Daniel Ben-Ami: Do asset managers pose a systemic threat?

Daniel-Ben-Ami-DBA-700.jpg

Regulators are increasingly warning of the dangers that asset managers pose to global financial stability. The thrust of the argument is that as the fund management industry has grown in importance it has also come to represent a systemic threat. From this premise it is a short step to conclude that tighter regulation is needed. 

For their part, fund managers accept that their industry has grown in importance but are wary of calls for more regulation. In their view any comparison between the industry and the systemic risks posed by banking are misleading. Any modifications to the regulatory regime should be implemented with caution. 

The regulators’ concerns were spelt out recently in the 85th annual report from the Bank for International Settlements (BIS). Although the Basel-based organisation is not well known among the general public it is exceptionally important. Its members include all of the world’s leading central banks. 

The passage in the report summarising what it sees as the new financial landscape is worth quoting at length: “Market-based intermediation has filled the gap left by strained banks. In particular, the asset management sector has grown rapidly, supporting economic activity but also raising new risks. Even when asset managers operate with low leverage, their investment mandates can give rise to leverage-like behaviour that amplifies and propagates financial stress. In recent years, asset managers have catered to the needs of yield-hungry investors by directing funds to emerging market economies. This has added fuel to financial booms there, possibly exacerbating vulnerabilities. More generally, the potential impact of asset managers on financial stability has placed them on regulators’ radar screen.” 

From this starting point it is hardly surprising that the BIS argues that a plethora of new regulation is needed. The key proposals include restrictions on portfolio shifts, caps on leverage and curbs on redemptions from certain funds.

Such statements from the BIS should not be a surprise to anyone who follows regulators’ discussions closely. For example, the April 2015 edition of the IMF’s twice-yearly Global Financial Stability Report had a chapter on the asset management industry and financial stability. The Bank of England has also expressed concerns in this area. Andrew Haldane, the executive director for financial stability at the Bank, gave a speech on the “the age of asset management?” in April 2014. 

Until a few months ago the discussion was often posed in terms of “shadow banking” – that is new forms of credit intermediation besides banks.

For their part, fund managers have resisted the comparison with banks. Daniel Godfrey, the chief executive of the Investment Association, wrote a letter to the Financial Times in which he pointed out that asset managers are fundamentally different types of institutions. For example, banks create credit by lending money to borrowers, routinely engage in high leverage and borrow money for shorter time frames than they lend it out. 

Of course fund managers are unlikely to deny that their industry has grown in importance in recent years. Their concern is to avoid what they regard as a heavy-handed regulatory response. For instance, Huw van Steenis, a managing director of Morgan Stanley, has argued that stress testing is the best place to start. In other words, there is a need for computer simulations to assess the likely effect of an economic crisis on asset managers. 

As is often the case, both sets of arguments are one-sided. 

Fund managers are right to contend that their industry is different from banking but they should be wary of downplaying the new risks. Financial instability often emerges in unexpected forms. The increasing role of asset management creates the potential for new types of financial volatility. 

But the financial regulators, along with their political backers, have too much faith in the power of regulation. Every crisis seems to bring a call for more extensive supervision but generally problems just emerge in new forms. 

Regulators make the mistake of missing what could be called the push factor from the real economy. There are vast amounts of surplus liquidity in circulation precisely because it is not being reinvested in productive activity. Companies frequently prefer to engage in complicated forms of financial engineering rather than focus on their core businesses. 

The sheer scale of this liquidity helps create the basis for financial instability. Once the markets become anxious for some reasons it can create an unsettling ripple effect. 

It follows that restructuring the real economy should be a central part of the solution. Weaker firms should be allowed to go under and stronger companies should be encouraged to engage more in capital investment and less in financial activities. That would substantially reduce the amount of surplus liquidity in circulation. 

The impulse to respond to every threat of financial turmoil with increased regulation is misplaced on several counts. Its impact is likely to be limited, it is based on a misdiagnosis of the problem and it is a diversion from the real task at hand.