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Finance and economics
The Economist August 2nd 2014 Also in this section 55 Buttonwood: Whither interest rates? 56 Deleveraging in America 56 A recent history of default 57 Latin American economies 58 Free exchange: Why the ECB should adopt QE
For daily analysis and debate on economics, visit Economist.com/economics
Fund managers
Assets or liabilities? Regulators worry that the asset-management industry may spawn the next financial crisis
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INANCIAL crises may seem a familiar part of the economic cycle, but they rarely repeat themselves exactly. In the 1980s the locus was Latin America; in the late 1990s, Russia and South-East Asia; in 2007-08, American housing and banks. Now, some worry that the next crisis could occur in the asset-management industry. The industry manages $87 trillion, making it three-quarters the size of banks; the biggest fund manager, BlackRock, runs $4.4 trillion of assets, more than any bank has on its balance-sheet. After the crisis, regulators tightened the rules on banks, insisting that they hold more capital and have sufficient liquidity to cope with short-term pressures. But that may be a case of generals fighting the last battle. In the absence of lending from banks, many companies have turned to bonds (mainly owned by fund managers) for credit. Fund managers have caused problems in the past. The collapse in 1998 of LongTerm Capital Management, a hedge fund run by some of the brightest minds on Wall Street and in academia, led to a rescue instigated by the Federal Reserve. Bear Stearns’s bail-out oftwo hedge funds it had been running contributed to its collapse in 2008. In the same year a money-market fund run by the Reserve group was forced to “break the buck” (impose losses on investors), setting offa run that prompted the Fed to provide a backstop yet again. All this has made regulators nervous. In
January the Financial Stability Board (FSB), an international body which tries to guard against financial crises, published a consultation paper which asked whether fund managers might need to be designated “systemically important financial institutions” or SIFIs, a step that would involve heavier regulation. A new report from the Bank of England worries that pension funds and insurance companies are no longer playing the stabilising role in markets they used to—taking advantage of short-term market falls by buying assets that look cheap. Instead, they may be amplifying the cycle because of the need to meet more conservative accounting and regulatory requirements. The asset-management industry has marshalled some powerful counter-arguments. First, managers act as stewards of other people’s capital, which is held in separate accounts (with third parties acting as custodians). Banks like Lehman Brothers, in contrast, were speculating on their own account. Were a fund manager to go bankrupt, the assets would simply be transferred to a competitor, with no loss for the investors concerned. Hundreds of mutual funds close each year, with minimal market impact and without needing government rescue. Second, the parallels with banks are inaccurate; with the exception of hedge funds, asset managers tend not to operate with borrowed money, or leverage. The size of BlackRock’s balance-sheet
is just $8.7 billion; HSBC’s is nearly $2.7 trillion, or more than 300 times bigger. Fund managers are thus far less vulnerable to sudden falls in asset prices than banks proved to be in 2008. Third, there is little evidence that mainstream asset managers contribute to market panics. Retail investors are less flighty than institutions; many invest through defined-contribution pensions, called 401(k) plans in America, through which they put a bit of money into the market every month. This makes them indifferent to short-term fluctuations. The Investment Company Institute, a trade body, says that in the autumn of 2008, a low point for stockmarkets, equity sales by mutual funds comprised only 6% of total trading volume in New York. Finally, designating fund managers as SIFIs would have perverse consequences. The FSB paper stated that size was the key criterion, suggesting a threshold of $100 billion, which would capture 14 American mutual funds. This may miss the point: Reserve ranked only 81st among American asset managers and 14th among those running money-market funds. In any case, many big funds are low-cost trackers such as Vanguard’s 500 index fund, which allows retail investors to get a broad exposure to the stockmarket for fees of just 0.17% a year. As one of the consequences of being a SIFI, the fund might be required to hold a capital reserve; the cost of doing so would be passed on to retail investors. In addition, SIFIs could be required to support the orderly liquidation fund, a bailout vehicle for other SIFIs. In other words, when the next Lehman goes bust, small investors in Vanguard might be on the hook. As yet, no fund manager has been designated a SIFI. But Andy Haldane of the Bank of England cautions, “As any self-respecting asset manager would tell us, past 1