Systemic risk definition could create two-tier market for AMs
After a wave of rules designed to stop banks being ‘too big to fail’, attention is now turning to whether large asset managers could be a threat to market stability.
Whether parts of the industry will be deemed as systemically important is to be decided, but fund managers must take the possibility seriously and start planning now as the possible consequences could be profound.
Under current proposals by the Financial Stability Board (FSB), investment managers with $100bn and over in net AUM will be subject to closer scrutiny and special assessment by national authorities. In the case of hedge funds, an alternative threshold will be set at a value between $400-600bn in Gross Notional Exposure.
Should these proposed reforms be taken forward, it could create a two-tier market structure, penalising some participants over others.
In such circumstances normal market dynamics would be altered. Those above the asset threshold would face heavier regulatory burden and incur higher costs, creating a competitive disadvantage against smaller unconstrained peers.
Larger managers would have to absorb any new costs, with the possibility that the higher price of doing business would be passed on to clients. Additionally, new restrictions such as redemption limits for some funds would further impede larger firms’ ability to compete with unrestricted rivals.
In a crowded marketplace this could have a big impact on asset raising and will ask fundamental questions about existing fund models.
For now the debate is ongoing. Earlier this year, Andrew Haldane at the Bank of England expressed concern about the systemic risk posed by asset managers aggravating frictions in financial markets as a result of their sheer size.
The argument is that a large troubled fund forced to sell assets to raise cash could drive down asset prices in the markets.
The worry of funds’ potential impact on markets was echoed in a June report from the Bank for International Settlements.
It argued that the threat stems from the fact that managers are evaluated on the basis of short-term performance, yet revenues are linked to investor inflow patterns, which consequently exacerbates ‘”the pro-cyclicality of asset prices, feeding the market’s momentum in booms and leading to abrupt withdrawals from asset classes in times of stress”.
However, not all see systematic risk as such a clear cut matter. Many managers of long-only mutual funds which use little leverage, struggle to see how they could be considered as a high-risk component of the financial system.
Furthermore, the assets in a mutual fund are held separately to the funds on company’s balance sheet. Thus, it could be argued that the size of a fund is not the best way to measure the systematic risk, and that a banking style regulation template does not apply.
Regardless of whether the new proposals come to fruition, asset managers should prepare. The potential challenges that will be faced are just too significant to ignore.
The fact is that implementing new compliance procedures is often time and people intensive, and can drain valuable time and resources away from the core business, potentially impacting innovation in products and services.
To combat this, larger managers need to improve collaboration between internal business units. The teams in charge of delivering on regulatory change and those responsible for innovation must work together to develop solutions that not only satisfy the requirements of any regulations, but position the business to deal with possible future changes.
This will also be important for ensuring that any changes to the business are not just geared towards compliance, but improving client service and hence competitiveness. New cost-effective, but innovative services provided to clients can make it possible for these firms to still thrive in a new market structure.
So what is the likelihood of these proposals coming to fruition?
With the FSB and the OFR spearheading the debate and the reluctance of the G20 to see another systemic failure, it is more than likely the larger asset managers will be deemed to pose a threat to the financial system.
Furthermore, the latest murmurings from Brussels regarding Jean-Claude Juncker’s plans for a new regulatory directorate, combining the banking and markets units with the financial stability units into a single hub, adds further fuel to the fire.
This move would likely see increased regulation for the city of London to ensure ‘systemic stability’ in the region. What will finally happen remains to be seen, but the starting gun has most certainly been fired.
Given the potentially far reaching nature of FSB’s proposals and with further changes on the way from the EU Commission, those asset managers that fall above the recommended thresholds would be well advised to begin contingency planning now.
Saghir Khan is a partner at Parker Fitzgerald