The Office of Financial Research (OFR), at the behest of the Financial Stability Oversight Council, conducted an analysis of whether, and how, to bring the activities of asset management firms within the scope of enhanced prudential standards and supervision under the Dodd-Frank Act.
Asset Management and Financial Stability, September 2013, the report by the OFR, analyzes the industry’s activities, the key factors within it that could generate systemic risk, and the identification of the channels through which such risks could transmit to the broader financial markets.
Asset managers: Key players
The report contains an interesting table that ranks the top 20 asset managers by Worldwide AUM:
“The industry is highly competitive and, in some ways, highly concentrated. Economies of scale in portfolio management and administration, combined with index-based strategies, have increased industry concentration in recent years. The largest asset managers generally offer the most comprehensive, low-cost client solutions… Ten firms each have more than $1 trillion in global assets under management (AUM), including nine
U.S.-based managers, as concentration in the sector has increased… Higher concentrations could increase the market impact of firm-level risks, such as operational risk and investment risk, or increase the risk of fire sales.”
Reaching for yield and herding
Asset managers may be tempted to ‘reach for yield,’ that is hunt higher returns by acquiring riskier assets, when faced with low-yield or low interest rate environments. Additionally they may be tempted to invest ‘with the crowd’ in an investment that may be the current fad without analyzing that asset’s liquidity. This behavior can aggravate market volatility and cause market shocks if these risky or crowded investments have to suddenly unravel.
Performance fee structures that share in investors’ gains on the upside, but not in their losses, encourage managers to take undue risks with the investments.
Competition amongst asset managers compels the under-performing managers to take on additional risks in an effort to match benchmarks.
Pooled investment vehicles such as ETFs may transmit or amplify financial shocks originating elsewhere, for example in emerging markets. These vehicles “could also potentially accelerate or amplify price movements in markets during market turbulence, thus reducing market liquidity.”
The pressure for returns caulk cause managers to lead investors into uncharted investment territories such as alternative investments that they may not fully understand, leading to panic and huge redemptions during market volatility.
Systemic shock could emanate from redemptions, particularly in vehicles that give the ‘early-bird’ redeemer an economic advantage. During the financial crisis, the sophisticated and larger investors were able to redeem out before the retail investors, and secured an advantage over the latter.
The ‘slower-to-redeem’ investors would be left holding the bag – “an increasingly less liquid portfolio whose net asset value (NAV) may fall at an accelerating rate as market liquidity premiums rise.”
A crisis of confidence in the asset manager itself could trigger redemptions en masse. This could quickly spread to the manager’s other funds or business units. Similarly, a market upheaval affecting a large number of similar vehicles or asset management activities could cause a shock to the larger financial system.
Asset managers may need to step in with support from their own funds and this could cause liquidity issues in connected operations. In one example in November 2007, Bank of America supported investors in the $40 billion Strategic Cash Portfolio, then the largest enhanced cash fund in the country, and closed the fund after losses on mortgage-backed securities prompted the fund’s largest investor to withdraw $20 billion.
Correlated investments in similar assets could set off a domino effect in any tail-risk event. According to the report, “As of 2012, 32 percent of mutual funds were bond and hybrid funds. Bond funds could be exposed to a risk of sudden price declines if interest rates were to suddenly rise. In times of sharp changes in interest rates or related bond-market volatility, managers of these funds may be exposed to sudden heavier redemptions if they have not adequately managed the fund’s liquidity, given market risks and the thinly traded nature of some fixed-income markets.”
Risks emerging from redemption demand relating to reinvestment of cash collateral for asset management securities lending programs can also cause contagion and financial stability shocks.
The report cites the real life example of AIG. “Through a subsidiary, AIG Securities Lending Corporation, AIG ran a large securities lending business on behalf of its life insurance subsidiaries. AIG Securities Lending Corporation’s cash collateral reinvestment practices, coupled with AIG’s financial distress, caused it to sell assets that had become illiquid at a loss in order to return the cash collateral. This substantially contributed to AIG’s losses.”
Assets managers using leverage
Asset managers use various kinds of leverage in their operations. These include through derivatives, securities lending and repurchase agreements. These can be at the firm level, the fund level or at the portfolio level.
Leverage can significantly boost the risk carried by an asset manager and can be a source of systemic risk in times of heightened volatility.
The report cites the example of credit default swaps (CDS) during the financial crisis. “By 2008, 60 percent of the 100 largest U.S. corporate bond funds sold credit default swaps (CDS), up from 20 percent in 2004, according to a Federal Deposit Insurance Corporation working paper. During the same period, the size of the average credit derivatives position in these funds grew from 2 percent to almost 14 percent, as measured by the notional value of the position relative to the fund’s net asset value (NAV). The notional value exceeded 50 percent for six of the funds covered in the study. The study found that funds predominantly used CDS to increase their exposure to credit risks—that is, they were net sellers of credit protection, not net buyers.”
Firms as Sources of Risk
Today’s large financial asset managers are highly inter-connected and have multiple business lines. Others offer comprehensive services through various broker-dealers, pool operators, trusts or divisions. Many have international branches, divisions, affiliations, or subsidiaries. In the event of a crisis, the failure of such large firms could be a major source of risk to the financial system.
How Risk Could Creep Up to Us
Asset managers are inexorably connected to creditors, counter-parties, investors and any number of market participants.
“The extensive connections asset managers have with other financial services firms, and the concentration of some of these services, increase the potential that risks originating in other market sectors could be transmitted or amplified through asset managers into broader financial markets, or conversely, that risks originating in asset managers could be transmitted to other market sectors.”
Fire sales could be caused by the unwinding of large positions, markets becoming illiquid, trade crowding, excess leverage, mismatched funding, and reputation risk.
H/T Sarah N. Lynch of Reuters