The Financial Stability Board (FSB) has consulted on policy recommendations for addressing structural vulnerabilities from asset management activities. This follows a long debate at international level involving both the FSB and the International Organization of Securities Commissions (IOSCO). The FSB’s proposed recommendations relate to risks arising from liquidity mismatch, leverage, operational issues in transferring investment mandates in stressed conditions, and indemnifications related to securities lending.
The full impact on firms will not be known until the details are fleshed out but the FSB’s consultation provides an important indication of the direction of travel. The FSB’s proposals are broadly in line with recent messages from regulators such as the Financial Conduct Authority (FCA), which published good practices for liquidity management for investment firms in February 2016, the Bank of England (BoE), which published the Financial Policy Committee’s analysis in its December 2015 Financial Stability Report, and the US Financial Stability Oversight Council, which issued an update on its analysis of potential asset management risks in April 2016.
In the EU, there are existing rules in most of the areas highlighted in the FSB’s report. We think the recommendations are likely to lead to more consistency at global level and more detailed requirements in some areas, potentially including fund stress testing and liquidity risk management tools. A few of the recommendations could lead to significant changes, depending on how they are implemented. For example, the FSB envisages that authorities could impose restrictions on the frequency of redemptions offered by funds holding less liquid assets, which could significantly alter the terms of some funds. And authorities could be given power to suspend redemptions in individual funds in exceptional cases, which would be likely to increase scrutiny of how firms manage surges in redemptions. The potential introduction of capital requirements for indemnifications provided by asset managers in relation to their securities lending activities is also new. We do not expect that the UK’s decision to leave the EU will affect the UK’s commitment to implementing FSB/IOSCO standards, but it could lead to some differences in the way they are implemented in the UK compared to the EU.
Liquidity mismatch between fund investment assets and redemption terms in open-ended funds
The FSB is concerned that asset managers may face pressures from investors to offer daily dealing in funds holding primarily illiquid assets. EU asset managers are already required to align a fund’s redemption terms with its liquidity profile, but we think the FSB’s proposals are likely to result in more detail on which types of asset classes or investment strategies are deemed unsuitable for funds offering frequent redemptions. Andrew Bailey, the new CEO of the FCA, has already questioned whether property funds should be allowed to have frequent revaluations. The FSB also proposes that minimum standards for internal risk management practices could include the use of appropriate liquidity buffers or targets, the division of assets into liquidity “buckets” and limits on illiquid assets. The US Securities and Exchange Commission (SEC) has already consulted on detailed rules in this area.
The FSB recommends that authorities should have rules and/or guidance on fund liquidity stress testing. It asks IOSCO to review its existing guidance on this by the end of 2017, and consider clarifying the objective of fund stress testing, the desired frequency, and related governance and reporting obligations. EU asset managers are already subject to high-level requirements on fund stress testing, with alternative investment fund managers having to report the results of liquidity stress tests to regulators. We think that the FSB’s recommendation could result in more detailed requirements for firms. Nevertheless, since funds have very diverse risk profiles we think regulators are unlikely to prescribe as detailed test scenarios as in the banking sector. In addition, the FSB envisages proportionality for funds which are smaller or have lower risk investment strategies.
The FSB also recommends that authorities consider system-wide stress testing. In October 2015, the BoE announced its intention to extend its system-wide stress tests to include asset management activities, which will require substantial enhancements to its modelling and data capabilities. The BoE is considering what additional data it will need, which may result in additional reporting requirements for firms.
The FSB proposes that authorities should widen the availability of liquidity management tools, such as swing pricing, redemption fees, gates and suspensions. IOSCO’s December 2015 survey on liquidity management tools reports that a wide range of such tools are already available in the UK and many other jurisdictions. In the US, there are currently proposed rules that would modernise the regulatory framework related to a mutual fund’s use of derivatives and its liquidity management practices, including the potential use of swing pricing by mutual funds. In France, work is being done to change the law to allow UCITS funds to use gates. The FSB proposes that authorities should promote clear decision-making processes for the use of extraordinary liquidity management tools and asks IOSCO to enhance its guidance in this area. It envisages that authorities could be given the power to direct the application of such tools in exceptional cases, while acknowledging that the decision should usually remain with the asset manager. This could lead to increased scrutiny of how firms manage surges in redemptions.
The FSB recommends that authorities ensure that investor disclosures on fund liquidity profiles are of sufficient quality and frequency, with the intention of reducing the perception that a fund which offers daily redemption of units necessarily holds liquid assets. If successful, in some cases this could encourage more risk-averse investors to switch to more liquid funds.
The FSB recommends that authorities enhance reporting requirements where appropriate to ensure they have sufficient information on funds’ liquidity profiles. IOSCO is currently engaged in an initiative to address data gaps related to funds, including on liquidity profiles. We think this is likely to result in more harmonised reporting across jurisdictions.
Leverage within investment funds
The FSB recommends that IOSCO develops simple and consistent measure(s) of leverage in funds using appropriate netting and hedging assumptions. These would be used by authorities to monitor funds’ use of leverage, both at national and international level. We think this is likely to be a positive development for both firms and regulators. In the EU, existing leverage measures are reported to regulators and disclosed to investors, but these measures have a number of limitations. A more consistent approach across jurisdictions would facilitate better comparability.
Operational risk and challenges in transferring investment mandates in stressed conditions
The FSB recommends the introduction of requirements or guidance for asset managers that are large, complex and/or provide critical services to have robust contingency plans to enable the orderly transfer of their investment mandates in stressed conditions. In the EU, some asset managers are already required to produce recovery plans under the Recovery and Resolution Directive. However, we think this may lead to a greater focus on the smooth transfer of investment mandates. The FCA has previously highlighted difficulties in transferring services between outsourced providers in stressed market conditions. In the US, the SEC recently proposed a rule that would require registered investment advisers to have written business continuity and transition plans. Concurrently, SEC staff issued guidance reiterating the importance of business continuity plans for mutual funds, including the routine oversight of plans implemented by “critical” service providers to a fund.
Securities lending activities of asset managers and funds
The FSB recommends that authorities monitor indemnifications provided by asset managers to insure clients against potential losses from securities lending activities, and ensure that they adequately cover potential credit losses. Currently, asset managers acting as agent lenders do not face capital requirements related to their indemnification exposures, unlike banks. The FSB intends to collect additional data on agent lender activities to monitor trends and potential risks. However, it reports that currently only a very limited number of large asset managers act as agent lenders.
The consultation closes on 21 September 2016, and the FSB intends to finalise its recommendations by the end of 2016. The details will then be fleshed out by IOSCO and the relevant FSB working groups. Following this, the authorities in each jurisdiction will review their regulatory and supervisory frameworks in light of the agreed principles.
Once these recommendations are finalised, the FSB intends to continue its work on assessment methodologies for non-bank non-insurer global systemically important financial institutions in conjunction with IOSCO. This work was delayed in July 2015 pending completion of the work on structural vulnerabilities from asset management activities. The revived project will focus on any residual entity-based sources of systemic risk that cannot be effectively addressed by market-wide activities-based policies. It will also include an assessment of the potential vulnerabilities of pension funds and sovereign wealth funds, which was not fully taken forward as part of the FSB’s work on structural vulnerabilities.