Office of the Superintendent of Financial Institutions
The spotlight of global regulatory reform has been shining brightly on the banking community for many years now. Banks around the world have been required to shore up capital and liquidity positions and tighten up governance and risk management practices in the wake of the worst financial crisis since the great depression. While the reform spotlight continues to have banks firmly in its sights, it is also actively probing the shadows of the financial system. More attention is now being paid to other types of financial entities that manage large sums of money. Today, I am going to focus on one group in particular, the managers of large investment funds commonly referred to as global asset managers.
Now, some of you might liken the global regulatory reform spotlight to the eye of Sauron in Lord of the Rings. For those of you not familiar with the blockbuster movie trilogy or the J.R.R. Tolkien books on which it was based, Sauron was a dark lord who sowed mischief and mayhem across the land from his tower in Mordor and was intent on recapturing a powerful ring that would restore his power. His fiery eye was adept at targeting folks for destruction. But he was ultimately defeated by a lowly hobbit called Frodo, who, with the help of his friends, carried the ring over many miles, through thick and thin, to cast it away in the fires of Mount Doom, so that the ring was destroyed forever.
I like to think of Sauron as the creator of Black Swan events and OSFI as more akin to Gandalf in that trilogy. Gandalf was a wizard who played an important role in helping Frodo succeed in his quest, just as we at OSFI work with the financial institutions we supervise to protect the interests of depositors, policyholders and creditors while allowing those institutions to compete and take reasonable risks. I must confess that I have some difficulty in visualising major banks and life insurance companies as hobbits, but I digress. Pushing the analogy further, I see the spotlight of global regulatory reform as being more akin to the “star of light’ that the Lady of the Woods, Galadriel, gave to Frodo to light his path when all other lights go out.
Now, it may seem strange to you that someone from OSFI would come to speak with you about asset managers, given OSFI does not actually regulate any of the largest global asset managers. Indeed, Canada is not home to any of the major asset managers that are currently under the global regulatory reform spotlight. Natasha Cazenave from France’s AMF and I are co-chairing a Financial Stability Board project, working with other prudential and conduct regulators, plus officials from central banks and finance ministries, to explore whether there are any vulnerabilities inherent to the asset management industry that could give rise to global financial stability concerns. It is these prospective vulnerabilities that I would like to discuss with you today.
Asset managers are very different from banks and insurance companies. That statement may seem blatantly obvious to many of you. But the distinction matters because it means asset managers and their investment funds pose different financial stability issues than do banks and insurance companies. For one thing, asset manager balance sheets are not usually involved in financial transactions between their investor clients and the broader financial marketplace. And, their own balance sheets are typically very small in relation to the amount of money they manage. This means an asset manager encountering stress should pose fewer issues to global financial system stability than would distress across the investment funds they manage.
It is also important to bear in mind that investment returns and investment risks associated with most investment funds are ultimately borne by the end-investors of those entities, NOT by the asset managers themselves. So, any problems in this sector are more likely to be distributed and absorbed across a wide range of investors.
Asset managers and their funds are also generally smaller and less complex than the banks that have been designated by the Financial Stability Board and the Basel Committee on Banking Supervision as global systemically important financial institutions or G-SIFIs. More like hobbits than elves in my Lord of the Rings’ analogy, if you will. So it should be easier to manage any issues that may arise in the event an asset management firm or its funds encounter stress. And, I have to say that I am personally struck by the fiduciary obligations that asset managers owe to their investor clients.
But let’s face it. The asset management sector is not immune to stress that can spark global financial stability concerns. The collapse in 1998 of Long-Term Capital Management (a leveraged hedge fund) disrupted many important debt markets in the US and other countries. And some U.S. money market funds were important contributors to the global financial crisis in 2008. Much has been done to address the underlying issues that led to broader system-wide stress in those cases. But we would be remarkably naïve and complacent if we assumed that we have nothing more to worry about in this sector going forward. After all, as prudential supervisors of financial institutions we, at OSFI, are paid to shine light on what can go wrong in the financial system, and to work with our regulated institutions to plan for those contingencies -- even when the likelihood of a problem occurring may seem very remote.
When thinking about potential vulnerabilities associated with asset management activities, it is important to distinguish at the outset between those issues that are more related to the structure of the asset management sector itself versus others, like investor herding, which are in fact more associated with the behaviour of their investor clients and investors generally in the marketplace. The latter type of vulnerabilities may be important, but they are not the focus of our work.
On 25 September, the Financial Stability Board reviewed the initial findings from the work on structural vulnerabilities associated with asset management activities and identified five areas for further analysis.Footnote 1 They can be summarized as:
While work is underway on all five fronts, let me focus on the first three topics today given they are the ones of most interest to the Canadian investment fund industry. By contrast, the issues surrounding securities lending—notably the indemnities provided by some asset managers—are frankly only relevant at this stage for some asset management firms in foreign jurisdictions. And, the work on pension funds and sovereign wealth funds is mainly focused on assessing the extent to which those entities pose financial stability risks of their own – a rather different topic.
The first topic I would like to address relates to liquidity mismatches. Combining less liquid investments with short-notice redemption features for fund units gives rise to a potential misalignment between the redeemability of investment fund units versus the actual liquidity of their underlying investments. This mismatch may result in fragile demand for those investments if investors think they are more liquid than they really are. When times are good, everyone benefits. But if prospects dim and investors suddenly decide to rush to the exit gates, it could prove very disruptive for the markets in question, particularly if a fund has to quickly liquidate large blocks of securities to meet the redemption requests.
In some cases, this vulnerability is compounded by the terms and conditions surrounding redemptions, which may provide some first-mover incentives. This could arise, for example, in cases where redeeming investors do not bear the full cost of redemptions, and instead those costs are borne by remaining unit-holders. An investment fund could experience even larger redemptions in a stress situation if its unit-holders believe that by rushing to the exit gates they may be able to avoid some of the costs associated with their redemptions by being first out of the gate.
This is especially true in the current environment. Exceptionally low interest rates have been accompanied by a search for yield that has tempted more investors into less actively traded assets, such as thinly traded corporate debt and emerging market securities.
Market volatility, in and of itself, is not necessarily a global financial system stability concern. But it can result in highly disruptive fire-sales of assets if price declines are large and persistent enough to undermine balance sheet and collateral valuations for other players in the global financial system.
Further, in some jurisdictions, the flow of credit in the economy could conceivably be disrupted if borrowers rely on investment funds as important sources of funding. Those funds may not be able to supply as much credit if they are experiencing heavy redemptions, and finding alternative sources of credit to quickly fill the gap is no mean feat when financial conditions are unsettled. But, the importance of this channel likely varies across countries, depending on the stock of corporate debt outstanding as a share of corporate credit and the size of investment funds’ holdings of these instruments relative to those of other investors.
Another issue is the counterparty channel. This could arise in situations where other parts of the financial system are relying on investment funds as sources of wholesale funding or treating fund units as near-cash substitutes.
Thus, liquidity risk management is a core issue for the managers of investment funds. On the one hand, they are incented to be as fully invested as possible to maximise their investment performance, given the intense competition among funds in terms of performance. But, on the other hand, they also need to carry enough sufficiently liquid assets to be able to meet redemption requests of unit holders (e.g. within a couple of business days) without disrupting core portfolio holdings.
While most funds are well positioned to cope with normal redemption flows, their ability to cope with an unexpectedly large surge in redemption requests merits further exploration. As we shine light down this corridor, however, we should resist the temptation to treat investment fund liquidity management practices as a macro-prudential tool for cushioning markets from the actions of end-investors. Taken to extremes, that would slow markets’ processing of new information, which could give rise to some easy arbitrage opportunities. I do not think we need to give more sophisticated and nimble market participants new ways to profit at the expense of everyone else.
The second area I want to highlight is the issue of leverage. Investment fund reliance on leverage is another potentially important structural vulnerability in the asset management sector. While mutual funds are already prevented by existing regulations from issuing debt or assuming more than a modest amount of leverage, many private funds, like hedge funds, use leverage in the form of short-term debt or repo financing to boost investment returns.
Investment funds of all types also make use of financial derivatives to hedge risks and as a cheap way to establish investment positions. The latter is often prevalent in situations where cash markets are less liquid and positions can be established at lower cost through derivatives markets. This can, however, result in the creation of leverage within a fund when the values of the derivatives’ exposures change over the life of the contracts.
As was shown by the failure of Long-term Capital Management in 1998, global financial stability concerns can emerge in situations where banks supply the financing for these investment funds or serve as the principal counterparties for investment fund derivatives transactions. Of course, much has changed since then. There have been advances in asset manager and bank risk management practices, plus a number of regulatory measures to contain the amount of leverage in the global financial system.
More attention needs to be paid, however, to leverage that could emerge in the future as prices change and derivative positions are marked to market. A good place to start would be to collect more comprehensive data that would help regulators understand not only how much leverage is actually in play at any given point in time, but also how much might emerge in the future as market prices change.
The third potential vulnerability I want to highlight focuses on the challenges of replacing asset managers. Now, let me stress at the outset that the asset management industry has plenty of experience in transferring investment mandates from one asset manager to another, with no disruptions to markets or other parts of the financial system. A lot of credit is due to the asset managers in question, their advisers, custodians and the firms that specialize in providing transition services. But, if you take a snapshot of the global asset management sector at any point in time, you will see a small group of asset managers that clearly stands out from the rest in terms of the amount of assets they have under management. This begs the question of how easy would it be to transfer their investment mandates to other asset managers on short notice, especially if the need arose in a period when markets are under stress.
Presumably, such an event is most likely to arise in a situation where a very large asset manager is experiencing operational difficulties or challenges that inhibit its ability to deliver services as per investor expectations. If the issues are serious enough and the disruptions sufficiently prolonged, it is conceivable that investors could lose confidence in the funds offered by the asset manager and seek to either move their funds or accounts to another manager, or even liquidate their investments and re-establish them with another manager. Similar issues could also arise from a reputational risk perspective.
Such events are likely to be idiosyncratic in nature. Not all asset managers are likely to experience such an event at the same time. And, the underlying assumption should be that end-investors are actually comfortable with their investments from an investment perspective. Thus, the only reason why they might redeem their fund units would be due to concerns with the manager in question, not because they want to change investment strategies. Consequently, while there could conceivably be some short-term turbulence in global markets in response to investor actions, any such turbulence should be fairly short lived. After all, one would expect that investors would likely want to re-establish their original positions with another asset manager as soon as practicable. The actual impact on markets would therefore be fairly limited, unless the event in question had the misfortune of happening in the middle of a major financial crisis.
Nevertheless, it does beg the issue of what steps could be taken to quickly transfer investment mandates from one manager to another in a smooth fashion, so as to minimise the need for any actual redemptions of fund units by end-investors that would then trigger transactions in financial markets. As I noted at the outset, the asset management industry argues that such processes operate fairly smoothly in practice, given the role that transition managers and custodians play in facilitating transfers of funds and investor accounts from one manager to another. The industry is also quick to cite the recent PIMCO experience as a good example to that effect. And, certainly, that has been the experience to date. But, one cannot help but wonder whether the PIMCO episode would have played out so smoothly had it happened say, in the autumn of 2008, when the global financial system as a whole was in the midst of trying to cope with a major crisis.
It is now time to wrap up. What I have done today is use the “star of light” to illuminate three possible structural vulnerabilities in the asset management sector and how they might conceivably play out in practice in global financial stability terms. But this project is a work in progress. Work is currently underway to assess the materiality of all five vulnerabilities flagged by the Financial Stability Board because of their potential impact on the functioning of the global financial system were they to crystalize.
We will also need to see if additional policy remedies are needed to buttress the current global regulatory framework. If so, our plan is to explore measures that could be applied at a global level to specific activities or to all asset managers/investment funds engaged in that activity. This activities-based approach should help to limit any disruptions to the highly competitive landscape in the asset management sector.
The past eight years have seen some significant achievements as we work to implement the global regulatory reform agenda. But the journey is not yet over. We have more miles to travel and challenges to face before we can cast the ring of financial turmoil into the fire of Mount Doom.
Thank you for inviting me here today. I look forward to your questions and the discussion.
See the press release following the meeting of the FSB Plenary located at http://www.financialstabilityboard.org/2015/09/meeting-of-the-financial-stability-board-in-london-on-25-september/
Return to footnote 1