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Treasury Study on Asset Management and Asset Stability

The Office of Financial Research within the Treasury Department has published a study containing “an analysis of how asset management firms and the activities in which they engage can introduce vulnerabilities that could pose, amplify, or transmit threats to financial stability.”  This report discusses risks posed by all mutual funds, not just money market funds; it does not address risks posed by private funds. 

The report details what the authors find to be the key factors that make the asset management industry “vulnerable to shocks,” including behavior such as “reaching for yield” and “herding” behavior (when many asset managers have funds with similar or identical investment objectives).  The report notes that if many asset managers employ strategies to increase yield through use of derivatives, borrowing, or other activities, this “could pose, amplify, or transmit a threat to the financial system.”  The paper explains this risk could potentially occur if there are heavy redemptions, which “could create contagion effects,” which would spread and amplify market impacts.

The report notes that strong regulations surround the asset management industry, including transparency through full disclosures, and states that because the industry is highly competitive, advisers have strong incentives both to provide investment strategies matching investors’ risk-return preferences, and to meet client expectations as to those preferences.  Yet the report finds potential issues with a regulatory scheme designed to “ensure that managers adhere to their clients’ desired risk-return profiles” because it does not inherently curtail asset bubbles or market cycles:  “Pooled investment vehicles can potentially create market volatility and more rapid price impacts due to herding behaviors regarding investments in less liquid assets or increased redemptions due to shifting investments as risk tolerances or perceptions change.”

The report expresses concern with funds’ use of derivatives and leverage, in part because “concentration of risks among funds or activities within a firm may pose a threat to financial stability.”  The report also notes that funds “are not specifically required to conduct ongoing credit analysis of their derivatives counterparties.”

While the report does not explicitly advocate additional regulatory solutions to the issues it presents, the final section of the report discusses “data gaps” which “block regulators’ and supervisors’ view of risk-taking, leverage and liquidity transformation across financial markets and hinder their ability to fully analyze the nature and extent of financial stability risks relating to the asset management industry.”  Specific gaps include information on separate accounts, detailed information on securities lending activities, and firm-specific information:  “Many of the largest asset managers are private and do not issue public financial statements.”  Although the report suggests no specific additional disclosure, it warns that lack of this data may hinder the ability of regulators to identify activities that could pose a threat to financial stability.

The SEC has asked for feedback on the report.

The full report is here.