On 18 April 2016, as part of an on-going process that began in 2014, the Financial Stability Oversight Council (FSOC) released a statement providing an update of its on-going review of asset management products and activities. The statement, Update on Review of Asset Management Products and Activities (‘Update’), provides FSOC’s views regarding the risks to financial stability posed by asset management with respect to five areas: (i) liquidity and redemption, (ii) leverage, (iii) operational functions, (iv) securities lending and (v) resolvability and transition planning. As described by Treasury Secretary Jacob J. Lew, Chairperson of the Council, in a Wall Street Journal Op-Ed published 19 April 2016, the first two risk areas – liquidity and redemption, and leverage – are the ‘key’ areas where FSOC sees significant potential risks to financial stability.
The liquidity and redemption risk is associated largely with runs on mutual funds shares in a crisis, where funds, particularly those that invest in illiquid assets, can be forced to sell at distressed prices, hurting shareholders and potentially threatening financial stability. FSOC’s focus on leverage risk is associated with hedge funds’ ability to unwind highly leveraged positions in a time of crisis. The Update’s discussion of these two key risk areas provides some indication of what mutual funds, hedge funds, and other asset management companies can expect from FSOC moving forward.
With respect to liquidity and redemption risks associated with mutual funds, FSOC is concerned that investor redemption rights and underlying asset liquidity may not match. In light of this risk, FSOC will consider a number of mitigation measures, including enhanced reporting and disclosures by mutual funds of their liquidity profiles and liquidity risk management practices, and the establishment of regulations governing risk management practices and the ability of mutual funds to hold illiquid assets. FSOC also urges regulators to consider whether these or other measures may be appropriate for reducing potential liquidity risks in collective investment funds and similar pooled investment vehicles subject to their respective jurisdictions.
FSOC believes that individual regulators lack access to the data necessary to develop a comprehensive understanding of the risks that hedge fund leverage may pose on the financial system. Concluding that further analysis is needed to determine the extent of the risk, the Update commits FSOC to establish an interagency hedge funds working group to address the lack of information. The hedge funds working group will share and analyse existing regulatory information and data, consider the enhancement and/or establishment of leverage measurement standards, and consolidate the group’s finding in a report targeted for late 2016.
The Update is a clear signal that the FSOC is considering taking a greater regulatory role over the asset management sector, which is already subject to significant regulatory oversight by a number of FSOC’s member agencies. Given Secretary Lew’s commitment that ‘data and thorough analysis continue to guide FSOC’s work’ it is imperative that mutual funds, hedge funds, and other asset management companies weigh in with FSOC via comment letters and with in-person meetings. FSOC must have all the data and information necessary to understand the implications of further regulation.