Asset Management Industry and Systemic Risk

January 21, 2014

The asset management industry should not be classified as a potential source of systemic risk, says Peter Wallison, a fellow in financial policy studies at the American Enterprise Institute.

As part of the Dodd-Frank Act, two Treasury Department agencies were created: the Financial Stability Oversight Council (FSOC) and the Office of Financial Research (OFR). Notably, the FSOC has the power to determine its own jurisdiction, thanks to Dodd-Frank.

The FSOC reached out to the OFR and asked the latter agency to issue a report on the asset management industry. The OFR report, issued in September, identified the asset management industry (such as mutual funds, hedge funds and pension funds, etc.) as a potential source of systemic risk, the idea being that losses from these funds could produce an event felt by the market as a whole, leading to a crash.

However, says Wallison, these funds are different from the other types of industries (banks and managed funds, for example) that are classified as systemically important financial institutions:

  • When collective funds suffer losses, those losses flow to their investors. Because those investors are so widespread, it is very unlikely that losses within the asset management industry could lead to a systemic event.
  • OFR assumed that losses within collective investment funds would lead to effects similar to the 2008 mortgage meltdown. However, the financial crisis was not caused by a decline in value but by the fact that the mortgages at issue were carried with borrowed funds in a very small amount of highly leveraged institutions.
  • When assets are funded with equity (as is the case in the asset management industry) rather than debt, systemic effects will not be felt when losses are suffered.

The OFR report is a threat to asset management, as it could lead the FSOC to impose stringent federal regulations. Unfortunately, the FSOC has the power to exercise its discretion under Dodd-Frank and could very well decide to list these types of funds as sources of systemic risk.

Source: Peter J. Wallison, "Unrisky Business: Asset Management Cannot Create Systemic Risk," American Enterprise Institute, January 13, 2014.

 

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