The September 2013 Office of Financial Research (OFR) report entitled “Asset Management and Financial Stability” attempts to present a critical analysis of how asset management firms and the activities in which they engage can introduce vulnerabilities that could pose, amplify, or transmit threats to financial stability. The report’s assumptions and conclusions have provoked some very strong responses from members of the asset management industry, commentators, and even some legislators. Despite the mixed reviews, the reports yields some very useful findings and analysis.
The OFR’s report begins with a comprehensive yet high level review of the asset management industry. This overview examines the industry from a number of perspectives, including the broad categories of sources of investable assets, the various types of investment vehicles and the managers that provide them, estimates for the top 20 asset managers by AUM and their relationships with their parent companies, and significant asset class business lines of the largest asset managers. One of the key observations resulting from this review is that the asset management industry is by no means monolithic, but a diverse interaction of a number of very different types of asset managers, investors, investment activities, investment goals, and investment vehicles. This observation underpins what is perhaps the most important conclusion of the report: any attempt to analyze or understand the industry must be approached from the perspective of the activities engaged in by asset management industry participants and the respective risks associated with those activities.
[A]sset management firms have a diverse mix of businesses and business models, offer a broad variety of funds, and engage in many activities. This diversity suggests that asset management activities should be the analytical building blocks for understanding the industry. Such an approach permits the flexibility to analyze risks posed by firms (firm divisions, or firms as consolidated entities) or by industry market sectors by aggregating activities and assessing the interplay among them.
Notably, this focus on activities for assessing systemic importance appears to have been taken into account by the FSB when formulating their non-bank SIFI consultative document. However, unlike the OFR report, the FSB’s Consultative Document proposes assessing systemic importance at the fund-level, as opposed to at the asset manager-level with all funds combined. Despite this difference, both the OFR report and the FSB seem to agree that the factors that make the industry vulnerable to financial shocks include (1) “reaching for yield” and herding behaviors; (2) redemption risk in collective investment vehicles; (3) leverage, which can amplify asset price movements and increase the potential for fire sales; and (4) firms as sources of risk. Most of the controversy about the OFR’s report stems from disagreement on just how vulnerable
According to the OFR, an activities based approach, however, faces some challenges because of some serious gaps in available data. The report finds that most of the data available to analyze the industry relate to firms or funds, not to activities, and these data gaps are major hurdles to macroprudential analysis from an activities perspective.
Significant data gaps impede effective macroprudential analysis and oversight of asset management firms and activities. Data gaps block regulators’ and supervisors’ view of risk-taking, leverage, and liquidity transformation across financial markets and hinder their ability to fully analyze the nature and extent of financial stability risks relating to the asset management industry.
Some areas where OFR identifies data gaps are separate accounts and securities lending and repo markets. An OFR also notes a serious lack of data on at the asset management firm level.
Separate accounts can be opaque, says the OFR, because data about the types of assets held in these accounts, their counterparty and other risk exposures, and amounts of leverage are limited. Given this limited data, the potential ways that separate account exposures or asset sales could affect markets may not be understood adequately, and regulators do not have the data they need to assess fully the nature or extent of any financial stability risks that could be amplified or transmitted by the activities of these accounts.
Data about securities lending and repo activities of asset management firms is also inadequate. What is needed, OFR says, is more transaction level and position data on securities lending between large international financial institutions, including the composition of the underlying cash collateral reinvestment assets. The Dodd-Frank Act specifically requires more transparency in this area, and the OFR feels that the SEC still has much work to do in this area.
[M]onitoring the reinvestment of cash collateral from securities lending is important for financial stability purposes, but such monitoring is limited by a lack of data. Collecting transaction level and position data on securities lending between large international financial institutions, including the composition of the underlying cash collateral reinvestment assets, would improve regulators’ visibility into market activities. Section 984 of the Dodd-Frank Act requires the SEC to adopt rules increasing the transparency of information about securities lending available to broker-dealers and investors. Such a rulemaking could fill some of the data gaps described earlier. Similar concerns exist regarding the involvement of asset managers in repo activity.
Finally, OFR identifies gaps in the available data at the firm level as a major hurdle to understanding the macroprudential effects of large asset managers.
Many of the largest asset managers are private and do not issue public financial statements. Assessing their financial positions and constructing a complete picture of their activities and interconnections is difficult, if not impossible. Lack of data on these firms limits the ability to assess their financial condition or identify activities, such as excessive borrowing or liquidity transformation, that could pose a threat to financial stability. Given that many large asset managers are private, cross-industry measurements of fundamental metrics, such as overall leverage, are difficult to calculate, which complicates effective macroprudential oversight.
Despite the controversy surrounding it, the OFR’s examination of the asset management industry was indeed a worthy exercise, if not for its conclusions, for its analysis and the insight its analysis has provided into where our blind spots may be. It may be that what we still don’t know about the asset management industry is at least as, if not more important than what we do.