Regulators' Odd Focus on Funds Could End Badly for Investors
Slapping the 'systemically important financial institution' designation on asset managers could cost investors and the broader economy.
Will an alphabet soup of U.S. and global regulators change how the investment management business works? That answer increasingly appears to be yes--and investors and investment firms should be very worried.
Right now, U.S. and global regulators are conducting parallel inquiries to determine whether asset-management firms should be deemed "systemically important financial institutions," or SIFIs. Globally, a Basel-based group called the Financial Stability Board, or FSB, has led the investigation. In the U.S., using authority granted by the Dodd-Frank Act, a group of regulators called the Financial Stability Oversight Council, or FSOC, has managed its own inquiry.
Regulators basically are seeking to determine whether certain asset-management firms or activities create systemic risk to the global financial system. The goal is to avoid a repeat of the 2008 global markets meltdown, which resulted in a severe recession, plunging share markets, and bailouts of highly leveraged banking institutions. Regulators' SIFI deliberations initially focused on banks, but they have more recently expanded their brief to insurance companies and now, asset managers.
For the asset-management business, it is unclear what the SIFI designation would mean, but it probably would not be good for investors. In other areas of financial services, including the insurance industry, a SIFI designation has led to onerous regulation--led by bank regulators--and higher capital requirements. These provisions are so burdensome that General Electric (GE), which was designated a SIFI in 2013, decided to sell off most of its massive financial-services business. Insurer MetLife (MET) is pursuing a court case against regulators who slapped it with the SIFI designation.
Industry observers have speculated that, at a minimum, SIFI designations for the fund industry could lead to higher compliance costs--which will almost assuredly be passed along to investors--or even the need for some portfolios to hold greater amounts of liquid securities such as U.S. Treasuries. The SIFI designation might also lead to some funds paying a fee to the government to fund future bailouts.
Along with a lack of clarity about the consequences of a SIFI designation, it is also uncertain what firms, funds, or activities might be considered SIFIs. Regulators seem to be prepared to consider any individual fund with $100 billion a SIFI. Any asset manager with more than $1 trillion in assets may be designated a SIFI. And the most recent inquiry by the FSOC suggests smaller investment managers and funds may have certain activities that would attract a SIFI designation. So the effects on the industry and investors might be very widespread.
The fascination of (mostly) bank regulators with the asset-management business strikes some observers as odd. True, there was one major fund failure during the financial crisis, that of the Reserve Primary Fund, but that was actually a relatively small fund, which, by the way, has returned more than 99 cents of each dollar owed to investors. Moreover, the SEC has already taken action to require floating NAVs for institutional money market funds, which should prevent a recurrence of a Reserve Primary Fund meltdown.
Mercer Bullard, a law professor at the University of Mississippi and the founder of investor-rights group Fund Democracy, says he is perplexed that "regulators who have overseen thousands of bank failures over the past 30 years are fixated on the failure of one money market fund." In short, bank regulators might more productively focus their attentions on their own industry, rather than seeking out new industries to regulate.
SEC commissioner Daniel Gallagher has taken aim at the international regulators, the FSB, which are also attempting to apply the SIFI label to large asset managers and funds. In a recent speech, Gallagher said that the G-20 nations that compose the board include "such free-market stalwarts as Russia and China," with European nations also seeking to impose a strict regulatory regime on U.S. asset managers. Gallagher noted the "wholly arbitrary" threshold of $100 billion to designate an individual fund a SIFI would capture U.S. mutual funds but no non-U.S. offerings. Moreover, "based on the global assets under management threshold (of $1 trillion), four American asset managers would be considered systemically important versus--wait for it, wait for it--zero foreign asset managers."
It is also unclear whether the regulators even understand the problem that they are trying to solve. Bullard says that the regulators do not have much expertise outside of banking. Indeed, during regulators' discussions about whether to consider insurer MetLife a SIFI, Bullard says it was "clear that they didn't have a lot of sophistication about the business." Similarly, there are some huge differences between the highly leveraged, thinly capitalized banks, which largely caused the financial crisis, and mutual funds, which have little or no leverage.
In fact, by law mutual funds must have $3 of equity for each $1 of borrowings. By contrast, the large financial institutions at the heart of the global financial crisis had enormous leverage, with both Bear Stearns and Lehman Brothers having more than $30 of liabilities for each $1 of capital. Obviously, with that degree of leverage, fairly small changes in asset prices could (and did) wipe out the equity of these large investment banking firms--a risk that simply does not exist for Vanguard Total Stock Market Index (VTSMX) and other large mutual funds. Indeed, most of the large funds that might be designated SIFIs have no leverage at all.
As former Fed Chairman Alan Greenspan notes, it was leverage that fueled the 2008 financial crisis. Greenspan says that if mutual funds had owned most subprime mortgages, "we would not have seen the serial contagion we did. It is not the security that is critical, but the degree of leverage of the holders of the asset."
Nor do large asset-management firms create systemic risk. For one thing, fund assets are segregated from fund firm assets--they belong to the fund shareholder, not to the firms--and fund firms tend to have low capital needs and little borrowing. Even if a fund firm for some reason became unable to discharge its managerial duties, it is relatively easy for mutual funds--which have separate company structures and boards of directors--to find another advisor or merge with another fund.
Russel Kinnel, Morningstar's director of mutual fund research, says that in the 2008 financial crisis, fund firms showed that they could weather the financial difficulties of a parent company and even provide needed stability to a leveraged owner. Neuberger Berman survived the 2008 bankruptcy of its parent, Lehman Brothers, with the fund firm and its client assets intact. Moreover, when Barclays (BCS) needed to raise capital during the financial crisis, it was able to sell its highly successful iShares unit, which has continued to thrive under its current owner, BlackRock (BLK).
Even if the fund firm is intact, might investor behavior drive a financial crisis? Regulators posit that in a time of market stress, a "waterfall scenario" might occur, in which shareholder redemptions prompt fund managers to sell their most liquid assets, leaving the funds with less-marketable, lower-quality securities. This, in turn, might prompt additional shareholders to redeem, according to the regulators' hypothesis, creating a sort of vicious cycle that would increase market dislocations.
It is impossible to know exactly what will happen in the future, but we do know that in the 2008 financial crisis--the largest since the Great Depression--nearly all funds easily met redemption requests, which by the way, were generally not massive. To take just one example, among U.S. equity mutual funds, net redemptions in 2008 totaled approximately $130 billion, which was actually about $30 billion less cash than those funds had on hand, in the aggregate, at the beginning of the year. If the downturn in 2008 was not large enough to trigger the so-called waterfall scenario, is this really the right area for regulators to be focusing so much of their attention?
Moreover, even when funds do receive significant redemptions, managers do not necessarily need to resort to panicked selling. As the Investment Company Institute, the fund industry's trade association, has argued, fund managers have a number of sources of cash to meet redemptions, including ongoing investments by 401(k) participants, dividends and interest payments on investments, and lines of credit.
Sources of Stability
With respect to applying the SIFI designation to funds, therefore, Fund Democracy's Bullard contends that regulators have things exactly backward: "Mutual funds are the solution (to market instability), not the problem. 401(k)s were sources of stability during the financial crisis."
To be sure, there are some areas where it is appropriate for the regulators--specifically, the SEC--to take actions to prevent future market dislocations. For example, the SEC has a worthwhile project to improve and standardize mutual funds' derivative disclosures. Nick Vassilos, who heads up Morningstar's portfolio acquisition and analysis group, says that even for sophisticated investors, "current derivative risk disclosure is quite poor, often footnoted or aggregated in regulatory filings without the proper detail needed to assess these instruments."
The SEC's derivatives transparency initiative should, therefore, attract broad industry support--and in fact, BlackRock endorsed clear derivatives disclosure in its comment letter.
It is also sensible for the SEC to continue investigating whether certain fund types, including bank-loan funds, pose risks because they offer daily liquidity to investors while their assets could prove more difficult to sell during periods of market turbulence. Unlike the Financial Stability Oversight Council and the Financial Stability Board, the SEC has the expertise to conduct such an investigation.
For these two regulatory groups, however, tagging funds or fund firms with the SIFI label just does not make a whole lot of sense--and is not in the interest of fund investors. Applying the SIFI designation to the asset-management business would have repercussions for the broader economy as well, according to Bullard. He says overregulation could lead to "less risk-taking" in the private sector, "which will make us all poorer."
That is a high price to pay to insure against a hypothetical financial crisis that almost certainly would not be caused by the fund industry anyway.
This article originally appeared in the June/July 2015 issue of Morningstar magazine.
Scott Cooley does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.