Bailout Risk, Far Beyond the Banks; In the too-big-to-fail parade, what about a closer look at the asset management firms that oversee trillions of investor dollars?

Bailout Risk, Far Beyond the Banks

JAN. 11, 2014

By GRETCHEN MORGENSON

Everyone knows that the largest of our nation’s banks would be destined for a taxpayer bailout if they ran into trouble anytime soon. But which nonbank financial institutions — say, asset management companies offering hedge funds or mutual funds — might also pose too-big-to-fail risks because of their size and interconnections?It’s what you could call the $53 trillion question. That’s the amount of assets currently overseen by the United States money management industry, federal regulators say.

Last week, global financial regulators moved a step closer to answering that question. A paper published by the Financial Stability Board and the International Organization of Securities Commissioners laid out how regulators planned to identify financial entities that are not banks orinsurance companies but nonetheless are systemically significant and whose failure could pose a threat.

Among the paper’s main suggestions: Investment funds with more than $100 billion in assets should be designated as systemically important and subject to closer oversight. Many of these funds currently fall outside of a strict regulatory regime or are subject to only a light touch by financial overseers. Many — think hedge funds — are also shrouded in secrecy.

Nevertheless, the report said, such funds should be analyzed by regulators interested in determining the impact that a failure might have on the global financial system. Size is not the only indicator of a systemically significant institution, the regulators note. Interconnectedness is another. Trading partners that have provided financing to a troubled fund could be destabilized by its heavy losses, while investors owning the same types of assets held by the troubled fund could suffer when those holdings are liquidated quickly to meet redemptions by panicked shareholders. The amount of borrowed money that a large fund uses can also increase the potential for contagion.

None of this is earth-shattering news. But no investment executive wants his company to land on a list of systemically important financial institutions. The increased scrutiny that this would bring is unwelcome to many in the powerful asset management industry.

The response of the Investment Company Institute, the mutual fund industry’s lobbying organization, to the idea of heightened regulatory oversight is typical. Dan Waters, managing director of ICI Global, contends that mutual funds are already regulated adequately and don’t pose systemic risk. In a statement in response to the F.S.B. paper last week, Mr. Waters said, “A fund’s portfolio results — whether positive or negative — belong solely to the fund’s shareholders, and do not flow through to any other fund, to the asset manager, or to the financial markets at large.”

But others say the F.S.B. is asking appropriate questions. “There are clearly funds that are not systemic,” such as broad market index funds, said David S. Scharfstein, a professor of finance and banking at Harvard. “But there may be very large hedge funds, like Long Term Capital Management was, and money market funds that are clearly systemic. There is a gray area here that is worthy of investigation.”

Certainly money market funds have shown themselves to be vulnerable to investor runs. We saw what happened to the $62 billion Reserve Fund after the failure of Lehman Brothers in 2008; its holdings of that brokerage firm’s debt resulted in an investor rush for redemptions, which it had to halt. Unlike banks, these enterprises don’t need to hold capital for redemptions or losses. Recognizing that the potential for problems wasn’t limited to that fund, the federal government decided to insure money funds during the crisis. In other words, the government determined that the Reserve Fund and other money funds were too big to fail.

To some degree, the F.S.B.’s paper echoes a September report from the Financial Stability Oversight Council, the multiregulator group created under the Dodd-Frank law to find risks to our economic system. Its Office of Financial Research also examined the asset management arena, identifying factors that make the industry susceptible to shocks and describing how those shocks could reverberate.

“The connections asset managers have with an array of financial companies,” the report noted, “could transmit risks among asset managers, other financial companies, and broader markets.”

Both reports cite the relative dearth of available data on the asset management industry, making it harder for regulators to identify potential risks.

And the highly concentrated nature of the industry only increases the market impact that one firm’s failure could have on the financial system, the reports indicate. Ten firms — including BlackRock, State Street Global Advisors and Pimco — each oversee more than $1 trillion in global assets, the report said. Risk management practices vary greatly among all such companies. For example, while registered investment advisers and companies must employ compliance officers, not all have chief risk officers, the report noted.

Perilous behavior that asset managers might pursue, the report said, includes reaching for yield and using leverage or derivatives to do so. This is especially likely during low-interest-rate environments like the one we are in now. Redemption risk, as occurred at the Reserve Fund, also looms large, the report said.

The F.S.B. will receive comments from the industry and the public on its proposals until April, at which point the regulators will decide how to proceed.

“If you look at how large these firms are and how interconnected their individual funds are, you have to ask. ‘What would happen if they go down?’ ” said Sheila C. Bair, vice chairwoman of the Systemic Risk Council and former chairwoman of the Federal Deposit Insurance Corporation. But Ms. Bair said she thought that rather than designating these institutions as systemically important, regulators like the Securities and Exchange Commission should work to restructure them or reduce their size.

“A lot of the weaknesses are related to these companies’ activities, which the S.E.C. has plenty of authority to deal with,” Ms. Bair said. “But the agency’s kind of trapped in an investor disclosure model. They need to think more like a systemic regulator and get ahead of this.”

That’s asking a lot, given that the S.E.C. has been unable to complete an adequate overhaul of money market funds. At least regulators both overseas and at home understand that big banks are not alone in posing bailout risks to taxpayers. Happily, they seem willing to do something about it.