The age of asset management may be upon us. The industry has grown rapidly over the last decade and the market power of its major players has been analysed from different points of view, including corporate governance and competition policy. In a recent paper, I analyse the nexus between asset management and financial stability. Specifically, I ask the question whether asset managers can be systemically important and, if so, how EU and US regulators should respond.
Both jurisdictions already regulate systemically important financial institutions: the US implemented such regulation as part of the Dodd-Frank Act in 2010; the EU included it in the 2013 Capital Requirements Directive. Systemically important financial institutions or “SIFIs” are institutions that can cause or amplify systemic risk. Systemic risk, in turn, is “a risk of disruption to financial services that is caused by an impairment of all or parts of the financial system and has the potential to have serious negative consequences for the real economy” (as defined by the IMF, FSB and BIS in 2009). But current SIFI regulation does not account for a scenario in which asset managers and/or investment funds become systemically important. The designation procedure and regulation in the EU is tailored to banks, while the US system does leave room for designation of asset managers but makes it impossible in practice – particularly after reforms under the Trump administration. In addition, there is no scholarly consensus on the question whether SIFI regulation for asset managers would be useful.
All this would be no cause for concern if asset managers could never ascend to any level of systemic importance in the first place. However, in my paper, I analyse recent literature in finance (which often employs network theory to better gauge the intricacies of the financial system) and I show that it is likely that asset managers and investment funds cause and/or amplify systemic risk in certain circumstances. Fire sales are perceived as the main channel through which contagion could infect large parts of the system. These are sudden large-scale sell-offs that cause a shock to asset prices. Because the portfolios of many market players overlap, all these institutions would have to record substantial write-offs if a big player started a fire sale. The main takeaway here is that insofar as asset managers cause and/or amplify systemic risk, they do so in a way that is different from banks. A far cry from the horror scenario of a cascade of defaults crashing through the financial system, financial instability can also be caused by the sheer amount of assets that the world’s biggest asset managers control and the (individually rational) decisions they could take when encountering financial distress themselves.
The above insights from the finance literature contrast sharply with the current regulatory framework in the EU and US. I therefore argue that SIFI regulation of asset managers is needed and justified for multiple reasons, the main reason being that a mere focus on activities could not allow a regulator to ex ante stop or dampen the negative externality of a fire sale. I also submit that good SIFI designation and regulation should reflect the way in which asset managers can indeed cause and/or amplify systemic risk, necessitating a considerable reform of the current system in two ways.
First, asset managers should only be designated as systemically important if they have a potentially significant impact on trading volume in multiple distinct securities markets of which the instruments are widely held. The European Systemic Risk Board (in the EU) and the Financial Stability Oversight Council (in the US) are the most appropriate regulators to be put in charge of this designation process.
Second, there is a need for SIFI regulation that is tailored to asset managers. Once they are identified as systemically important, the European Securities and Markets Authority and the Securities and Exchange Commission, respectively, should receive enhanced competences to directly supervise them. This should be paired with a substantive restriction on large-scale sell-offs: in those markets in which the asset manager has been identified as systemically important, it would have to spread out such sell-offs over a 90-day period if it wished to exit a position. In contrast, additional capital buffers – the quintessential piece of banking law that is the main thrust of SIFI regulation, particularly in the EU – are not the appropriate regulatory response. The rule that I propose implies a trade-off between free competition and investor protection on the one hand and financial stability on the other. The latter should prevail here.
The case of asset managers shows that SIFI regulation still has room for growth. By this, I do not mean that more regulation is always necessary. Rather, SIFI regulation should more accurately reflect sectoral differences and, in particular, account for the way in which systemic risk can build up across the financial system. One of the FSB’s priorities in 2022 is indeed to enhance the understanding of and develop policies for systemic risk in nonbank financial intermediation. In my paper, I more extensively argue that entity-based regulation of asset managers would be a step in the right direction, but a broader debate is needed. Only then can SIFI regulation grow from a reaction to bank bailouts across the world into the genuine top layer of financial regulation.
This blog post was published on the Oxford Business Law Blog on 18 April 2022.