Asset managers who pick up the credit business that banks are shunning create new risks to financial stability because they fuel bubbles and may amplify potential stress, the Bank for International Settlements said.
Regulators should consider restricting asset managers’ ability to shift investments quickly, capping leverage and introducing liquidity buffers, as well as limiting rapid redemptions, the BIS said in its annual report published on Sunday. They should also seek to restore the “vibrancy” of banks as the traditional source of credit, it said.
“The asset management sector has grown rapidly, supporting economic activity but also raising new risks,” according to the BIS, which is owned by the world’s leading central banks. “Even when asset managers operate with low leverage, their investment mandates can give rise to leverage-like behavior that amplifies and propagates financial stress.”
The BIS, known as “the central banks’ central bank,” is highlighting the risks created by the asset management industry after global regulators abandoned a project to identify too-big-to-fail managers earlier this month. The Financial Stability Board’s effort to rein in funds ran into opposition from companies including BlackRock Inc. and Pacific Investment Management Co., which argued they weren’t as likely to cause mayhem as banks because they invest other people’s money.
Asset managers are under scrutiny because the assets they run more than doubled from about $35 trillion in 2002 to $75 trillion in 2013, with the top 20 managers overseeing 40 percent of that total, according to the BIS. Managers based in North America now account for more than half of total assets under management and about two thirds of the funds run by the top 20 managers.
The role of investment funds in credit markets has increased in recent years because the tougher regulatory requirements banks face have limited their ability to lend and made their loans more expensive. As more borrowers turn to debt markets, the increase in supply has been met by greater demand from investment funds seeking higher returns.
“In recent years, asset managers have catered to the needs of yield-hungry investors by directing funds to emerging-market economies,” said the BIS. “This has added fuel to financial booms there, possibly exacerbating vulnerabilities.”
‘Stressed Market Conditions’
The increase in market-based lending has helped relieve banks’ balance sheets and spread risks more widely in the economy, according to the BIS. Drawbacks include funds’ tendency to adopt similar strategies and the fact that their behavior hasn’t been tested in times of stress.
David Wright, secretary general of the International Organization of Securities Commissions, said on April 23 that “stress-testing and looking at how funds operate in stressed market conditions is one of the areas” regulators are looking at.
The stream of debt going into emerging markets has meant that borrowers there increased their debt levels and are now more vulnerable to losses should the tide turn. At the same time, asset managers have a built-in tendency to do the same things at the same time, behavior that could quickly turn inflows into outflows, the BIS said.
Asset managers’ business models, such as benchmarking to market indices, rewarding performance relative to each other and the investment structures that they offer “incentivize short-sighted behavior that can be destabilizing in the face of adverse shocks,” the BIS said.
The key issue for regulators is whether asset managers have the same ability as banks to absorb temporary losses, in particular if they rely on risk-averse individual investors who may pull funds quickly. Possible rules to address those risks could focus on measures to discourage herdlike behavior and to slow down portfolio shifts and redemptions, the BIS said.
“These issues become more important as the assets managed by an individual company grow in size,” the BIS said. “The decisions taken by a single large asset manager can potentially trigger fund flows with significant system-wide repercussions.”