Global Regulators Back Off Shadow Banking Rules

WASHINGTON — U.S. regulators have already signaled they will take a lighter touch in overseeing large asset managers, but now the industry has won a similar victory on the international stage.

Greg Medcraft, who heads the International Organization of Securities Commissions, said this week that global regulators have moved too fast and too aggressively in targeting firms in the so-called "shadow banking" sector. His comments echo the group's decision earlier this month to table a framework — developed along with the Financial Stability Board — for identifying which asset managers are "systemically important." IOSCO will instead conduct a broader review of risks posed by activities across many firms.

"The international regulatory community, I believe, may have been too willing to draw conclusions about the nature and the scale of risks posed by market-based financing to financial stability," Medcraft, the chairman of IOSCO's board who also heads Australia's Securities and Investments Commission, said at a press conference in Washington Monday. "There is a concern that the international regulatory community may have gone too far in seeing problems and underestimated the effectiveness of the existing tools to regulate market-based financing."

IOSCO's reversal is seen as a win for the industry as U.S. regulators similarly lean toward an activities-based approach. It is not yet clear though if the FSB too wants to table the framework.

IOSCO does not regulate securities firms directly but develops standards incorporated into policies of member nations, similar to the Basel Committee's jurisdiction over banks. The industry had objected to the groups' earlier proposal to take a firm-by-firm approach, which institutions worry will lead to excessive regulatory burden for designated companies.

The proposed IOSCO and FSB methodology "does not reflect the avalanche of empirical studies and substantive comments that highlight how asset managers and investment funds do not present systemic risk," Timothy Cameron, head of the Securities Industry and Financial Markets Association's asset manager group, wrote in a May 28 comment letter to the two organizations.

Karen Shaw Petrou, managing partner with Federal Financial Analytics, said in a June 19 client memo that IOSCO's decision to table the designation methodology may be the first time the financial services sector has successfully defeated a major policy reform since the 2008 crisis. It also demonstrates the growing unpopularity of firm-by-firm designations for nonbank companies, she said.

"As the designation-criteria exercises in both the U.S. and global venues have demonstrated, even if institutions can't beat designation, the complexity of the process and the time it takes are totally self-defeating," Petrou said.

Others said IOSCO's decision sounded less definitive. Dennis Kelleher, president of the public advocacy group Better Markets, said he did not view IOSCO's communiqué or Medcraft's speech "as being a dramatic change" because the organization was not closing the door to either activities-based or entity-based regulation. He noted many activities — including wholesale funding, leverage, derivatives trading, and off-balance-sheet guarantees — that pose clear systemic risk and should make individual asset managers eligible for designation.

"The truth is asset managers are gigantic and engage in some extremely high risk and potentially systemically risky activities," Kelleher said. "At the same time, it ought to be a data driven fact based analysis, and that's what I heard Medcraft saying.

Medcraft, who was an executive at the Paris bank Société Générale for over 20 years before joining ASIC in 2009, said in his speech that size alone cannot justify increased regulation of asset management firms. Any new policy to add requirements to the industry must be backed up by market evidence rather than "theoretical" concerns rooted in historical data.

"I'm not convinced that asset managers put financial stability at risk simply because they are large," Medcraft said.

Yet the announcement may also signal a schism between the FSB and IOSCO, which to date have largely proceeded in lockstep.

In a June 17 press statement, which came at the conclusion of IOSCO's annual meeting, the group favored a review of asset management activities as the primary focus of international efforts to curb systemic risks in the sector, and said its work with the FSB on how to identify particularly risky firms should be suspended and "reassessed."

"On asset management, the [IOSCO] Board concluded that a full review of asset management activities and products in the broader global financial context should be the immediate focus of international efforts to identify potential systemic risks and vulnerabilities," the IOSCO release said. "Therefore, the Board believes that this review should take precedence over further work on methodologies for the identification of systemically-important asset management entities."

But in his remarks, Medcraft said IOSCO's decision does not necessarily reflect the opinion of the FSB. He noted, however, that the proposed framework had allowed for some activities-based standards, showing that the stances of both groups have been evolving over time. Medcraft added that he had spoken to FSB Chairman Mark Carney, the governor of the Bank of England, about the change in position and that Carney "understood what we're saying."

"It has been an evolutionary process," Medcraft said. "I think that you've seen a more assertive IOSCO and you will continue to see a more assertive IOSCO from now on."

A spokesman for the FSB said it will review comments on the proposed framework "in the coming weeks" and is conducting other analysis of financial stability risks associated with asset managers. The FSB will discuss preliminary results of the analysis at its next plenary meeting in September and "has no [additional] comment at this stage," the spokesman said.

IOSCO's shift comes as enthusiasm for designating systemically risk firms is also waning in the U.S. The Financial Stability Oversight Council — a panel of U.S. regulators authorized to label specific nonbanks as needing heightened supervision — has not come to a definitive conclusion about asset managers. But so far its moves on the sector have been cautious. Last year it sought public comment on various aspects of the asset management industry, whereas nonbanks in other industries have already received designations.

The Securities and Exchange Commission and Federal Reserve Board — both of which have seats on the FSOC — have each sounded support for an activities-based approach. The SEC has already moved forward with activities-based rules for the industry, and Fed Gov. Daniel Tarullo earlier this month said if more rules for the industry are necessary they will "almost surely" be written in an activities-based fashion rather than by designating individual firms.

In her memo, Petrou pointed out how designations of nonbanks in other sectors are still a big question mark, including insurers. Indeed, the FSOC is currently embroiled in a lawsuit with the life insurance giant MetLife over its designation and no firms have been labeled since that legal battle began.

"Five years on, and the rules governing systemic insurance companies are unfinished and no one yet knows how to designate other targets identified years ago: broker-dealers, hedge funds, finance companies, and private-equity firms, just for starters," she said.

For asset managers specifically, she said, a focus on single-firm designations may overlook more pressing risks in the industry connected to a whole array of companies. In the absence of standards across the whole industry, Petrou said, risk will continue to flow to unregulated firms.

"There are important unanswered questions about asset management, especially the largest, most complex, and international of these companies," Petrou said. "Their use of derivatives, their exposure to short-term funding, their on-balance-sheet holdings, and other aspects of modern asset management mean that no one yet knows what would happen if a sudden investor outflow, massive operational failure, or other shock hit one or more of these companies."