Earlier today, the BoE’s formidable Andrew Haldane took on the awesome $87 trillion asset-management industry, arguing that so many assets under such increasingly high-risk management pose significant systemic risk. Mr. Haldane’s remedies, however, are focused on systemic designation for a few of the big boys and macroprudential tools of largely unspecified form. The problem with this approach is first that firm-by-firm designations not only take time, but also have limited impact without an accompanying regulatory regime. And, even if naming names worked, it would be just a short-term solution since the un-named would quickly pose new risk. Better, I think, to take the Haldane analytics, using his signpost to emerging correlation and contagion risk to craft a functional regulatory framework that catches risk wherever it arises.
Interestingly, Mr. Haldane’s approach is dramatically different than the one so far advanced in the U.S. with regard to asset management. To be sure, the Office of Financial Research raised the specter of systemic risk in a controversial study that has forced FSOC later this year to convene a conference before any action on it is contemplated. Otherwise, the systemic-risk gun here is largely pointed at money-market funds (MMFs). Suggesting that MMFs are a systemic activity that warrants new rules, FSOC asked the SEC to hop to it. Sooner or later it may, but when it does, the rules won’t go as far as FSOC or the FRB wants and, even if they were to do so, they would govern only one increasingly small part of the asset management industry – one that Mr. Haldane persuasively argues is rapidly becoming its least risky.
To be sure, the analytics presented in Mr. Haldane’s remarks concur with asset managers who argue that, because they do not themselves own assets, they do not pose solvency risk. However, characterizing the industry as “solvency remote,” but not “solvency immune,” Mr. Haldane argues that increasing demand for higher-risk assets to meet investor demand drives down risk premiums during periods when, as now, macroeconomic conditions are relatively benign and conventional interest rates are zip in real terms. This concentrated risk-taking behavior, he rightly says, creates correlation risk because asset managers in different parts of the industry – e.g., emerging markets, junk paper – are putting investors into holdings that create procyclical demand for yield in ways that make returns ever more elusive.
Yield-chasing thus creates a vicious cycle of demand for return that leads issuers to craft ever more creative structures that get driven down in price spurring still more feats of financial engineering. In the financial crisis, yield-chasing of course hit the wall with disastrous consequences as liquidity shortfalls at large financial institutions forced fire sales of like-kind assets into an ever-more frozen market. New liquidity rules and capital standards for the biggest banks are intended to prevent this. But, much as Mr. Haldane supports these tough rules, he rightly observes that bank-specific requirements can do little when the threat to systemic stability arises outside them.
I think the situation is even scarier than Mr. Haldane suggests because, unlike 2008, financial-services firms now must hold increasingly high margins to trade through central counterparties and to engage in securities financing. When the condition of one or another firm worsens, geopolitical risk changes commodity pricing, ratings drop, or other stress hit, firms must now not only handle liquidity demand, but also meet higher margin calls with high-quality assets. To do this, many may need to liquidate higher-risk paper ineligible for margin calls, leading to fire-sale repeats that could come faster and more furiously than in 2008 because shocks can be even more instantaneous.
Functional regulation helps to cure for this correlation and contagion risk because it goes beyond sanctioning just big banks to govern all parties in similar transactions in similar fashion. Building out a framework for global asset managers that parallels the liquidity and market-risk protections mandated for banks will take time and require sophistication, since there is indeed a significant difference between holding a trading book for yourself and operating one for third-party investors. Instead of spending more years figuring out which asset managers might be systemic, trying to cite them under complex rules subject to legal sanction, and – even if all this is done sometime soon – figuring out what rules should then be imposed over lengthy transition periods, global regulators would be better advised to identify risk-premium driven hot spots and use both prudential and monetary-policy tools to prick these bubbles before they blow up.