Top 10 impacts of regulation on asset managers
The wave of new financial services regulations is causing deep changes in the asset management industry, heralding a period of transformation that will threaten some business models’ profitability. Higher regulatory costs in the US and Europe are squeezing asset managers’ profit margins, just as regulation also forces them to review some of the fundamental ways in which they operate. But the effects of regulation aren’t all disruptive – new opportunities await those asset managers that adapt most adroitly.
With the huge and detailed task of complying with the new regulations keeping asset managers fully occupied, many have yet to look into the accompanying strategic challenges. Yet in an industry where regulation is changing the game, doing so is essential.
Asset managers need to analyse how new regulations will affect their businesses – the effects may range across their organisational structures, cultures, capital requirements, product development, investment strategies, marketing and distribution. They need to think about how to adapt in order to grow profitably in a world where some business models might become outdated; where regulatory risk is rising; yet where financial regulation is leading to opportunities to launch new investment products and to access new markets.
Some parts of the industry have to tackle considerable challenges. For example, how will medium-sized and small asset managers find the scale to absorb regulatory costs? And, how will future proposals for regulation of ‘shadow banking’ affect money market funds and securities lending? Asset managers and their service providers need to understand how new regulations – some of which have yet to be defined – are shifting the foundations of their industry, how this will impact their business models and where their new opportunities lie.
Below are what, we believe, the main impacts of regulation will be:
Top impacts of regulation
- Benefits of scale grow
As new regulations have made asset managers become more institutionalised in a relatively short space of time, so the benefits of scale have grown. Managers have implemented new internal controls, policies and procedures and governance structures. Alternative investment managers, in particular, have had to evolve quickly, accomplishing in just a few months a maturity that would previously have taken several years to attain. Larger asset managers are in the best position to absorb the costs of regulation, including: new people, technology and processes.
- Regulation motivates mergers in Europe
Bank capital regulations and the mounting costs of compliance have become a motivation for selling assets and businesses. European banks have attempted to sell their asset management subsidiaries, with mixed success. Meanwhile, some smaller asset managers and wealth managers have merged to gain sufficient scale to absorb the increased costs of regulation.
- Transparency drives commoditisation, builds trust
The common regulatory principle of increased transparency is likely to increase product commoditisation and reduce margins in some countries. In the UK, the Retail Distribution Review (RDR) will introduce greater transparency and hand competitive advantage to lower priced products. In Europe, the Markets in Financial Instruments Directive (MiFID) II might have a similar effect, although its exact measures have yet to be agreed.
- Regulators put a premium on culture and governance
Many asset managers have not yet come to grips with the growing importance of culture and governance. In Europe and the US, in particular, regulators are placing a premium on firms achieving the right culture, starting with top management, to make sure that financial institutions treat clients fairly and minimise conflicts of interest. These demands are a response to cultural issues that surfaced during the crisis, and intensify reputational risk.
- New business opportunities emerge
New business opportunities are emerging unexpectedly from regulatory flux. Banks’ withdrawal from certain areas of capital markets trading and proprietary trading is creating opportunities for asset managers and others to fill the gaps. What's more, as alternative investments become more regulated, institutional investors are becoming more willing to place them within a balanced investment portfolio. Asset servicing firms have an opportunity to take on administration activities from boutique asset managers seeking scale.
- Uncertainty over money market funds and securities lending
Regulators in several different countries are debating how to reform ‘shadow banking’. They’re seeking to restrict the risks of money market funds – chiefly to reduce the potential for "runs" in times of stress. Depending on the path taken, regulations could further reduce funds’ profitability and limit their utility to investors. What’s more, regulators are seeking to limit the ability of banks and custodians to rehypothecate assets, with implications for the securities lending industry.
- Investment freedom falls
Asset managers have less investment freedom, both as banks withdraw liquidity from capital markets and as the cost of derivatives trading rises. These fundamental changes are reducing the profitability of some asset classes and investment strategies. For example, infrastructure, private equity and real estate firms have suffered over the past few years from a squeeze on leveraged funding. What’s more, some investment banks are cutting back their commitments to providing liquidity in capital markets and new OTC derivatives regimes are increasing the cost of hedging.
- Distribution channels under pressure
Regulations such as the UK’s RDR and similar measures in Australia and Europe are altering the dynamics of distribution, potentially making it more difficult for some types of asset managers to sell their products, while handing an advantage to others. But in the US and Europe, regulations will provide alternatives managers greater visibility, perhaps expanding distribution opportunities.
- Remuneration challenges emerge
The EU’s Capital Requirements Directive IV and Alternative Investment Fund Managers Directive (AIFMD) are changing the way that portfolio managers can be remunerated, possibly handing an advantage to asset management operations which are not subject to these rules. In particular, asset management companies in Asia and the US should have an advantage when bidding for talent.
- Shake up for service providers
As asset service providers become increasingly regulated, so this is likely to drive consolidation as Europe’s AIFMD and Undertakings for Collective Investment in Transferable Securities (UCITS) V directives force administrators and custodians to assume more risk. Across the globe, discussions aimed at regulating the ‘shadow banking’ sector are likely to limit rehypothecation, making prime brokerage less profitable. As investment banks review how they allocate capital to different businesses, they might choose to exit or sell some of these businesses.
How to prepare?
The array of new regulations is creating huge change already – which is likely to increase still further as regulators introduce yet more rules to safeguard the financial system. Most notably, many asset managers face mounting IT and people costs as they prepare for testing compliance regimes. Others are beginning to look into strategic issues such as their organisational structures.
As asset managers move beyond the task of compliance to address strategic issues, they’ll need to adapt strategy more dynamically than ever before. Learning from the experience of banks, asset managers will need to embed approaches to identifying, analysing and preparing for regulatory change, making sure new practices become part of a new business as usual. As part of this, they will have to analyse the strategic implications of new regulations.
Given the increased importance of scale and brand, asset managers may be able to learn from other industries where these factors matter. Generally speaking, asset managers’ success will depend more on factors such as maintaining a strong infrastructure to support regulatory, investor and marketplace expectations. The quickest to adapt to the effects of regulation will be best able to avoid damage from the effects of regulation, and to exploit their opportunities.
Further articles will be published in due course providing more insight around each of these topics, but in the meantime, if you would like to discuss any of the issues raised here in greater deteail, please get in touch with your usual PwC contact, or any of the authors listed above.