposure, relationships to banks and other financial institutions, the extent to which assets are managed rather than owned, and the level of regulation already in place. With an “exceptionally opaque” process, “FSOC must correct an imbalance in its decision-making ... which places a thumb on the scales for designating companies systemically important by giving great weight to unsubstantiated speculation about what would happen if a company is not designated systemically important, while ignoring what will happen if the company is deemed systemically important,” Mr. Scalia said. “FSOC has not even defined "systemic risk.'”

Before any SIFI designations or lawsuits, “the discussion needs to come down to a much more detailed level, and the definitional issues really need to be worked out,” said Sean Tuffy, Dublin-based senior vice president and head of regulatory intelligence for Brown Brothers Harriman & Co., a custodian bank whose customers have a cumulative $4 trillion in assets. “I think there is starting to be some buyers' remorse from the folks who set it up.”