On January 12, 2017, the Financial Stability Board (FSB) published its Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities. The FSB published a consultation on this topic in June of 2016, and the January publication incorporates comments received from over 50 respondents including asset managers and their trade associations, banks, pension funds, other financial intermediaries, and individuals. These policy recommendations are part of the FSB’s larger effort launched in 2015 to understand and address potential financial stability risks from structural vulnerabilities associated with the rapidly growing global asset management industry. The recommendations are designed to provide authorities and asset management entities with the tools and data to effectively detect and address the identified risks.
The document sets out 14 policy recommendations to address four categories of structural vulnerabilities:
- liquidity mismatch between fund investments and redemption terms and conditions for open-ended fund units;
- leverage within investment funds;
- operational risk and challenges at asset managers in stressed conditions; and
- securities lending activities of asset managers and funds.
The policy recommendations for liquidity mismatch are applicable open-ended funds, while the document's leverage recommendations are intended to apply to all types of funds that may use leverage. Meanwhile, the recommendation for operational risk applies to all asset managers, commensurate with the level of risks their activities pose to the financial system. The recommendation for securities lending activities targets asset managers providing indemnifications to clients. The FSB notes that, among these identified "areas of structural vulnerability, issues associated with liquidity mismatch and leverage are considered key vulnerabilities on which to focus.” For this reason, most of the recommendations focus on liquidity and leverage.[1]
Securities Lending Indemnification
As it did in the consultation, the FSB identifies in the final recommendations a number of potential systemic risks associated with securities lending activities by asset managers, including: (1) maturity/liquidity transformation and leverage associated with cash collateral reinvestment, (2) pro-cyclicality associated with securities financing transactions, (3) risk of fire sales of collateral securities, and (4) inadequate collateral valuation practices. Although regulatory tools and risk management practices seem to be in place for funds that engage in securities lending as beneficial owners and for asset managers acting as agent lenders, the FSB sees some aspects of borrower default indemnification as particularly in need of attention. The FSB notes that a very limited number of large asset managers act as lending agents. According to the FSB, this concentration increases the risk that a default on an indemnification commitment by any one of the lending agents could cast doubt on the ability of the other lending agents to meet their indemnification commitments. Many market participants will not or cannot engage in securities lending absent broker default indemnification. And a sudden impairment or loss of confidence in agent lenders’ abilities to meet these commitments could cause lenders to withdraw suddenly from the market, affecting asset prices and impairing market liquidity. The FSB views this risk associated with securities lending indemnification as potentially quite significant: “although very few asset managers seem to be currently involved in providing such indemnifications, the scale of exposures can be as large as that of some global systemically important banks (G-SIBs).”
Agent lenders mitigate indemnification-related risks by managing their operational risks, knowing their clients, hedging, stress testing, internal risk management, portfolio diversification, and by maintaining a diverse set of counterparties. Agent lenders also mitigate risks associated with indemnification by obtaining insurance coverage to back the indemnification commitments from one or more unaffiliated insurance companies and holding liquidity reserves against the exposure to assist in withstanding adverse liquidity shocks.
Despite regulations in place and tools lending agents employ to manage risks associated with securities lending indemnification, the FSB makes the following recommendation intended to address residual risks posed by agent lender business in which asset managers are (and may in the future be) involved:
"(Recommendation 14) Authorities should monitor indemnifications provided by agent lenders/asset managers to clients in relation to their securities lending activities. Where these monitoring efforts detect the development of material risks or regulatory arbitrage that may adversely affect financial stability, authorities should verify and confirm asset managers adequately cover potential credit losses from the indemnification provided to their clients.”
Improved data collection is vital, says the report, and recommends that the FSB’s own Data Experts Group, should consider adding relevant data elements to the Standards for global securities financing data collection and aggregation.
Also, the FSB notes that it may be appropriate for authorities to take an approach consistent with the recommendation regarding securities lending indemnification in other areas, if any, where asset managers take on similar financial risk as principals
[1] These areas receive the most attention in the final draft. They were also the most changed from the consultation as a result of comments from the industry. Among other things, the recommendations on liquidity were revised to encourage authorities to develop consistent reporting requirements, to better distinguish the information that is useful to authorities and investors, and to emphasize the exploratory nature of system-wide stress testing at this time. The purposes and uses of leverage measures were also clarified.