The decisions of just a few fund managers can cause the next financial crisis!
We may not see it on the front pages of our newspapers but the next financial crises could occur in the asset management industry (Peston, 2014). Otherwise, why would regulators be extremely unease about the current trajectory in the industry? Of course financial crises are a familiar part of the economic cycle: In the 1980s the locus was Latin America; Russia and South-East Asia had their own crises in the late 1990s while American housing and banks just had theirs in 2007-2008. So what makes the next victim – the asset management industry – unique?
For the records, the asset management industry is three-quarters the size of banks, managing as much as $80 trillion worth of assets. Black Rock, which is the largest fund manager in the world, manages an asset size that exceeds what any bank has on its balance sheet: $4.4 trillion. It should be noted here that the previous financial crises made regulators to tighten their rules on the banking industry, forcing them to hold more capital and have sufficient liquidity to meet with short-term pressures and obligations. By doing this, the regulators only achieved something that’s not sexy for the investors: Insufficient credit. So naturally, many companies turned to bonds (mainly owned by fund managers) for credit in the absence of lending from banks (Ernst & Young, 2014; Economist, 2014).
Fund managers are not “financial saints” though. It is our own experience that they have caused problems in the past. Long Term Capital Management was a hedge fund run by the brightest mind in Wall Street and in academia. Its collapse in 1998 led to a rescue instigated by the Federal Reserve (Edwards, 1999). Another bad news is Bear Stearns. Its downfall was quick, facilitated by its bail-out of the two hedge funds it had been running. In the same year the Federal Reserve were forced to provide another backstop to stem off a run caused by the downfall of a money market fund run by the Reserve Group – a private equity firm based in Akron, Ohio(Bloomberg, 2014; Economist, 2014).
With these developments, it is very understandable that regulators are nervous. So, should we blame Financial Stability Board (FSB) – an international body which tries to guard against financial crises – for suggesting in their consultation paper published in January that fund managers should be heavily regulated? Available evidence points to the contrary. Generally speaking, pension funds and insurance companies have veered off their main role of stabilizing the market, which involved taking advantage of short-term market falls by mopping up cheap assets. Instead they have continued to play games with the market, amplifying the market cycles just to meet more conservative accounting and regulatory requirements (Economist, 2014).
The tango continues
By marshaling some powerful counter arguments, the assets management industry is proving that they are not letting their critics succeed without a fight. Their first claim is that they are actually the real stewards of other people’s capital. Because these capitals (or assets) are held in separate accounts with third parties acting as the custodians, they can be simply transferred to a competitor, with no loss for the investor concerned, if a fund manager goes bankrupt. It is not a surprise then that, while hundreds of mutual funds collapse each year, the impact on the market is very minimal. Not only that, they have no need for government bail-out or rescue. In contrast, banks like the Lehman Brothers are not doing a good job of protecting the investors’ capital, since they speculate on their own accounts, putting their investors’ money at risk.
Here is another interesting argument offered by the industry: With the exception of hedge funds, asset managers usually avoid using borrowed money or leverage. Take Black Rock. The company’s balance sheet is just $8.7 billion. That of HSBC – A British multinational banking and financial services company – is more than $2.7 trillion, a large percentage of which are debts and loans. Again, this offered persuasive evidence that explained why banks were more vulnerable to sudden fall in asset prices than fund managers proved to be during the 2007- 2008 crisis.
In their third argument, the industry claimed that there’s no proof that the mainstream asset managers contributes to market panics. As a matter of fact, there wouldn’t be need for the retail investors to panic or be as flighty as those of the banking institutions. After all, most of them invest through defined-contribution pensions (called 401[k] in United States) through which they put a certain percentage of money into the market every month – a strategy that makes them indifferent to short-term fluctuations.
Right for the right reasons
Since the great debacle of six years ago, government and regulators were engaged in an arms race of regulating, sanitizing and strengthening the banking system. Regulations do have some benefits, though. Nothing pushes asset managers to become more institutionalized in a relatively short space of time as new regulations. And with it comes the growth in the benefit of scale as managers implement new internal controls, policies and procedures as well as governance structures. Larger asset managers enjoy a big advantage in that regard: they are in the best position to absorb the cost of regulation, which normally include costs associated with new people, technology and processes (PWC Network, 2014).
Another benefit of regulation is that it puts a premium on culture and governance. Generally speaking, in the business of fund management, coming to grips with culture and governance is very important: By placing a premium on firms achieving the right culture, regulators ensures that financial institutions treat clients fairly as well as minimizes conflicts of interest.
Effective regulations also breed new business opportunities. The United States and European markets are good examples of the regions where new business opportunities are emerging unexpectedly from regulatory flux. In a practical sense, when banks withdraw from certain areas of capital market trading and proprietary trading, they automatically create opportunities for asset managers and others to fill the gaps. And when alternative investments become more regulated, they become coveted by institutional investors who would see it as a lucrative addition to a balanced investment portfolio. Meanwhile, the asset servicing firm will also enjoy a boost in their business since they will have the opportunity to take on administration activities from boutique asset managers seeking scale (PWC Network, 2014).
Bloomberg (2014): Company Overview of Reserve Group. Retrieved September 17, 2014 from http://investing.businessweek.com/research/stocks/private/snapshot.asp?privcapId=6462397
Edwards F.R. (1999): Hedge Funds and the Collapse of Long Term Capital Management. Journal of Economic Perspectives, 13(2), 189-210.
Ernst & Young (2014): Global Wealth and Asset Management Industry Outlook. Retrieved September 10, 2014 from http://www.ey.com/Publication/vwLUAssets/EY-Global_wealth_and_asset_management-industry-outlook/$File/ey-global-wealth-and-asset-management.pdf
Economist (2014): Fund Managers – Assets or Liabilities. Retrieved September 10, 2014 from http://www.economist.com/news/finance-and-economics/21610297-regulators-worry-asset-management-industry-may-spawn-next-financial
Peston R. (2014): The Next Financial Crisis? BBC News – Business. Retrieved September 17, 2014 from http://www.bbc.com/news/business-28126241
PWC Network (2014): Top 10 Impacts of Regulation on Asset Managers. Retrieved September 29, 2014 from http://www.pwc.com/gx/en/asset-management/asset-management-insights/top-10-impacts-of-regulation-on-asset-managers.jhtml