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The consultation paper identifies size (with and without regard to leverage), substitutability, interconnectedness, complexity and cross-jurisdictional activities as potential drivers of systemic risk in the investment management space. These factors are considered in the context of private less-regulated funds, regulated funds and asset managers.
The two key drivers of systemic risk are the use of excessive leverage (and associated counterparty relationships) and "substitutability," or a fund's gross (leveraged) size relative to its investment sector. If one or more large, heavily leveraged funds come to represent "the market," this could introduce illiquidity in times of stress. The combination of these two factors, excessive leverage and a large market footprint, are most likely to create systemic risk in times of stress.
From this perspective, larger, leveraged private funds pose the most systemic risk in the investment management sector. Private funds are lightly regulated, and leverage constraints are far looser, reflecting counterparty risk limits rather than regulatory limits. Regulated investment funds are restricted from taking on excessive leverage. Leverage for regulated U.S. funds, measured as assets-to-net asset value, is restricted to 1.5x for senior debt, below the 3.0x or greater proposed by the FSB. In Europe, UCITs funds leverage is limited to 2.0x. This makes the transmission of systemic risk due to a forced deleveraging low in our view for regulated funds.
Regulatory treatment of certain off-balance sheet derivative transactions represents one potential caveat. Certain derivatives are used by regulated funds in the U.S., where the regulatory treatment may not fully capture the true "economic leverage" that is incurred.
In the case of asset managers, they operate primarily on an agency basis, acting on behalf of investors in their funds. As a result, asset management generally it is not a balance sheet intensive business and does not involve large amounts of leverage, maturity transformation or financial complexity. It is the funds themselves that take on leverage, to the degree allowed, utilize derivatives and have counterparty exposures.
Concentrating on unregulated private funds, with an emphasis on excessive leverage and fund-level market footprint, i.e. substitutability, may result in a more focused, nuanced approach. A deeper understanding of off-balance sheet activities at private funds and larger regulated funds also may help prudential regulators and the market identify less transparent sources of leverage and risk.