How to Regulate Asset Managers? There's No Easy Answer

WASHINGTON — If the Financial Stability Oversight Council was hoping for any kind of consensus on whether and how it should regulate asset management companies, the feedback it has received on its request for comment is likely disappointing.

Asset management companies, their representatives and public interest groups presented widely divergent visions about what, if anything, the council should do.

On one side were those that urged the FSOC to take no action at all.

"Asset management vehicles, such as mutual funds, allow average investors to have access to liquid, diversified investment vehicles … at a reasonable cost," wrote David Hirschmann, president of the Center for Capital Markets Competitiveness, an arm of the U.S. Chamber of Commerce. "Unnecessary regulation on asset management products and activities will interfere with the ability of average Americans to achieve their financial goals."

On the other side were progressive groups who noted that asset managers collectively hold an enormous volume of assets throughout various markets, including bonds and commercial paper. Poor management of those assets can trigger fire sales, which can cause harm to the financial system in general.

"With the exception of the [savings and loan] crisis, asset management practices have played a significant role in every major financial stability event of the last 30 years," wrote Americans for Financial Reform in an unsigned letter. "Simply because asset managers play such a vital role in deploying a vast stock of assets, their decisions and behavior are central to the financial system and can impact the real economy."

FSOC's interest in the risks posed by asset managers originated with the agency's 2012 publication of a final rule outlining the process for designating nonbanks as systemically important. At that time FSOC instructed the Office of Financial Research to study those risks, and the office released a report in 2013 that suggested asset managers post a threat to the economy. The industry, meanwhile, protested that assertion and said the OFR report was deeply flawed.

FSOC raised the issue again in December, issuing a call for public comment on how to handle asset managers. At that time, Treasury Secretary Jack Lew, who chairs the interagency council, said FSOC was just trying to gather information rather than pursuing a fixed agenda.

"There are no predetermined outcomes here," Lew said.

In the comments, which were due by March 25, the industry returned again to the need for FSOC to prove asset managers pose a systemic threat. The Chamber's Hirschmann, for example, urged FSOC to employ a rigorous methodology, using "realistic" risk models that have a "comprehensive global appreciation" of how risk factors interplay.

Fidelity Investments, which oversees one of the most substantial mutual funds in the industry, likewise said that FSOC's analysis requires "both rigor and balance" and suggested that any intervention made by FSOC should meet a high standard. Moreover, it said the Securities and Exchange Commission should take the lead in crafting any future regulations on the asset management industry.

"The SEC is the council member with the most expertise regarding the asset management industry, capital markets, and their regulation," wrote Scott Goebel, the general counsel of Fidelity. "The SEC is also presently focused on many of the same issued raised in this notice, including management of liquidity and redemptions in mutual funds, the use of derivatives by mutual funds, and ensuring that client assets can be transferred smoothly."

The American Bankers Association, meanwhile, limited itself in its comments to explaining why regulation of bank-maintained Collective Investment Trusts would be a bad idea. CITs are bank-managed portfolios that consist of the pooled assets of its trustees — similar to mutual funds or hedge funds, except with a different legal framework and not available to the general public.

Phoebe Papageorgiou, vice president and senior counsel with the ABA, said that because the funds are not available to anyone and are subject to a number of existing prudential regulations and backstops, they do not pose a systemic risk and should not be regulated as such by FSOC. In the unlikely event that a bank failed and was not covered by the Federal Deposit Insurance Corp., ABA said, the failure would not affect the fund or the financial system because it is held separately from the bank's balance sheet.

"Due to their fiduciary nature, limitation on eligible investors, and existing regulatory framework, CITs do not present a significant concern for liquidity, redemption, leverage, and operational risks," Papageorgiou said.

The Money Management Institute, which represents various managers of "separately managed accounts" likewise called for its constituents to escape systemic designation. SMAs are portfolios of equities or other assets managed professionally on the behalf of an individual customer — examples of firms that offer SMAs are T. Rowe Price, Janus Capital Group and American Century Investments.

The group said SMA investors are almost entirely invested in liquid assets and involve virtually zero leverage (as opposed to pooled investment vehicles like mutual funds or hedge funds). The failure of a single investment portfolio or investment manager would therefore be unlikely to create systemic risk, MMI said, because the portfolios by definition are not interconnected, except to the extent that they interact with broader financial markets.

"SMA programs are distinct from funds and other pooled vehicles in that they do not themselves have redemption features," MMI President Christopher Davis said. "SMA accounts that hold illiquid assets generally are limited to high-net-worth and institutional accounts held by investors who are sophisticated parties that can … set restrictions on exposure to illiquid assets."

While stakeholders within the industry appealed to FSOC not to designate their particular portion of the asset management industry as systemically risky, other groups urged FSOC to take swift and meaningful action.

Better Markets agreed with the asset management industry that any designation would have to be "extensive, grounded in fact and law, and contain concrete support for any assertions made." Dennis Kelleher, the group's president and CEO, suggested that, should FSOC encounter difficulties in obtaining necessary information to aid it in its investigation of the industry, it should ask the OFR to subpoena the necessary data.

The group also called on FSOC to revisit Money Market Funds in particular, saying that the sector can "create, amplify and propagate systemic risks" and that the SEC's reforms to date have been "incomplete and insufficient." The run on the Reserve Primary Fund that was sparked in September 2008 when its net asset value, or NAV, fell below its nominal value, meaning that investors who put $1 in the fund would receive less than $1. The Federal Reserve and the Treasury had to effectively guarantee the entire $3.7 trillion industry, the letter said, in order to restore market confidence.

"This unprecedented and, indeed, breathtaking action from the first days of the 2008 financial crisis conclusively demonstrates that the MMFs are systemically significant and can spread destabilizing risk throughout our financial system," wrote Kelleher.

Whether FSOC will take any action at all is unclear. The comments the council received are on general lines of inquiry rather than a specific proposal, suggesting that FSOC — which is composed of the heads of all financial regulatory agencies, who each have an equal vote — may not have a consensus position on whether to regulate asset managers at all. SEC Chair Mary Jo White said last year that she opposed the move, and in December proposed a handful of changes to her agency's rules for asset managers just ahead of the council's decision to put out the request for comment.

But some regulators appear convinced that more needs to be done to rein in asset managers. Federal Reserve Board Vice Chairman Stanley Fischer said in a speech March 30 that because many funds allow participants to withdraw their investments immediately, even though the fund portfolio contains more illiquid assets, there is a potential for funds to face a liquidity crisis in a run or fire-sale event.

Rules requiring leverage-based or risk-based capital requirements might manage the risks associated with such runs, Fischer said. He also said that rules now under consideration requiring the largest and most interconnected banks to hold a certain level of unsecured debt that can be converted to equity in a bridge company — known as the Total Loss Absorbing Capacity rule — "might be appropriate for some of the largest and most interconnected nonbanks as well."