Bringing a measure of transparency to its often secretive deliberations, the Financial Stability Oversight Council has released a public update on its review of potential risks to U.S. financial stability. Topping that list, beyond its controversial designations of banks and nonbanks as systemically important, are concerns about asset management products and activities.
FSOC’s evaluation has focused on, and will continue to assess: liquidity and redemption; leverage; operational functions; securities lending; and resolvability and transition planning. The public statement follows a December 2014 notice seeking public comment on how asset management products and activities could pose risks to U.S. financial stability. Created by the Dodd-Frank Act, FSOC is comprised of federal and state regulators and an independent insurance expert appointed by the President.
The statement notes that financial stability concerns may arise from liquidity and redemption risks in pooled investment vehicles, particularly where investor redemption rights and underlying asset liquidity may not match. The following measures were suggested:
Adoption of robust liquidity risk management practices for mutual funds;
regulatory guidelines addressing limits on the ability of mutual funds to hold assets with very limited liquidity, such that holdings of potentially illiquid assets do not interfere with a fund’s ability to make orderly redemptions;
enhanced reporting and disclosures by mutual funds of their liquidity profiles and liquidity risk management practices;
facilitating the use of tools by mutual funds to allocate redemption costs more directly to investors who redeem shares; and
additional public disclosure and analysis of external sources of financing for mutual funds.
FSOC also agreed that regulators should consider whether these or other measures are appropriate for reducing liquidity risks in investment vehicles that fall under their respective jurisdictions.
The analysis was, and will be, aided by data compiled by the SEC’s Form PF, used by private funds to report regulatory assets under management. Those mandatory filings revealed that many hedge funds use relatively small amounts of leverage, but it appears to be concentrated in larger hedge funds. The relationship between a hedge fund’s level of leverage and risk, and whether that risk may have financial stability implications, however, is a complex one. “While reporting on Form PF has increased transparency, it does not provide complete information on the economics and corresponding risk exposures of hedge fund leverage or potential mitigants associated with reported leverage levels,” the FSOC statement says. “In addition, hedge funds’ major counterparties are regulated by various regulators with different jurisdictions. Therefore, no single regulator currently has all the information necessary to evaluate the complete risk profiles of hedge funds.”
In response to the need for additional analysis of hedge fund activities, FSOC will create an interagency working group to share and analyze relevant regulatory information. It will assess the sufficiency and accuracy of existing data, including what is reported on Form PF, and consider how it might be augmented. It will report its findings to the Council by the fourth quarter of 2016.
Regarding operational risks, FSOC will also look at potential risks associated with the “growing reliance on service providers, the concentration of some service provider markets, and the continuously evolving nature of their services.”
“More comprehensive information on securities lending activities across the financial system is necessary to fully assess the materiality of potential risks,” the statement says, encouraging “improved and regular data collection and reporting, interagency data sharing, and additional engagement with international counterparts.”
“Greater leverage does not necessarily imply greater risk, or systemic risk, and many other factors need to be considered,” Treasury Secretary Jacob Lew said. “Individual regulators do not have a complete picture of the risks being taken, further complicating our ability to understand these issues. The need for further analysis and information sharing is clear.”
“We have not yet ‘connected the dots’ between the leverage metrics cited in the report and the amount of underlying risk that it represents,” Commodity Futures Trading Commission Chairman Timothy Massad, an FSOC member, said. This is evident, he explained, with the use of “gross notional exposure,” a metric that includes derivatives, but not in a manner that accurately measures risk. “It does not take into account a variety of factors that affect risk, such as product type, offsetting positions, whether a transaction is cleared, or whether margin is collected,” he said.
In a statement, SEC Chairman Mary Jo White said FSOC’s efforts dovetail with her agency’s own initiatives. The Commission is currently engaged in an effort to modernize and enhance its asset management regulatory regime, including enhanced data reporting, liquidity risk management and use of leverage, with four rule proposals that were proposed in 2015 and await enactment.
She stressed, however, that the FSOC update “should not be read as an indication of the direction that the SEC’s final asset management rules may take.”