Can mutual funds be too big to fail?

New report cites potential costs of systemic risk designation for asset managers

May 15, 2014 @ 11:16 am

By Mark Schoeff Jr.

If securities regulators designate asset management companies as potential sources of widespread disruption in the financial markets, it would reduce returns for investors by up to 25%, according to a report released Thursday.

The study, conducted by the American Action Forum, a conservative economic think tank, comes days before a May 19 forum at the Treasury Department that will explore whether large money managers pose a systemic risk.

The Financial Stability Oversight Council, comprised of 15 federal and state regulators, is considering whether to designate asset managers as so-called systemically important financial institutions, or SiFis. If they are put in that category, it could bring banking-style prudential regulation, and related capital requirements, to large mutual funds.

The AAF report assumed that asset managers would have to set aside 8% of capital, which would have to be “scraped off” of returns because the companies don't currently have capital reserves.

For a 25-year-old who makes an initial $10,000 investment in the largest mutual fund, the loss could amount to a $44,194 reduction in earnings over 40 years, the report said. For a 50-year-old investing in the largest fund, it could result in a loss of $17,796 over 15 years. The study focused on 14 mutual funds with more than $100 billion in assets, which would include Vanguard Group, Pimco, TIAA-CREF, Fidelity Investments and J.P. Morgan Chase & Co.

“It's clear that if the enhanced prudential supervision regime looks something akin to what is being discussed today, the impact on investors will be significant – especially for young investors with long investment time horizons,” the report states.

The Dodd-Frank financial reform law established the FSOC to monitor the overall health of the financial markets and to prevent firm failures like those that led to the 2008 financial market collapse. So far, FSOC has designated three nonbank companies as SiFis – AIG, GE Capital and Prudential Financial.

The asset management industry is trying to avoid a similar fate. Advocates argue that their business model is different from that of banks. They serve as agents for investors but do not risk their own assets or take on massive debt.

“It's extraordinarily rare to see asset managers go under or even be in distress,” said Tim Cameron, head of the asset management group and managing director of the Securities Industry and Financial Markets Association. “If there's a war in the Crimea, that risk is taken on by the investor. Asset managers are not leveraged like other financial players.”

Neil Simon, vice president of government relations at the Investment Adviser Association, also worries that FSOC may be misguided.

“We fear there is a fundamental misunderstanding of the asset management industry at Treasury,” Mr. Simon said. Prudential regulation “could in time trickle down to other advisers without regard as to whether they pose systemic risk,” he said.

Securities and Exchange Commission Chairman Mary Jo White, an FSOC member, seemed to be sympathetic toward the asset management sector at a May 14 Senate Appropriation subcommittee hearing.

“If these assets are not yours and not on your balance sheet, that's a very different situation before you to assess in terms of whether such an entity, if it were to fail, fails in any sense similar to a bank, which does carry positions on a balance sheet,” Ms. White said. “It's a critical distinction between asset managers and some other entities that have been considered.”

Ms. White has not taken a position on SiFi designation for asset managers. But other SEC commissioners have expressed doubt that it's appropriate.

Lawmakers have criticized the Office of Financial Research for ignoring the SEC in putting together a study released last September that suggested asset managers pose systemic risks.

In a May 13 letter to House Oversight and Government Reform Committee, Chairman Darrell Issa, R-Calif., a Treasury official said that the SEC was consulted extensively on the OFR report and that the FSOC's “judgment that asset management activities are worthy of examination is widely shared.”

“The OFR study was an initial data point that will be supplemented by additional analysis and engagement with industry and key stakeholders,” Alastair Fitzpayne, assistant Treasury Secretary for Legislative Affairs, wrote. “Only after evaluating and analyzing this information to determine the nature of any potential risk will the council take any policy actions.”

The May 19 forum is one way that the FSOC will try to gather more information. It will feature speakers from several large mutual funds – Pimco, BlackRock, Fidelity and State Street Corp. – as well as academics and other experts.

The session is being welcomed by mutual fund advocates as a way for them to communicate with FSOC. But Paul Schott Stevens, president and chief executive of the Investment Company Institute, said that where FSOC will go from there is a mystery.

“The FSOC process is opaque,” Mr. Stevens said in a conference call with reporters on Thursday. “I’m not sure I could tell you what the next steps will be. That’s part of the problem.”

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