As the global financial crisis unfolded, the enmeshment of a wide variety of financial services firms with each other was a major factor in it’s ultimate impact on the economy. From brokerage firms to mortgage brokers to asset management companies, it seemed like everyone had a role to play in magnifying the scope of the crisis.
Risk spread like the proverbial stone thrown into a pond, touching businesses, consumers and governments in virtually all corners of the globe. That’s why it seems to make sense to me that government regulators — in this case the Financial Stability Oversight Council — are examining all types of systemic risk and focusing on asset management firms, now that it has worked its way through banks and related firms such as American International Group and GE Capital.
Needless to say, asset management firms disagree, the Wall Street Journal reports. These firms, including Fidelity, PIMCO, and others are lobbying members of Congress and the Department of the Treasury in an effort to discredit a report from the Office of Financial Research (the research arm of the Financial Stability Oversight Council) that identified asset management firms as a potential systemic risk factor that should be targeted for stricter regulation.
As one of the millions of US taxpayers who ended up financing the bailout from the aforementioned financial crisis and who is a participant in an economy that is still limping along due to the after effects of it, I’m a firm believer in quantifying and constraining systemic risk where possible. In this juicy report, the Office of Financial Research makes a very credible case for extending the mantle of systemic risk regulation to at least some of the largest asset management firms.
Here are some of the issues they outline that could imperil the financial system, creating the need for some type of systemic risk regulation:
- Reaching for yield: the tendency of asset managers to seek higher returns through riskier assets
- Herding: the tendency of asset managers to crowd into popular asset classes
- Competitive pressures that incentivize managers to take risks to improve performance
- Redemption risk in volatile markets that may result in heavy redemptions by investors in falling markets
- Increasing use of leverage and derivatives that may impact funds in unexpected ways during a market crisis
- Potential failure of asset management firms
- Concentration of risks or risky activities within a asset manager or even a specific fund
- Interconnectedness and complexity of risks in firms’ business activities, products and services
I’m sold, but that’s not the end of the story. The report points out that asset management firms can transmit risks across the entire global financial system via exposure of creditors, counter parties, investors and market participants to an asset manager or activities of an asset manager. In addition, these risks and activities have the potential to cause disruptions via fire sales when asset prices are in a free fall.
None of this should be shocking to anyone who was paying attention to the last financial crisis. It seems like common sense to me that the largest firms that engage in these kinds of activities should be subject to additional regulation and supervision due to their potential risks to global financial stability.
I, for one, certainly don’t want to wait to find out what elevated risks asset management firms pose by waiting until the next financial crisis. I’d rather see them contained and evaluated today.