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Monthly Report - Focus
Asset management: an expanding sector on the regulator's radar

The global asset management sector has come out a winner from the financial agitation of the last ten years. The total volume of third party assets managed by investment and pension funds and insurers has rocketed: from 45 trillion USD in 2004 to 97 trillion in 2013. This is a huge amount, accounting for 130% of the world's GDP and 50% of all its financial assets. And the forecasts predict it will keep on growing, raising several crucial questions such as how the infrastructures of financial markets function, the efficient channelling of savings towards the real economy, investor protection and, of course, financial stability. It is precisely in this last area where debate is raging regarding the systemic nature of certain entities and consequently the possible actions by regulatory bodies.

The possibility of including important players in asset management on the list of global systemically important financial institutions or G-SIFI is under discussion. A consultative document presented jointly by the FSB (Financial Stability Board) and the IOSCO (International Organization of Securities Commissions) in January 2014 and updated last March establishes a series of criteria to identify those asset management firms and even specific investment funds that, due to their size or complexity, represent potential sources of systemic risk. The regulators propose setting the threshold at 1 trillion dollars of assets under management for the former and 100 billion dollars in balance sheet total assets for the latter. The aim is to apply stricter regulatory and supervisory standards than for other entities (as already occurs in the banking and insurance sectors where the 30 banks and nine insurers classified as G-SIFI are subject to more demanding criteria).

For the banking sector, regulation chiefly focuses on strengthening the capital and liquidity position of banks but applying similar rules to portfolio management, an action supported by some, would probably be ill-advised. Unlike the banking business, the asset management industry revolves around the agency relationship established between the owner of the resources (the principal) and the professional portfolio manager who is responsible for managing these resources (the agent). Consequently any credit, market and liquidity risks involved in the investments made by the asset manager are assumed entirely by the investor (or principal). On the other hand the levels of leverage observed in funds are ostensibly lower than those for banks, although there are exceptions in segments such as some venture capital and hedge funds.

Although the risk of insolvency on the part of asset management firms is remote, the problems due to the incentives arising from this agency relationship do require attention by regulators and supervisors. Experience has shown that, under certain circumstances, they tend to lead to excessive risk-taking and to herding behaviour by managers and both phenomena can distort the performance of asset prices. Tensions increase if a large number of investors redeem their investments hastily (fire sales), even more so if preceded by a search for yield, such as seems to be the case at the moment (funds have increased their exposure to more profitable but less liquid instruments). It is therefore likely and desirable that growth in the asset management industry over the next few years should go hand-in-hand with a more demanding regulatory environment. The truly vital question is whether impending regulation will focus on other variables likely to aggravate systemic risk apart from the size of a certain investment fund or asset management firm. The kind of investments and liquidity profiles of investment vehicles are good examples of where such attention should be focused.

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