Early regulatory change in the post-financial crisis era focused on the wholesale markets, over-the-counter (OTC) derivatives and hedge funds.
The debate on the structure of banks continues, but policy-makers and regulators are now increasingly turning their attention to the investment management industry.
The potential designation of the largest investment managers and funds as “systemically important” now seems less likely. But investment managers and funds of all sizes are under scrutiny. A number of regulators are raising questions about the activities of investment managers and market stability. In particular, bond funds and loan funds are being singled out for closer regulatory attention. Also, orderly capital markets and the conduct of investment managers as users of those markets on behalf of their clients continues to be a regulatory priority.
Investment managementand the systemic risk question
The debate over investment management and systemic risk has moved center stage.
The International Monetary Fund (IMF), Bank for International Settlements, Financial Stability Board (FSB), International Organization of Securities Commissions (IOSCO) and the US Financial Stability Oversight Council have all reacted to the large increase in assets managed by investment managers, and to concerns that this could lead to big outflows from one or more asset classes in the case of market crisis.
An IMF report in April 2015 urged authorities to press ahead with reforms of the investment industry. Building on IOSCO’s framework paper for NBNI GSIFIs—non-bank noninsurance global systemically important financial institutions—the IMF argues for a proactive approach by policy-makers. Its concerns were echoed by Mark Carney, governor of the Bank of England, who told the Davos 2015 conference that global regulators have cleaned up the banks and now have a new target in their sights. “The big question for us is about liquidity cycles that come from fund managers that do not have leverage,” Carney said. “It is $35 trillion of mutual funds that invest in relatively illiquid securities.”
Meanwhile, the IMF exhorts the US Securities and Exchange Commission (SEC) and the US Commodity Futures Trading Commission (CFTC) to continue to strengthen their ability to identify emerging and systemic risks. Enhancing mechanisms to ensure a holistic view of risks is recommended, in particular through each agency becoming more involved in assessing and monitoring responses to risks.
Just to make its message even clearer, the IMF’s latest Global Financial Stability Report (GFSR) includes an entire chapter on asset management and financial stability. It is the first instance of the GFSR including such a chapter, providing a clear indication of how fast the subject has risen up policy-makers agendas.
The report provides clear insight into the future direction of regulation in the investment management sector. It observes that the sector will be a major channel of financial intermediation and recommends stronger microprudential supervision of asset management companies and macroprudential oversight of the sector more generally.
This includes more intensive supervision, supported by global standards on supervision, better data, improved risk indicators (for financial soundness and liquidity) and stress tests.
It also includes consideration of how remuneration impacts systemic risk, including the potential imposition of higher levels of disclosure. It believes the way fund managers are paid is a “key” contributing factor to price bubbles that inflate equity and bond markets. It says fund managers generate higher earnings and performance fees from asset growth, which incentivizes them to remain invested.
“The rise of the institutional investment management industry has coincided with three of history’s largest bubbles in the last 25 years,” wrote Brad Jones, an economist, in the IMF’s working paper, Asset Bubbles: Re-thinking Policy for the Age of Asset Management. The paper recommends reforms to asset managers’ remuneration, including multiyear claw-back provisions, as per the banking industry. More emphasis should be placed on long-term performance and fund managers should be incentivized to deflate asset price bubbles, it said.
The IMF also wants to see greater focus on risk management, including liquidity requirements (for example, requirements for funds to hold minimum amounts of specific liquid assets), leverage caps, asset concentration limits, minimum redemption fees, exit gates, suspension of redemptions and fund share pricing rules.
It is not yet clear what the impact of this report will be. In many jurisdictions, such requirements have already been introduced or significantly expanded since the financial crisis.
How will systemically important investment activities be identified?
In its consultation of January 2014, IOSCO sought to identify entities whose distress or disorderly failure, because of their size, complexity and systemic interconnectedness, would cause significant disruption to the global financial system and economic activity across jurisdictions.
The FSB in March 2015 set out revised proposals for identifying NBNI GSIFIs, including both investment funds and investment managers. No individual entities have yet been designated as NBNI GSIFIs, and there is no indication of the policy measures that would apply to these institutions, most if not all of which may be in the US. However, the FSB’s thinking is instructive. It will initially assess firms with balance sheets of at least $100 billion of assets under management or more than $1 trillion, with different thresholds for investment funds. This means many countries’ firms would not receive further consideration. However, some regulators—the Canadian regulator for one—are scrutinizing the liquidity of open-ended funds even though they are not close to the USD 100 billion threshold.
For entities above a threshold, the criteria will largely follow those already established for banks and insurers—that is, size, interconnectedness, substitutability, complexity and cross-border activities. Then, probably in 2016, firms will be allocated to lead national authorities to undertake an initial designation assessment, which would then be subject to cross-country and cross-sector consistency checks, and then to IOSCO and the FSB review. The speed of progress, however, is likely to be glacial.
The updated FSB proposals help to clarify what is meant by “systemically important,” but do not develop the arguments about the potential systemic importance of investment managers or investment funds, as put forward most recently by Carney and the IMF. In this sense, the investment industry could be forgiven for thinking it is trapped in a time warp. Indeed, as Andrew Haldane said in April 2014: “We are in the intellectual foothills when understanding and scaling transmission channels through which asset managers could generate systemic risk.”
The US and Europe take different approaches on money market funds
In the US, money market funds (MMFs), once seen as vanilla investments, have become a focus for efforts to reduce systemic risk. Some invested in highly volatile investments, leading funds to “break the buck” and investors to suffer large losses in 2008–2009. The SEC’s aim is to reduce the risk of investor runs on MMFs in times of financial crisis.
The cornerstone of the SEC reform requires institutional MMFs to “float” their net asset value (NAV) per share, so that it reflects fair value of the investments in the fund. This is a significant change from the stable $1 per share NAV. Other provisions include the imposition of “liquidity fees” and “gates” on fund redemptions, increased disclosure on liquid asset levels, asset flows and market-based NAVs. The changes are being phased in, with the floating NAV and liquidity fee/redemption gate provisions taking effect in October 2016.
As a result, a number of funds are reorganizing, splitting up multiclass funds with both retail and institutional classes into separate retail and institutional funds. Others are involuntarily redeeming investors from single class funds. Many will need to evaluate the intermediaries they use to sell funds, and to understand their intermediaries’ systems and verify there are controls in place to ensure the ultimate investor is a person, not an institution. Meanwhile, Europe has grappled with the same issue and come up with a different solution, in part because the features of EU MMFs and, their investor bases are a little different. Also, while the US has amended its accounting rules (and, therefore, the tax implications for investors) in tandem with the regulatory changes, in the EU accounting and tax rules are largely a matter for national governments.
The European Commission’s proposal for a regulation of MMFs covers both institutional and retail funds and contains a number of provisions, such as prescription on eligible assets, diversification requirements, liquidity ladder, disclosures to investors, a documented internal assessment procedure and stress testing. The industry is arguing that various provisions need refinement—such as those relating to valuation and the accounting methodology, and to internal credit ratings. Most important, although the proposal does not explicitly ban Constant Net Asset Value funds (CNAVs), it requires them to hold a 3-percent capital buffer, which would almost inevitably lead to their demise.
The European Parliament’s Economic and Monetary Affairs Committee (ECON) has adopted amendments to the commission’s proposal. The text removes the death clause for CNAVs, in part as a consequence of corporate investors entering the latter stages of the debate. In contrast with the US MMF market, most EU MMFs are not marketed to individual investors.
Three types of CNAV are now proposed, all of which would be subject to additional provisions on liquidity fees and redemption gates. The introduction of the new categories of CNAVs may lead to further fragmentation of the MMF market in Europe. Fund managers will need to develop different products, increasing their operational and administrative costs.