— Paul Amery's Blog

Asset managers may be forced to descale

Asset managers are up in arms about regulators’ possible designation of certain firms or funds as too big to fail.

Any move to classify individual fund managers or funds as systemically important would be likely to impose onerous new capital or liquidity constraints on the entities concerned.

By comparison with banks, which have to hold substantial capital in the form of equity or retained earnings against their balance sheet loans, asset managers operate with a relative sliver of capital backing. This makes them highly profitable. But does it also make them risky?

Asset managers’ standard defence to regulators rests on three arguments: most of us don’t use leverage; we don’t guarantee the value of our funds; and, unlike banks, who act as principals, we are agents who don’t put our own balance sheets at risk.

There are some exceptions to these statements. Hedge funds—who are asset managers—are leveraged. Constant NAV money market funds in the US have long operated with something akin to a promoter guarantee of stable value. And asset managers’ expanding activity in the secured finance (repo and securities lending) markets may incur balance sheet risks for the firms involved.

As banks’ operations are crimped by new regulation, asset managers are reportedly taking up the slack in other, riskier areas of the financial markets too, like prime brokerage, trading and leveraged lending.

But for all their current lobbying dollars, asset managers may be misunderstanding regulators’ main concern—excessive scale.

The 2008/09 crisis exposed great vulnerabilities in the structure of the financial system. Its near-failure ended up costing hundreds of billions of taxpayer dollars.

From the perspective of network theory, the single riskiest type of actor in a network is one that operates at scale and with multiple links to other players.

The failure of such a “high-degree node”—one with many links—can easily bring down the whole system.

In the financial system, regulators can take action to reduce the risk of a key player failing by forcing bigger firms to hold more capital, downsize or even break up.

By comparison with banks, asset managers’ overall significance in the financial network is open to debate.

But you can see that regulators may be concerned about the huge scale of some asset management firms, and that of some of the funds they run.  Many large mutual funds promise instant liquidity while investing in less-than-liquid assets.

The investors in those funds should be well aware that the value of their holdings may fluctuate. But are they prepared for a logjam at the exit door if everyone tries to get out at once?

Add to that asset managers’ growing involvement in traditional investment banking activities and regulators are likely to err on the side of caution in classifying them. If an asset manager were at the root of the next crisis and regulators hadn’t acted, imagine the furore. Remember AIG, an insurance company, which blindsided them last time?

For this reason the largest asset managers, and the biggest funds they run, may well face new regulatory constraints.

And for BlackRock, Vanguard, Pimco, Fidelity and State Street, the largest asset managers, restructuring and reducing scale, perhaps by the demerger of different business activities, may be the way to avoid painful new capital and liquidity requirements.