Revealed: The next big regulated sector will be Asset Management

The U.S. Treasury Office of Financial Research (OFR) is reviewing the parameters of the largest fund management groups. OFR wants to design a post-Lehman Brothers financial system that will prevent a recurrent event and question if these entities should be in the same category as global banks and regulated as such. 

Not surprising, the fund management industry adamantly disagrees. What the opposition argues is regulated fund managers are agents, not financial institutions. They differ from banks as agents invest the money of clients, creating separate legal bodies (funds) that separate said funds from the companies that manage them. Unlike banks, they don’t borrow against assets.

Another major distinction is banks are susceptible to risk by over borrowing. This leads to loss on loans that dissipate capital. At this juncture, the bank suffers loss on all its loans and – if the bank is as prominent Lehman was at its downfall – a systematic financial crisis may follow.

Back in 1998, the fall of the Long-Term Capital Management hedge fund clearly demonstrated that leveraged hedge funds can grow too big. This enhances the possibility of failure, threatening the structure of the entire financial system. But large regulated fund managers that maintain pension and mutual funds don’t carry the same risk.

There is and always will be some jeopardy in fund management. Though they approach the handling and regulation of funds differently from a bank, it’s the management of huge sums of money and that always comes with risk. The end of 2012 saw at least 10 managers responsible for a trillion dollars in assets globally.

Size is a major issue. The OFR looks at herding and reaching for yield (investments based on increasing current income). If the bigger funds decided to invest in what are relatively high yield and high risk ventures, bubbles can form in risky sectors. This is evident as it happened during the past few years’ “QE” low rate atmosphere.

Funds can promise daily redemption and must honor redemption requests within a week. Capable of minute by minute trading, these exchange traded funds could result in, according to the OFR, amplified “future shocks” and “unexpected impacts.” This enhances the possibility of mass and panicked withdrawals.

Not that any of this should be equated with the systematic risk Lehman undertook. Still, taking Lehman into account, all this information adds to the possibility of market breaks. The bubbles in emerging market equities, commodities and high yielding currencies before 2008 created severe problems globally, inflated by fund managers and their affinity for herding.

The issue hits another slippery slope when investors believe that there are inherent backspots to safeguard against losses. For examples, the OFR looks at moments when parent companies paid money to stop funds from showing losses on the books. They also sustain these theories by pointing at the market breaks of the last thirty years. At least one prominent economist has said regulated fund flows have historically never achieved important levels.

Flows tend to follow market returns. Retail investors go in at the top and sell at the bottom. Only since 1987’s Black Monday, this has never exceeded two percent of fund assets in any given month. Mutual fund flows tend to average eight percent per month, falling below this number immediately following the Lehman incident. Others sold more.

The leverage of registered funds is heavily regulated and relies on derivatives. Book values of large management groups are small compared to managed assets. This is a systematic risk that should be preemptively guarded against. The most significant risks come from elements that have never demonstrated problems and not seen as high risk. That alone means research into the systematic risk of fund managers has to proceed.

No one doubts that fund management has risks that have to be addressed. Yet even those in favor know regulation could be counterproductive. If the OFR did move forward, regulation has to be tailored to manager risk and guided by relevant data.

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