December-January 2015

SYSTEMIC RISK: The black swans of asset management

BallerinaIn the march towards financial stability, attention is turning towards the funds industry. Asset management denies it poses a systemic risk. But Fiona Rintoul finds this view may be too shallow.  You know a topic is sensitive when people don’t want to talk about it. Thus, media requests to chat about the systemic risks potentially posed by the asset management industry are met with radio silence or a bland: “We do not see asset managers as systemically important”. Industry veteran, Bob Parker, senior advisor at Credit Suisse, is fitter for the fight. “The conventional wisdom is that asset managers do not represent a systemic risk since we are acting as fiduciary agents for our clients, not as principals, and that investment products and portfolios are diversified, and consequently, there are no or limited systemic risks embedded in the asset management industry,” Parker says.  He adds: “This view is, of course, naïve.”  So, what kinds of systemic risk might asset managers pose? In an April 2014 speech at the London Business School entitled The age of asset management?, Andrew Haldane, executive director, financial stability and member of the Financial Policy Committee at the Bank of England, cited three areas of concern.  First, as it has grown, the asset management industry may have spawned institutions that are too big to fail. Second, herding by asset managers has the potential to amplify pro-cyclical swings in the financial system and wider economy. Third, de-equitisation and other asset allocation changes may mean that the way asset managers behave in practice is not concomitant with their increasingly important role in financing long-term investment.  The first area of concern is perhaps the one that rings the most alarm bells, because of the bank failures that caused the financial crisis. Certainly, there are some pretty big asset managers out there. DIFFERENT SHEETS
Haldane notes that the assets under management of the world’s largest asset manager, BlackRock, are about a third larger than the assets of the world’s largest bank, China’s ICBI – although the two institutions’ balance sheets are quite different, and BlackRock only has $8.7 billion (€7 billion) of assets of its own. The trend is for asset managers to get bigger and for the asset management industry to become more concentrated. LEVERAGE
Aviva’s £5.6 billion acquisition of Friends Life, announced in December, is just the most recent example of consolidation affecting the asset management industry. An increase in the level of consolidation among the large asset management players obviously increases concentration risk. According to Peter Gray, partner at Cavendish Corporate Finance, concentration may also raise systemic risk, particularly if asset management’s role in society changes and the industry takes on more of the long-term financing of the economy, which is expected.  “If this is coupled with a radical change in the profile of their investment allocations, away from traditional and into alternatives and more exotic sectors, the level of systemic risk could increase significantly,” he says. “However, a key differentiator between banks and asset managers is that the use of leverage by the former is typically far greater than the latter, so this will mitigate any increase in systemic risk.”  Use of leverage by asset managers is not unconscionable, however, and Parker cites “use of leverage leading to manager failure” as a potential systemic risk within the asset management industry. But asset managers’ balance sheets are undeniably different from banks’ balance sheets.  “We don’t operate very large balance sheets in asset management firms, and there isn’t typically a great deal of credit market or illiquidity risk held on the balance sheet,” says Keith Skeoch, chief executive of Standard Life Investments (SLI). “It’s therefore difficult to see how risk in a contagious sense gets transmitted from balance sheet.” Another difference between the banking industry and the asset management industry, according to Angus Canvin, senior adviser, regulatory affairs, at the Investment Management Association (IMA), is that there is no substitutability issue in the asset management industry.  “It is a highly competitive and diverse industry,” says Canvin. “Asset manager size does not in itself determine the systemic threat, nor are large asset managers too big to fail, because they are so readily substitutable by a competitor.”  Others, however, question just how competitive and diverse the industry is. “There is often an illusion of choice,” says Catherine Howarth, chief executive of ShareAction. “The herding problem is very, very real.” ROAD TO HELL
Lack of diversity is a problem that has very deep roots. “We need to make sure we have a set of assets and balance sheets that are very well diversified,” says Skeoch. “For that, you need the right incentives. It involves taking time out and looking at the overall design of the system.” The road to hell is paved with good intentions. In Skeoch’s view, the roots of the financial crisis go back to the original Basel I in 1986. “That implemented a risk-based form of mark-to-market accounting that started to shorten horizons and facilitated the concentration of risk as opposed to recognising that what you need is true diversification.” Haldane points out that rapid changes in the scale and structure of the industry could lead to unexpected risks – what he calls “asset management black swans”. This may be one reason why the Financial Stability Board (FSB) is considering some asset managers to be among global systemically important financial institutions, or G-SIFIs.  There is, of course, resistance to asset managers’ inclusion in this ugly acronym, and not just on aesthetic grounds. A BlackRock report claims that proposals to apply “systemic” designations to large asset managers or to funds might cause money to move between different managers and different funds but would not address the issue of asset flows into and out of a specific asset class or type of fund. “These decisions are controlled by asset owners, not asset managers,” the firm says. In theory, this is true. In practice, however, many institutional asset allocation decisions are influenced by quite a small number of investment consultants.  “They do have an incredible amount of power,” says Patrik Karlsson, director of market practice and regulatory policy at the International Capital Market Association (ICMA).  “They are embedded in the system. Pension fund trustees rely on them very much.” PRO-CYCLICALITY
This brings us to the second area of potential systemic risk identified by Haldane: pro-cyclicality. Parker, who chairs a working group on systemic risk in asset management at the ICMA, describes this problem as “investor herding behaviour, either creating market/asset bubbles in bull markets or asset value collapses in bear markets with consequent economic effects”.  Bill Gross’s recent departure from Pimco demonstrated that investors can charge out of a particular fund in some numbers without the world coming to an end. But does that mean herding can never create systemic risk?  Some see little evidence that it does. “There is no evidence that previous trends had any adverse impact on financial stability. For example, increased investment by defined benefit pension funds in equities post-World War II and subsequent re-balancing to non-equities in more recent years,” says Canvin. “Indeed, long-term investment by the funds industry has frequently provided a shock-absorbing role against short-term trading activity.” The trouble is that – just when they are being asked to play a greater role in the long-term financing of the economy – asset managers are ceasing to be the patient long-term investors they once were. They are investing less in equities and more in derivatives and alternative assets.  “Financial capital, even among long-term institutional investors, has become restless at just the time the economy requires patience,” says Haldane. BUST OR DEFAULT
Even if this is true, there are advantages to investment funds becoming more involved in the long-term financing of the economy. Investment funds are much less likely than a lender to go bust or default, says Karlsson, and there is no maturity transformation involved.  In any case, there are deeper reasons for asset allocation having evolved as it has. “There are deeply embedded incentives in the system that create herding in and herding out,” says Skeoch. These include the tax regime, the regulatory regime and a system that treats interest rates as discount rates.  In Skeoch’s view, there needs to be more thought about what constitutes a discount rate.  “If you can use appropriate discount rates, you can start to lengthen time horizons,” he says.  “Interest rates are not necessarily a good proxy for use as discount rates for long-term liabilities because they are a product of the political and economic environment in the here and now.” The discussion about systemic risk in asset management has only really just begun. Pretending it isn’t an issue won’t work. SEVEN PROBLEM AREAS
Parker, a respected figure, identifies seven potentially problematic areas. Some of them have been mentioned. Others are: money market funds that guarantee par values will be held; ETFs that cannot meet redemptions in down markets and prices diverge from underlying asset values; any funds, and notably corporate bond funds, that have in the past relied on liquidity being provided by market makers; a failure to sell assets leading to investor lock ups in “side pockets”; any funds that invest in long-term illiquid assets, such as real estate or infrastructure, but which promise liquidity to investors.  The regulators are coming to get you, ready or not. Deep thought is required.  “The debate has been kicked off,” says Skeoch. “We need to think about it in terms of how we deliver product into the marketplace. This is really long-term stuff. There’s no quick fix.” ©2014 funds europe

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