In a January 30, 2015 address
, Federal Reserve Board Governor Daniel K. Tarullo once again voiced the Fed's concerns about the systemic risk posed by potential firesales in the asset management industry. Tarullo indicated that as regulators implement reforms under the Basel and FSB proposals and frameworks, they should take into account the “system-wide demands on liquidity during stress periods and correlated risks among asset managers that could exacerbate liquidity, redemption and fire-sale pressures."
In his address, Mr. Tarullo noted the rapid growth of the asset management industry since the financial crisis, both in terms of the dollar amount of assets under management and in the concentration of assets managed by the largest firms. As stricter prudential regulation makes investment in certain forms of assets more costly for banks, this growth is expected to continue apace.
While it is true that asset managers differ from banks in that they are regulated by the SEC, their funds aren’t backed by U.S. government guarantees, and fund companies don’t make big trades with their own assets, the use of leverage by investment funds, including in derivatives, “could create interconnectedness risks between funds and key market intermediaries,” Tarullo said.
In addition, asset managers differ from banks because clients of asset managers direct their own investments and can withdraw them at any time. It is the ability to redeem on short notice, however, that gives rise to the risk of firesales.
"To the extent that asset management vehicles hold relatively less liquid assets but provide investors the right to redeem their interests on short notice, there is a risk that in periods of stress, investor redemptions could exhaust available liquidity. Under some circumstances, a fund might respond by rapidly selling assets, with resulting contagion effects on other holders of similar assets and, to the degree they had not already been subject to redemption pressures, other asset management vehicles holding those assets."
It is this combination of leverage, interconnectedness, and liquidity pressure that makes firesales so systemically dangerous, potentially amplifying throughout the financial markets a seemingly isolated run on a fund and the associated firesale.
More Data Required
Mr. Tarullo admitted that the magnitude of the firesale risks he is concerned about is not entirely understood.
"Considerable work is needed, first, to develop better data on assets under management, liquidity, and leverage, in order to fill the information gaps that have concerned so many academics and policy analysts. Then there is more work to be done in assessing the magnitude of liquidity and redemption risks, including the degree to which those risks vary with the type of assets and fund structure. And finally, we will need tools that will be efficient and effective responses to the risks identified."
Short Term Funding
Mr. Tarullo noted that while it’s important to implement regulations “that protect against runs,” regulators should keep in mind that “the demand for relatively safe, short-term assets will not disappear,” he said. “Indeed, there is some risk that, as regulation makes some forms of such assets more costly, this demand will simply turn elsewhere.”
This led Tarullo to reiterate his concerns about short-term wholesale funding, which he said “can support a form of shadow banking outside the regulatory perimeter.”
"I have on past occasions described at some length my concerns with short-term wholesale funding--especially, though not exclusively, funding associated with assets thought to be cash equivalents.5 We are, of course, addressing these risks within prudentially regulated firms through various types of liquidity regulation and supervision, as well as changes in practice by the firms that clear tri-party repo transactions. But, as demonstrated in the years preceding the crisis, short-term wholesale funding can support a form of shadow banking outside the regulatory perimeter. Indeed, one might expect that as regulatory and supervisory practice forces the internalization by regulated firms of the systemic costs of excessive dependence on runnable short-term funding, there will be increasing incentives for more leveraged credit intermediation to migrate outside the regulatory perimeter."
Short term funding, however, presents a more complicated and nuanced challenge to regulators.
"In thinking about short-term wholesale funding and some forms of asset management, we encounter a background circumstance that complicates the task of developing effective macroprudential tools. Demand for safe short-term assets is both real and substantial, emanating from multiple sources, including sovereign nations that wish to self-insure against exchange rate pressures; non-financial corporations that have increased their cash holdings in the wake of the market disruptions associated with defaults by Enron and other companies; and institutional investors protecting themselves against redemption demands or other unexpected cash needs. While it is important to adopt measures that protect against runs and that counteract the illusion that cash equivalents are actually cash, it is equally important to realize that the demand for relatively safe, short-term assets will not disappear. Indeed, there is some risk that, as regulation makes some forms of such assets more costly, this demand will simply turn elsewhere. Thus the ultimate effectiveness of what I have termed prudential market regulation will depend on policymakers taking into account in their regulatory approaches the sources of, and motivation for, demand for short-term, liquid, and relatively safe assets beyond the debt of very creditworthy sovereigns."
In October of 2104, the FSB proposed a regulatory framework for haircuts on non-centrally cleared securities financing transactions
. Mr. Tarullo announced that the Federal Reserve expects to issue a notice of proposed rulemaking to implement the FSB's framework domestically, probably by using the Federal Reserve's authority under the Securities Exchange Act of 1934 to supplement its prudential regulatory authorities. He also indicated that the Fed would continue examine "other macroprudential policy options that would address the risks associated with short-term wholesale funding even if the FSB proposal does not extend to SFTs backed by government collateral, a very important source of short-term wholesale funds."