The Asset Management Industry and Systemic Risk: Is There a Connection?

Abstract

In the aftermath of the financial crisis, new legislation and regulation have pressured banks (and insurances) to reduce their size, leverage, and riskier lines of business in order to avoid another too-big-to-fail debacle. Nonbank financial intermediaries have naturally taken up some of that slack and, not surprisingly, regulatory scrutiny has turned toward these intermediaries to evaluate whether they could pose similar risks to financial stability that banks did pre-crisis.

Owing to their stunning growth in the past decade, focus among nonbank intermediaries is now centering on asset managers, which include firms offering mutual funds, exchange-traded funds, hedge funds and private equity funds. This report explores whether there is a demonstrable link between the asset management industry and systemic risk.

Key points:

Systemic risk is distinct from run-of-the-mill financial or operational risk, an important difference when determining whether the sector poses a risk to the broader financial system with the potential for negative spillovers into the real economy.

Because asset managers do not take on nearly the same level of leverage and do not guarantee balances on customer accounts as banks do with deposits, it is unlikely that the industry is the epicenter of (or creating) systemic risk in the financial system. Theoretically, however, they hold the potential transmit or amplify systemic risk in the system based on unique risk factors such as herding and liquidity mismatches.

One major regulatory concern is the mismatch between asset management firms offering investors highly liquid investment terms for funds investing in highly illiquid assets, which could create fire sale scenarios that negatively impact financial markets. A close look at the role of high-yield debt markets suggests that major disruptions to the sector’s funding environment could have a significant impact on the real economy. However, even during periods of acute investor outflows, high-yield mutual funds have managed liquidity risk effectively to-date, and high-yield ETFs have actually been a supplemental liquidity source for institutional investors.

In a post-crisis world, regulators have as much power (if not more) than financial firms’ shareholders. Using this power wisely to simplify rules and minimize complex regulatory changes to the financial system may be the best way to achieve long-term financial stability. Considerations must include:

i. The dynamic relationship between financial regulation and financial activity – rules must be targeted sufficiently to strengthen resilience of the desirable economic functions (such as lending to firms), but simplified enough to limit regulatory avoidance.

ii. The necessity of proper fiscal and monetary policies to complement prudential oversight – no amount of asset management oversight can prevent investors from reaching for yield in response to extraordinarily low interest rates to meet their investment goals.

iii. The reality that financial markets are connected globally – domestic oversight without internationally coordinated policies leaves marked gaps susceptible to opportunism and regulatory arbitrage.

Keywords: asset managers, systemic risk, macroprudential policy, financial stability

JEL Classification: E6, F4, G