Feds Say Asset Managers Put the Country‘s Financial System at Risk – Here’s How

“[The report] found that asset managers could transmit risks across the financial system through two primary channels: (1) exposure of creditors, counterparties, investors, or other market participants to an asset manager; and (2) disruptions to financial markets caused by fire sales.” (Stephen QuinlivanLeonard, Street and Deinard)

According to the Treasury Department’s Office of Financial Research (OFR), asset managers – who collectively oversee about $53 trillion in financial assets – are putting the US financial system at risk. The OFR released its findings in a report, write attorneys Jay Baris and Oliver Ireland of Morrison & Foerster, that:

“concludes that the diversity of investment management activities create vulnerabilities that could have implications for financial stability if they are not properly managed and if accompanied by use of leverage, liquidity transformation or funding mismatches.”

The report, Asset Management and Financial Stability, was commissioned by the Financial Stability Oversight Council (FSOC) to determine if additional regulation of asset managers is required. It could pave the way for FSOC to designate management companies as “Systemically Important Financial Institutions” (SIFIs) subject to heightened scrutiny.

What exactly are the “vulnerabilities” in the industry that could pose threats to the country’s financial stability? From law firm Dechert:

  1. Reaching for Yield and Herding Behavior. Portfolio managers may in certain situations “reach for yield” by seeking higher returns in riskier assets than they otherwise would select for a particular investment strategy. Competitive pressures may also cause asset managers to take on extra risks, and some risks (such as the difficulty of disposing of assets in less liquid markets) may be aggravated by numerous managers crowding into the same asset class. […]
  2. Redemption Risk and Liquidity Management. Collective investment vehicles offering unrestricted redemption rights could face large redemption requests in a stressed market if investors believe that they will gain an economic advantage by being the first to redeem. Asset sales in response to redemption requests could spread the stress from one asset type to another type within the same portfolio and to additional market segments. […]
  3. Use of Leverage. Leverage through derivatives contracts, securities lending and repurchase agreements may magnify both gains and losses compared to an investment in the underlying asset or index alone.
  4. Asset Managers as a Source of Risk. A large asset manager or an asset manager that is part of a large complex organization may expose its investors to liquidity risk or operational risk. For example, an asset manager of a number of funds could employ strategies that turn out to be correlated in unanticipated ways, or an asset manager could be linked to other companies that provide an array of services to the asset management industry, creating interconnections and dependencies that increase the asset manager’s importance in financial markets.

For more information on the report, see:

Get additional commentary and analysis on the Asset Management industry at JD Supra Law News>>