IOSCO and FSB are close to finalising the assessment methodologies for identifying global systemically asset managers, investment funds and other non-banks, following similar moves in banking and insurance. IOSCO’s board met in Madrid in May and made progress in this area, along with initiatives in long-term finance and benchmarks.
The idea that some banks are systemically important is clear cut: they use sacrosanct public deposits to fund investment in the economy (they also dabble in other more exotic, but less socially beneficial, activities which regulators are trying to curb). The failure of a bank can have deep and long lasting repercussions on an economy (Rogoff and Reinhart 2008). The systemic importance of banks is borne out by the costs of clearing up the recent mess and collateral damage bank failures cased to economic activity. The EC (2014) estimates that the recent financial crisis cost the EU economy (in terms of lost output) between €6 trillion and €12.5 trillion, a staggering number that equates to nearly an entire year of gross domestic product of the world’s largest trading bloc. In the US, the figure could be as high as $22 trillion if you factor in loss in householder wealth since 2008 (US Government Accountability Office 2013; Luttrell et al. 2013).
The case of insurance firms being systemically important is less certain. The average insurer is smaller (by a factor of 3.9 times in terms of assets) and relies less on short-term funding than its banking counterpart (Geneva Association 2012). Market concentration rates in insurance are generally low and competition is robust. So, the loss of one carrier is unlikely to cause widespread or systemic issues, and is less likely to pose problems for policyholders and the real economy (IAIS 2011). Moreover, interconnections between insurers and the ‘systemically important’ banking system are relatively weak (IAIS 2011). Insurers do not provide credit lines to banks and are not engaged in credit intermediation. Banks’ exposure to their holdings of insurance fixed-income and equity securities is small.
So are insurers systemically important?
Recent crisis history suggests that insurance groups tend to suffer distress as a result of an increased exposure to non-insurance activities. These lightly regulated activities appear to be an important source of risk that may become systemic over time. In the presence of intra-group commitments, such exposures may contaminate the traditional business – AIG being the classic case, the consequences of its reverberating across markets.
So there are strong arguments to support the case that banks, and to a lesser extent, insurance firms are systemically important. But what about asset managers and what risks do they pose to financial stability and the wider economy?
Asset managers are not banks. With the exception of hedge funds, they don't use leverage. And even hedge funds don't have the same leverage as banks. The assets in a mutual fund are not held on the fund management company's balance sheet, but are held separately. This massively reduces the systemic risk when a fund fails (Economist 2014). History is not littered with examples of failing funds wreaking havoc in financial markets. The historical examples we have tend to be confined to small and isolated corners of the financial system (Haldane 2014). Moreover, the 2008 financial crisis vigorously stress tested the asset management industry. With the exception of a few money market funds, there was no real problem.
So in considering how financial distress or disorderly failure of an asset manager could be transmitted to other financial firms, the primary focus is on counterparty exposures and the liquidation of assets (the FSB also include “failure to provide critical functions” as a systemic risk in its non-bank systemically important assessment methodology but this is more relevant to central counterparties).
Counterparty risk is easy to map out. The failure of a fund would affect its creditors, counterparties, investors, or other market participants through their exposures. The FSB believes that these effects may materialise in a cascading manner, “leading to broader financial system instability if their exposures and linkages are significant”.
Counterparty risk could be dampened by various prudential regulations, requiring firms to limit their single counterparty exposure and hold sufficient capital against these positions – but the risk remains. Redemption limits, if implemented correctly, could also work.
An investment fund’s relative size is also a problem and concentration in a particular asset class, particularly in the event of a fire-sale scenario. If a fund has to liquidate its assets quickly, this may impact asset prices and thereby significantly disrupt trading or funding in key markets, potentially provoking losses for other firms with similar holdings. The potential for forced liquidations and market distortions may be amplified by the use of leverage by financial entities. Just because we don’t have stark examples of this phenomenon happening yet doesn’t mean it won’t happen in the future.
So it is perhaps not unreasonable for regulators to conclude that asset managers can be systemically important in certain circumstances. For the ones that are classified as such, they can look forward to greater regulatory scrutiny and (potentially) enhanced prudential requirements. We should have further details about the incoming regime in the autumn.
But the wider problem facing regulators is that systemic risk is difficult to predict and can lay dormant in unhidden parts of the financial system. As the old Irish adage goes “a wave will rise on quiet water”.
Classification alone is not enough; policy makers need to understand more about the connections and interlinkages in the financial system, from shadow banks in China to flash boys on Wall Street.
Policy makers have learnt many lessons since the financial crisis: banks need more capital, markets are fragile, loans need to be eventually repaid etc. Client money isn’t as easy to identify and return as they (and we) thought it was.
The insolvency of a firm, although very painful, provides many insights on the wider business and regulatory environment. From car manufacturers to banks, policy makers can’t prevent firms from failing, but they can ensure that they do so in an orderly fashion, without causing too much collateral damage.
Recent insolvencies, such as Lehman Brothers and MF Global, have given the UK financial regulator (FCA) the impetus make a “radical shift” in how firms protect client money.
On 10 June 2014, the FCA released the final rules on its new Client Assets regime (CASS), clarifying its expectations of how investment firms should protect their customers’ money and assets. The principle objective of CASS is to ensure that client assets are adequately protected. A fundamental requirement is that firms must keep client money separate from firm money in segregated client accounts with trust status. The Lehman Brothers and MF Global highlighted many shortcomings in the regime, particularly in terms of the time lag in returning money to clients.
Although the FCA believes most of the CASS changes codify expected behaviours, for many firms it will feel like the bar has been raised. The approach is more prescriptive – in a number of areas provisions that were previously guidance have become rules. On the positive side, the new rules rectify a number of inconsistencies and areas that were unclear, which will be helpful to firms.
Some of the highlights include:
The protection of client money has risen to one of the top priorities of the FCA. Client money has never been under greater scrutiny. The UK is seeking to adopt rules which are best in class, to re-establish confidence in its regime. Other EU countries make similar moves, over and above requirements in MiFID II. The Central Bank of Ireland is said to be examining the appropriateness of the FCA’s changes to its own regime (which is based on the UK regime).
Our hot topic examines the new rules and the likely implications for firms.
The EU Parliamentary elections brought a few surprises, the sweeping victories of the right-wing candidates in France and the UK caused some domestic shocks. But by and large, the old guard remains intact. The centre right and left parties (the European People’s Party (EPP) and the Socials and Democrats (S&D) respectively) will have to move the EU legislative agenda forward. The Alliance of Liberals and Democrats for Europe (ALDE) will no longer play quite the same role as in the previous EP because its numbers have dropped near the levels of both the European Conservatives and Reformists (ECR) and the Greens/European Free Alliance. So the dynamic between these five groups will change.
As the dust settles on the EU elections, focus has turned to the appointment of the next European Commission president. The Lisbon Treaty stipulates that the results of the EP elections need to be taken into account when the appointment is made, perhaps explaining why the Council recently appointed the European People’s Party candidate Jean-Claude Juncker . The successful candidate needs to be seen as capable of navigating an acceptable future course for the EU, reflecting both the elections and national preferences. Whilst the EP must ratify the next President, the candidate must be proposed by the Council, so EU leaders retain the power to choose someone that will meet their own constituents’ EU desires.
Hopefully, the EC President won’t be as busy as his predecessor, who faced unprecedented challenges, including a sovereign debt crisis in many countries, economic recession throughout the Union, rising youth unemployment and political unrest, and most recently, geo-political tensions in Ukraine.
The composition of the influential ECON committee, which is responsible for the regulation of Europe’s financial services industry, will be an important force again in shaping regulatory policy. The FT estimates that nearly half of the members of ECON have changed.
Sharon Bowles, the prominent UK Liberal Democrat MEP who chaired the committee, Jean-Paul Gauzes, the French MEP who oversaw the development of the Alternative Investment Fund Managers Directive, and Wolf Klinz, a German MEP who was heavily involved in drawing up rules around UCITS, have all left.
Members of the new Econ will have significant responsibility to keep the reform agenda on track. On the financial regulatory front, the President and EP will still face a mountain of regulation to complete. Many reforms remain to be finalised, including measures on shadow banking, anti-money laundering, money market funds and bank restructuring.