FSB exploring possible ‘policy remedies’ to address asset managers’ risk: OSFI

None of the world’s largest asset managers are regulated by Canada’s Office of the Superintendent of Financial Institutions (OSFI), but that sector is vulnerable to incidents “that can spark global financial stability concerns,” OSFI deputy superintendent Mark Zelmer suggested Tuesday.

“The asset management sector is not immune to stress that can spark global financial stability concerns,” according to prepared remarks, to the C.D. Howe Institute Dec. 8, for Zelmer (pictured left). “The collapse in 1998 of Long-Term Capital Management (a leveraged hedge fund) disrupted many important debt markets in the U.S. and other countries. And some U.S. money market funds were important contributors to the global financial crisis in 2008.”

Zelmer noted that OSFI does not regulate “any of the largest global asset managers” and that Canada “is not home to any of the major asset managers that are currently under the global regulatory reform spotlight.”

Zelmer co-chairs the Financial Stability Board’s work-stream on non-bank/non-insurance entities, which is exploring the “potential vulnerabilities” of asset managers the funds they manage.

The other co-chair of that work-stream is Natasha Cazenave, deputy head of the regulatory policy and international affairs directorate of France’s L’Autorité des marchés financiers (AMF).

OSFI is a member of Basel, Switzerland-based FSB. The association’s other members include the Bank of Canada and the federal finance department, as well as central banks and regulators from the United States and 22 other countries. Other FSB members include the Hong Kong Monetary Authority, European Central Bank, European Commission and the International Association of Insurance Supervisors (IAIS).

“Asset managers and their investment funds pose different financial stability issues than do banks and insurance companies,” Zelmer said Tuesday. “For one thing, asset manager balance sheets are not usually involved in financial transactions between their investor clients and the broader financial marketplace.”

FSB recently identified five vulnerabilities of asset managers, Zelmer explained.

One is the leverage in some funds.

“Many private funds, like hedge funds, use leverage in the form of short-term debt or repo financing to boost investment returns,” Zelmer warned.

Other vulnerabilities of asset managers flagged by FSB include the “potential vulnerabilities” of pension and sovereign wealth funds; their securities lending activities; and the operational risk and challenges that may arise if a large asset manager ever needed to be quickly replaced in the middle of a financial crisis.

The other vulnerability is “a mismatch between the liquidity of investment fund assets compared to the ease with which end-investors in those funds can redeem their fund units,” Zelmer suggested

“Combining less liquid investments with short-notice redemption features for fund units gives rise to a potential misalignment between the redeemability of investment fund units versus the actual liquidity of their underlying investments,” Zelmer explained. “This mismatch may result in fragile demand for those investments if investors think they are more liquid than they really are. When times are good, everyone benefits. But if prospects dim and investors suddenly decide to rush to the exit gates, it could prove very disruptive for the markets in question, particularly if a fund has to quickly liquidate large blocks of securities to meet the redemption requests.”

FSB is working to “assess the materiality” of those five vulnerabilities, Zelmer said.

“We will also need to see if additional policy remedies are needed to buttress the current global regulatory framework,” he added. “If so, our plan is to explore measures that could be applied at a global level to specific activities or to all asset managers/investment funds engaged in that activity. This activities-based approach should help to limit any disruptions to the highly competitive landscape in the asset management sector.”