The asset management industry in Asia has undergone some pretty big changes since AsianInvestor got its start in 2000. Having served as the title's founding editor and, more recently, as editorial director at Haymarket Financial Media, I’ve enjoyed a front-row seat. Yet I feel I have more questions than answers about where the industry is headed.
As my final contribution to AsianInvestor, I have come up with a list of what I consider the top five issues, which will run over the coming days. My first question is:
Can asset managers be ‘too big to fail’?
Last year, the industry won a reprieve when the International Organization of Securities Commissions decided to avoid tagging the biggest players as ‘systematically important’. The question has been deferred, but it hasn’t gone away.
Big asset managers such as BlackRock argue they cannot be compared to ‘systematically important’ banks because they don’t take risk on their balance sheets to the same degree, and because they are not as endangered by the sudden withdrawal of liquidity. Fidelity, among others, argued that efforts to regulate asset managers would only harm investors and markets.
Size alone does not make a bank or other institution ‘systemically important’. To be ‘too big to fail’ requires several conditions.
First, the institution must treat risk as a commodity rather than as something to be methodically mitigated. Are risks being insured against, or are fund houses relying on mathematical equations, such as those underpinning discredited notions such as value-at-risk, to either assume too much risk or to shift risk to unsuspecting counterparties?
Second, the institution must be involved in many complex counterparty relationships. The greater the number of players involved in trading, settlement, cash management and so on, particularly when hedging and derivatives come into play, the more likely a problem with one entity puts others in danger.
Third, is the asset manager taking additional risk in the belief that it is likely to receive government support in the face of a looming collapse? Long-Term Capital Management, a hedge fund, enjoyed such backing in 1998, so it’s not only banks that are guilty of exploiting conditions of moral hazard.
Fourth, how dependent is the asset manager’s trading operations upon liquidity? Liquidity is ample until it isn’t; it is a service available on demand but only if most customers don’t take advantage of it. Lehman Brothers and Bear Stearns failed when they faced relatively modest, short-term breakdowns of liquidity, suggesting these were badly managed businesses rather than victims of temporary cash shortages.
‘Flash crashes’ in both stock and bond markets have revealed how quickly liquidity can disappear. An abundance of liquidity does not reflect anything other than an abundance of trading, but if counterparties stop trading with an asset manager, even for a short period, the pain may be acute. And if such an event happens, would the fallout damage its counterparties?
Finally, temporary shortages are likely to be magnified if the asset manager is using leverage. Leverage is more than borrowing: it is a multiplier, of both returns and of losses. It is often the factor that makes the difference between a crisis of liquidity versus one of solvency.
If these five conditions describe the business of BlackRock and its brethren, then there is a strong case to suggest they are too big to fail, and should be subject to stricter regulation.
In that case, however, the onus would remain on regulators to come up with measures that are appropriate. Asset managers face far fewer conflicts of interest than banks; banks, with their unsavoury blend of broker-dealers and depositor money, have a reliable track record of menacing society. So even if an asset manager is ‘systematically important’, it is important in different ways than banks.