The US Office of Financial Research (OFR) has raised concerns that the $53 trillion US asset management industry could pose and amplify a threat to financial stability.
In a report on Monday, the OFR highlighted several areas of concern from the behavior of separate accounts and ‘herding’ mentality to leverage, lack of transparency and concentration risk of assets – a move being seen as a potential precursor to greater regulatory control over the largest US asset managers.
The 31-page report, called Asset Management and Financial Stability, comes in response to a request by the US Department of Treasury’s Financial Stability Oversight Council for the OFR to study activities of asset management firms and consider them for greater control under section 113 of the Dodd-Frank Act.
Section 113 of the Dodd-Frank Act gives the Oversight Council powers to designate a non-bank firm as a ‘Systemically Important Financial Institution’ (SIFI), which in turn brings with it heightened supervision by the US Federal Reserve and also makes the firm subject to orders to comply with risk-based capital requirements and leverage rules. A SIFI also might have to heed warnings that it can no longer run a certain type of business, be subjected to certain limitations, be compelled to dispose of assets or off-balance sheet items or be prevented from engaging in “systemically risky” activities.
Though not pointing the finger at any one firm, the OFR listed the top 20 asset management companies, some of which have real estate divisions or possess more than $50 billion in alternative assets under management. They include the largest, BlackRock, as well as BNY Mellon Asset Management, Pacific Investment Management Company, Deutsche Asset & Wealth Management, Prudential Financial – which already is contesting its designation as a SIFI – Amundi, Goldman Sachs, Franklin Templeton, AXA Investment Managers, MetLife, Invesco, Legg Mason and UBS Global Asset Management.
The report identifies several area of concern, with one major one being “risk-taking with separate accounts – defined as typically being when an asset manager has discretion to select and manage assets on behalf of a large institutional investor or high net worth. The OFR said if “improperly” managed or accompanied by the use of leverage, separate accounts could present systemic risk. The OFR also said the activities of separate accounts managed by US asset managers were less transparent than for registered funds, despite separate accounts representing an estimated two-fifths or more of total AUM at the US firms.
Also an area of high concern was “reaching for yield,” meaning managers that sought higher returns by purchasing relatively “riskier” assets for a particular investment strategy. “Depending on the flexibility of investment mandates, managers may take risks that investors do not fully appreciate,” said the report.
“Herding” was yet another area highlighted, which for illiquid investments may have greater potential to create adverse market impact if financial shocks trigger a reversal of the herding behavior. In the case of separate accounts, herding can be dangerous if a number of large accounts take similar positions, particularly if highly leveraged or if concentrated in a relatively illiquid market, the OFR suggested.
Asset managers that took out short-term leverage opening them up to margin calls and liquidity constraints also was pinpointed as being something that could have “cascading effects” and deepen a crisis if “fire sales” resulted.
Furthermore, “concentration of risk” was highlighted as being problematic. Asset managers with large, specialized funds and separate accounts with similar strategies may manage significant shares of important niche markets, which may not be fully transparent, warned the OFR. “Specialization concerns apply most directly to funds that focus on illiquid investments or funds that make large, concentrated bets,” it said. The lack of data itself from asset managers could even pose a threat to financial stability, claimed the research body.
Though the report only provided analysis of the asset management industry, reports from some quarters are taking it to mean greater regulation is on the way for some. Reuters reported that the study “boosted the likelihood the largest asset managers would face tougher federal scrutiny.”
Prudential Financial, the US insurance giant that owns Prudential Real Estate Investors, is one company that already is unhappy at being designated a SIFI, which could flow over time for some of the other large asset managers now that the asset management industry has been analysed. The Financial Stability Oversight Council denied Prudential’s appeal of the decision to be named a SIFI on September 19, and the firm is contemplating fighting the designation in the US federal court.
“As a designated SIFI, (Prudential) will be supervised by the US Federal Reserve and subject to stricter regulatory standards. We note that, while designation is one thing, details of implementation and its impact of an undefined regulatory standard are another. Both remain very unclear,” Prudential said in a statement.
However, one emailed response to PERE from a senior figure at a major US asset manager, reacted in more sanguine fashion. “The government and its regulators are assessing all kinds of systemic risk. I don’t believe the US is going after large asset managers. I believe they are doing all they can to prevent another crisis.”