While New Oversight Council Aims to Scrutinize Asset Managers, Consultants Worry About Overregulation

The top financial regulatory board in the United States has laid out standards by which insurance companies, hedge funds, and other non-bank financial firms could fall under stricter regulation, yet industry sources voice apprehension that firms may be overburdened by regulation and reporting.

(October 16, 2011) — The Financial Stability Oversight Council — created by the Dodd-Frank Wall Street Reform and Consumer Protection Act to help guard against another financial crisis — has voted to proceed with rule-making that provides regulators with greater authority to oversee financial companies that are not banks but have more than $50 billion in assets and $20 billion in debt.

The vote approved rule-making to give the Federal Reserve permission to regulate systemically significant firms following the council’s determination of “systemically important financial institutions” — a determination based on a series of thresholds.

The council, chaired by Treasury Secretary Timothy Geithner, includes the top officials of all Washington financial regulatory agencies, including the Securities and Exchange Commission, Commodities Futures Trading Commission, and Federal Reserve.

The proposed evaluation would be based on asset size and a number of other criteria, such as having a 15-to-1 leverage ratio, $3.5 billion in derivatives liabilities, or $20 billion of outstanding loans borrowed and bonds issued. Once meeting those criteria, companies would undergo further evaluation before the council would vote to take regulatory action. For firms deemed risky based on asset size, leverage, and debt levels, the criteria approved for further rule-making by the nation’s top regulatory board could mean tougher regulation by the Federal Reserve with requirements to meet more stringent standards.

According to the council, the heightened scrutiny reflects an effort to determine which non-bank financial firms need additional supervision to mitigate their potential threat to the economy. Under the Dodd-Frank act — which was passed last year — bank holding companies with more than $50 billion in assets are automatically viewed as systemically risky. The approved rule-making also aims to reduce the likelihood of another financial crisis, as some of the largest financial companies — such as Lehman Brothers, Bear Stearns, and AIG — were not supervised and monitored by a single agency prior to the 2008 crisis.

Investment consultants, asset managers, and others in the industry say the proposed regulation has good intentions and potential to provide better safeguards for financial firms, yet they also stress the importance of checks and balances to make sure hedge funds and other financial institutions are not overburdened by regulation and reporting.

“These regulations are positive for the industry,” Sean Kurian, director of structured solutions at Towers Watson, told aiCIO in a telephone interview. “I just hope the legislation will be applied with pragmatism — we don’t want less risky institutions being rolled into this framework. But we do want risky institutions to be captured. There will be fine lines — it’s going to be interesting.”

Towers Watson is currently coordinating with the American Benefits Council to determine what potentially heightened regulation may mean for its clients, making sure pension clients and other institutional investors are protected, according to Kurian. “Initially, I think there will be room to maneuver for certain entities, and there will be a review and appeals process for managers deemed risky,” he said.

Additionally, Kurian asserted that insurers in particular may have issues with the regulation, since they have never been subject to such oversight before. “We’re playing catch-up in the US versus Europe with regards to heightened levels of regulation for insurers,” said Kurian, describing Solvency II taking hold in Europe.

Consultants and industry sources say pensions may be largely tangentially impacted by the regulations. “Pensions may be affected indirectly,” said Kurian. “But they would be most impacted because of investing in hedge funds, or if they reduce their liabilities by transferring risk to an insurer deemed to be systematically risky.”

A letter written to the Financial Stability Oversight Council on February 25 by Barbara G. Novick, BlackRock vice chairwoman, and Robert P. Connolly, BlackRock’s senior managing director and general counsel, provided insight into the general responses among asset managers to greater regulatory scrutiny, stating that the council should consider the underlying causes of the financial crisis and the risks presented by different types of firms before designating financial institutions as systemically risky.

The letter asserted: “While part of the financial services sector, the business model of an asset manager is fundamentally different than that of other financial institutions (such as commercial banks, investment banks, insurance companies and government sponsored entities), and these differences are critical in assessing systemic importance. As the Council considers the question of designating firms as systematically important financial institutions (SIFIs), we urge it to give due weight to the different risk profile presented by asset management firms from the other institutions in the financial services sector.”

In BlackRock’s claim that asset managers should not be considered systemically important financial institutions in need of further controls, the letter outlined a number of key considerations, including the following:

1) Balance sheet risk was the common factor among financial firms that experienced distress during the financial crisis

2) Asset managers invest on behalf of clients, not with their own balance sheets

3) Asset managers rely on a generally stable fee-based income stream

4) The principal of and any returns on investments made on behalf of clients are not guaranteed — asset managers do not have access to the Federal Reserve’s discount window

The letter concluded: “We believe it is important that the FSOC proceed promptly to define the criteria for identifying SIFIs, as uncertainty and speculation about the potential for designation affects financial institutions –their business plans (including plans for expansion and new hiring), their customers and investors and the market as a whole. As the Dodd-Frank Act was debated in Congress, it was clear that the intention was that SIFI designation authority was to be used sparingly. This is also consistent with recent statements made by Secretary Geithner and Chairman Bernanke. While we appreciate that the FSOC may desire to retain as much flexibility as possible, we urge the FSOC to reaffirm the Congressional intent to use this designation sparingly and to clarify the intention to apply the SIFI designation to financial institutions that place their balance sheets at risk as these entities have demonstrated their ability to create systemic risk. We also urge the Council to clarify its intentions with regard to asset managers given the business model differences outlined above, the lack of balance sheet assets or exposures and the extensive regulatory oversight already in place for asset management activities.”

To contact the <em>aiCIO</em> editor of this story: Paula Vasan at <a href='mailto:pvasan@assetinternational.com'>pvasan@assetinternational.com</a>; 646-308-2742