The focus continues to be leverage, and the differences between banking and asset management. This perspective is too narrow. Politicians and regulators are currently trying to determine if the asset management industry contributes to systemic financial risk. The research that has been presented to date has been weak and misguided. The asset management industry has pushed back against the implications of this misinformation. While these defensive efforts need to continue, the regulators are unlikely to be sidetracked. This industry is too big, growing too fast and investment product innovation is crossing regulatory boundaries.
Based on these factors, the asset management industry deserves scrutiny. And we can expect that the level of oversight will continue to creep higher over time. While these costs of compliance will rise, they probably won’t materially negatively affect the business or its growth potential.
The regulators seem to be particularly concerned with selected parts of the asset management business. Their interests also appear to be somewhat compatible with the needs of investment management firms to be sustainable in the long run. There are steps that can be taken in new product innovation for example, that can both meet future regulatory demands and ensure firm continuity.
A larger concern is a significant leap in regulation. If the regulators determine that systemic risk is significantly increased by the actions of asset management firms, then the regulatory burden will increase in scope and scale. And some product innovations may be contributing right now to a possible step-change in regulation.
Everyone understands that most asset management firm failures occur because of rogues or operational issues. But these are idiosyncratic risks, and not systemic. The next largest causes of asset management firm failure are excess leverage and inadequate liquidity. These arguably, could also contribute to systemic risk. Investment strategies that involve borrowing and lending, or expose clients to potential illiquidity, will compel policy makers to regulate further.
Our client preferences and requirements also heighten systemic risk through their actions. For example, clients often herd together into highly leveraged and/or illiquid investments. A related driver of systemic risk is accounting and actuarial requirements that require mark to market pricing, or insistence on continuous liquidity. Asset managers could be required to become the policeman who limits the contributions to systemic risk from client actions.