A version of this article originally appeared on
MarketWatch.com on 24 June 2014.
While the financial crisis is increasingly in the rearview mirror for many, policymakers in the U.S. and abroad continue to be – and rightfully so –
preoccupied with preventing another systemic failure of the financial system. This is especially true for the Financial Stability Oversight Council, or
the “FSOC,” a creation of the Dodd-Frank Act, which is charged with the extraordinary task of identifying and taking action to reduce systemic risk. To
this end, the FSOC has the authority to designate certain non-bank entities as systemically important financial institutions, or “SIFIs,” which are
subject to prudential regulation, such as capital requirements and supervision by the Federal Reserve.
We at PIMCO wholeheartedly support the goal of securing the integrity of the financial system; in fact, as stewards of retirement assets for millions
of individuals and thousands of institutions, we depend on well-functioning global capital markets and welcome the FSOC’s focus on
facilitating a more stable financial infrastructure. Yet, we fear that the FSOC – with its seemingly singular focus on SIFI designation of large
entities, such as asset managers, and its associated opaque processes – is drifting from its goal of reducing systemic risk.
We worry that designation of asset management firms would not improve financial stability and would in fact result in unintended and undesirable
consequences. We are concerned not because we are reflexively against regulation – in fact, as fiduciaries and registered advisers, the asset
management industry already operates in a highly regulated world. Instead, we believe that the designation of asset managers would represent bad public
policy and would inevitably harm our clients, the millions of individuals and institutions saving for retirement, education and other purposes, for
whom we invest.
How would designation harm our clients? While the FSOC has yet to promulgate the policy measures to which SIFI asset managers would be subject, we worry
that those it may consider, such as capital requirements and measures to limit redemption activity, would fundamentally and adversely alter the
relationship asset managers have with their clients. At the center of that relationship is the fiduciary duty an asset manager has to its clients – a
binding legal obligation to function solely in the best interests of its clients. By requiring certain SIFI funds to hold more capital (e.g., more cash),
for instance, an asset manager’s ability to optimize the return and risk objectives of its clients – and function in their best interest – would
necessarily be hampered. The practical effect would be that the savers and retirees invested in those funds would suffer – either from diminished
performance, or if they felt compelled to select another manager, from a smaller universe of asset managers from which to choose.
Asset manager designation would not only likely hurt millions of savers and create winners and losers in the asset management industry, but it would also
not reduce systemic risk. Why is that the case? Unlike banks, which as entities arguably do give rise to systemic risk, asset managers are
fundamentally different. Asset managers function as agents that manage other people’s money and do not trade for their own account. Asset managers
typically have very small balance sheets, even though the “assets under management” may be large, which underscores a key distinction: Assets under
management represent someone else’s assets. Each client account represents a separate legal entity to which an asset manager has no legal claim, and each
client has its own distinct return and risk objectives for its assets that are held at a third-party custodian bank. Moreover, unlike banks, asset managers
do not depend on leverage as part of their business model. For these reasons, asset managers as entities pose little systemic risk.
History would validate the argument that asset managers are not sources of systemic risk. No traditional asset manager was at the heart of the financial
crisis, and of the more than 700 recipients of TARP (Troubled Asset Relief Program) money, not one was an asset manager. To our knowledge, no mutual fund
with a floating net asset value was unable to meet redemptions during the crisis. In many cases, asset managers were not only able to protect, but to grow
their client assets in the aftermath of the financial crisis.
Of course, the FSOC has little use with previous crises; it is more concerned with prospective risks. We are not arguing that there are not risks
in the asset management industry, but we do believe that unlike with banks, those risks are not consolidated in particular entities. We argue that the
FSOC’s goals would be better served if they were to consider the activities within the capital markets that give rise to systemic risk.
Activities, such as excessive leverage and liquidity transformation, bear more study and possible policy recommendations on an industry-wide basis.
This framework approach is consistent with years of capital market regulation. A recent example of a successful activities-based reform is the Dodd-Frank
requirement to clear derivatives through a central counterparty. Realizing that assets are mobile and the largest derivative user today may not be so
tomorrow, the law requires the clearing of derivatives on a market-wide basis for all participants. We think this approach makes sense – in terms
of reducing risks in the system, maintaining a level playing field and avoiding inflicting harm to millions of unwitting savers.
We hope that as the FSOC spends more time engaging with the industry and its primary regulators, it, too, will come to the conclusion that asset managers
as entities do not pose systemic risk. Instead, we believe that the FSOC, our clients and the system as a whole would be better served by focusing on
industry-wide, activities-based policies, which have served the country well for years.