[Originally published on 5/6/2014]
"Financial crises are always and everywhere due to problems of short-term debt" quoth Doug Diamond, and wisely. Not so, according to the Office of Financial Research and the Financial Stability Council, which are, apparently, planning to "designate" as "systemically important" asset managers such as BlackRock and Fidelity.
The depths of this silliness are hard to fathom.
"Fail" means to fail to pay borrowed money. An equity mutual fund or asset manager pretty much literally cannot fail. They don't borrow money. If they do, you own the assets. You bear risks. You cannot run and demand your investment back. Vanguard -- which manages passive equity mutual funds -- is number two on the OFR's list (Figure 2 p.5.) Vanguard ought to be number one on the list of institutions forever exempt from "systemic risk" worries and poster child for how a run-free financial system works.
When the Treasury Office of Financial Research issued its "Asset Management and Financial Stability" report last year, I held back comment. I thought it was a joke. OK, seriously, I thought it was one of those pro-forma documents that poor government economists have to write occasionally when their bosses get really stupid ideas, a sort of Washington drunk-texting, that polite readers quietly dismiss and wait for a sheepish apology in the morning.
The Financial Stability Oversight Council (the Council) decided to study the activities of asset management firms to better inform its analysis of whether—and how—to consider such firms for enhanced prudential standards and supervision under Section 113 of the Dodd-Frank Act.1 The Council asked the Office of Financial Research (OFR), in collaboration with Council members, to provide data and analysis to inform this consideration...
You know, "the teacher made me do it."
OK, the report said a few sensible things like
asset managers may create funds that can be close substitutes for the money-like liabilities created by banks
May. But regulating short-term debt is easy, asset management companies are a drop in that bucket, and regulating short-term financing does not require that the whole institution be "designated" and subject to "enhanced supervision." (The phrase has a lot of Darth-Vader overtones.)
Just how can an equity fund manager cause any "systemic" problem according to the OFR?
An extended low interest rate investment climate, low market volatility, or competitive factors may lead some portfolio managers to “reach for yield,” that is, seek higher returns by purchasing relatively riskier assets than they would otherwise for a particular investment strategy. Some asset managers may also crowd or “herd” into popular asset classes or securities regardless of the size or liquidity of those asset classes or securities. These behaviors could contribute to increases in asset prices, as well as magnify market volatility and distress if the markets, or particular market segments, face a sudden shock.
Stop and think about this for a minute. People who pick stocks on your behalf, might make unwise purchases. The Federal Government is going to solve this problem by designating the institutions as "systemically important," bringing forth an avalanche of regulatory oversight. A bunch of bureaucrats are, I guess, going to stop your manager from making unwise investments. This is the purpose of the Federal Government in the 21st century. Are any founding fathers not rolling over in their graves?
If the managers are such morons, why would people let managers screw around with their money anyway?
... potential information disparities between investment advisers and their clients could undermine those mitigants in the industry. Specifically, investors might not fully recognize or appreciate the nature of risks taken by their portfolio managers, despite required disclosures and investment mandate restrictions. In some cases, managers’ incentives (for example, some performance fees) may be structured so that managers share investors’ gains on the upside but do not share investors’ losses on the downside, a situation that creates incentives to invest in riskier assets
Caveat Emptor. This reads like an advertisement for Vanguard's passive funds. Sure. People give their money to morons, who squander it. What in the world does that have to do with stopping runs? And, really, direct federal regulation is going to sort this all out?
Name an ideal financial structure, one completely immune from runs. Answer: an exchange-traded-fund. The fund makes no promise at all. If the value of assets is in question, you can't go demand your money back. If you want out, you sell your shares to someone else. Yet even this is not above the OFR's scrutineering wishlist:
For example, exchange traded funds (ETFs) may transmit or amplify financial shocks originating elsewhere.
Why? well, they trade and trading might push up or down prices. (to be fair, there is a good paragraph on potential glitches in ETF plumbing, but nothing remotely justifying treating them as "systemic.")
...data for separate accounts managed by U.S. asset managers are not reported publicly and their activities are less transparent than are those of registered fund
A "separately managed account" is just what you think it is. You own a bunch of stocks and hire some guy to buy them and sell them for you. If he goes under, you own the stocks. They're in your name! This guy is about to be designated "systemically important."
Bottom line, pretty much anyone, any institution, or any structure that ever buys or sells any security is now potentially "systemically important." Grandmas who meet in an investment club to trade tips on their e-trade accounts? Well, they "herd," they "reach for yield," and they'll be "systemically important" soon.
The Dodd-Frank act never defined what "systemically important" or "danger to the US financial system" means. Therefore, it never defined what is not systemically important, hence safe, hence protected from regulatory over-reach. Limitations on regulatory power turn out to be more important than grants of authority.
I held off writing about this report originally because I figured something this silly would surely blow over. But I was wrong. The Wall Street Journal reports on Tuesday 5/5 that the FSOC is going forward with the plan. The Journal gets the point:
They're not banks. They don't lend out depositors' money with a promise to return it. Rather, they are agents that invest on behalf of clients, who bear the risk of loss. The firms don't even hold the clients' money—custodians do that—and the asset managers have no claim on client funds....
They don't carry much debt. They don't rely on short-term funding. As far as we can tell, no one in the market is betting on their success or failure via credit-default swaps. So where's the systemic risk?
...if BlackRock and Fidelity were to go bankrupt, the investors in their funds should not suffer any losses....
But as taxpayers have sadly learned since the financial crisis, concepts like "systemic risk" have never been precisely defined and remain in the eye of the regulator.