Why Fund Managers Should Escape Regulators’ Overreach
The world’s bank regulators, led by the Federal Reserve and a European group known as the Financial Stability Board, have been arguing for several years that “shadow banking” requires regulation.
It was never very clear how shadow banking was defined, but there were strong indications that the goal was to subject the securities industry to the kind of “prudential regulation” that governs banks. In a statement at the end of last week, the FSB made clear how far its ambitions extend: Any investment fund that manages more than $100 billion in assets would be eligible for banklike regulation.
This proposal follows recent reports by the Office of Financial Research, a U.S. Treasury Department agency established by the Dodd-Frank Act, suggesting that large money managers of all kinds -- hedge funds, mutual funds, pension funds and others -- could create systemic risk.
If so, this would provide the Financial Stability Oversight Council, a group of U.S. financial regulators led by the Treasury secretary, with a foundation for designating the largest members of the asset-management industry as systemically important financial institutions. Such a designation would automatically place them under “stringent regulation” (the statutory term in Dodd-Frank) by the Federal Reserve.
It is difficult to see how asset managers, of whatever size, could create systemic risk. Losses suffered by a managed fund flow through immediately to investors in the fund. According to the Office of Financial Research, the total amount of funds under management is approximately $53 trillion. This means that no matter how large the losses incurred by funds, there is about $53 trillion in equity that is available to absorb them.
That is quite different from what happened in the 2008 mortgage meltdown, when banks and other financial institutions that held mortgage-backed securities based on subprime loans were carrying these assets with debt. When mortgage-backed securities fell precipitously in value during 2007 and 2008, the financial institutions that held them were still liable on the underlying debt obligations. Their net assets and their capital declined, and they looked unstable and possibly insolvent. Many, including Fannie Mae and Freddie Mac, failed.
This couldn’t happen to a managed fund of any kind. Losses are borne by the investors, so the fund itself doesn’t become insolvent; because the losses flow though to a huge pool of equity capital, the chances of a systemic event are vanishingly small.
This effort to bring asset management under the control of the FSB or the FSOC and the Fed is a consequence of the false narrative about the causes of the 2008 financial crisis that was conjured after the crisis and endorsed by the Financial Crisis Inquiry Commission (from which I dissented). This narrative posits that the crisis was caused by insufficient regulation of the financial system and thus could have been prevented by better and more comprehensive oversight.
The story fit well with the views of the Barack Obama administration (remember “never let a good crisis go to waste”?) and the large Democratic majority in Congress after the 2008 election. The result was the enactment of the Dodd-Frank Act and the establishment of the FSOC, with its power to designate financial institutions as systemically important.
An alternative view is that the financial crisis was caused by the U.S. government’s housing policies, which -- principally through the affordable-housing goals imposed on Fannie and Freddie in 1992 -- forced reductions in mortgage underwriting standards. By 2008, 58 percent of all mortgages were subprime or otherwise weak, and 76 percent of these risky mortgages were on the books of U.S. government agencies, principally Fannie and Freddie. When the housing bubble deflated in 2007 and 2008, these risky mortgages defaulted in unprecedented numbers, driving down housing prices and setting up the financial crisis.
As Dodd-Frank moved through Congress in 2010, most of the financial industry assumed that the law was only a problem for the banks, and perhaps for some of the larger insurance companies; everyone else would be able to sit on the sidelines.
Now the other shoe has dropped. From the beginning, banking regulators worldwide have seen the conventional narrative for the causes of the crisis as a basis for extending their authority from bank regulation to the regulation and supervision of all large financial institutions.
The ground was laid by referring to nonbank financial intermediaries as “shadow banking.” Fed Chairman Ben Bernanke was particularly strident in pushing the shadow banking idea, which sounds sufficiently mysterious and dangerous to warrant government regulation and supervision.
We are now seeing the results. Yet there is a good chance that bank regulators have overplayed their hand. With no likelihood of a systemic event, there is no foundation for banking regulators’ efforts to extend their authority to the asset-management industry.
By moving against an industry that cannot create systemic risk, the FSB and FSOC showed that their ambition wasn’t to prevent the next financial crisis, but instead to extend their power. That alone should be reason for repealing the authority of the FSOC under the Dodd-Frank Act.
(Peter J. Wallison is a senior fellow at the American Enterprise Institute.)
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