The US Office of Financial Research recently released a report raising concerns that the largest asset managers could pose a threat to financial stability. That puts firms like BlackRock, Deutsche Asset & Wealth Management, Prudential Financial, AXA Investment Managers, MetLife, Invesco and UBS Global Asset Management in the cross-hairs of being considered “systemically important.”
The Financial Stability Oversight Council decided to study the activities of asset management firms to better inform its analysis of whether to consider such firms for enhanced prudential standards and supervision under Section 113 of the Dodd-Frank Act. Section 113 gives the FSOC the power to designate a non-bank firm as a “systemically important financial institution”. Being considered “systemically important” means heightened supervision by the US Federal Reserve and also makes the firm subject to risk-based capital requirements and leverage rules.
The FSOC asked the Office of Financial Research to step in and collect data. The Dodd-Frank Wall Street Reform and Consumer Protection Act established the Office of Financial Research within the Treasury Department to improve the quality of financial data available to policymakers and to facilitate more robust and sophisticated analysis of the financial system.
This report is the first step to seeing greater regulatory control of large asset managers. According to the Report, the U.S. asset management industry oversees the allocation of approximately $53 trillion in financial assets.
The Report asserts that separate accounts managed by large asset managers are less transparent than those of mutual funds, banks, and private funds because the activities are not publicly reported.
The Report identifies four key factors that make the industry vulnerable to shocks:
(1) “reaching for yield” and herding behaviors;
(2) redemption risk in collective investment vehicles;
(3) leverage, which can amplify asset price movements and increase the potential for fire sales; and
(4) firms as sources of risk;
To me, (1) and (3) seem to miss the point of separate accounts. Pension plans and institutional investors usually choose a separate accounts strategy to have greater control over their investments. The active involvement of the separate account holder acts as a control against the asset manager reaching for yield or using excessive leverage.
Of course, the findings in the Report do not mean that the big asset managers are imminently subject to additional regulatory oversight. There is a lengthy process for designated a firm as “systemically important.” However, this report could lead to adverse regulation that might adversely impact the separate account business of large asset managers, including those with real estate investment management platforms.
The first step in figuring out if a financial company is too big to fail, is to figure what it means to be “big”. Section 113 of the Dodd-Frank Wall Street Reform and Consumer Protection Act authorizes the Financial Stability Oversight Council to determine that a nonbank financial company will be subject to supervision by the Board of Governors of the Federal Reserve System and prudential standards. It’s up to the FSOC to determine whether material financial distress at the nonbank financial company, or the nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the nonbank financial company, could pose a threat to the financial stability of the United States.
The FSOC has come up with a three stage process. First, based on quantitative criteria, the FSOC narrows the universe of nonbank financial companies by de facto defining “big”.
The Too Big to Fail thresholds are—
$50 billion in total consolidated assets;
$30 billion in gross notional credit default swaps outstanding for which a nonbank financial company is the reference entity;
$3.5 billion of derivative liabilities;
$20 billion in total debt outstanding;
15 to 1 leverage ratio of total consolidated assets (excluding separate accounts) to total equity; and
10 percent short-term debt ratio of total debt outstanding with a maturity of less than 12 months to total consolidated assets (excluding separate accounts).
In the second stage of the process, the FSOC will conduct a comprehensive analysis, using the six-category analytic framework, of the potential for the nonbank financial companies identified in Stage 1 to pose a threat to U.S. financial stability. In general, this analysis will be based on a broad range of quantitative and qualitative information available to the FSOC through existing public and regulatory sources, including industry- and company-specific metrics beyond those analyzed in Stage 1, and any information voluntarily submitted by the company.
Based on the analysis conducted during Stage 2, the FSOC intends to identify the nonbank financial companies that the Council believes merit further review in the third stage. The FSOC will send a notice of consideration to each nonbank financial company that will be reviewed in Stage 3, and will give those nonbank financial companies an opportunity to submit materials within a time period specified by the FSOC .
The FSOC will determine whether to subject a nonbank financial company to supervision by the Fed and the prudential standards based on the results of the analyses conducted during the three-stage review process.
Looking at those thresholds from the perspective of the private equity industry, it’s the $20 billion in debt threshold that most concerns me.
I’m looking for guidance on whether it should be aggregated across funds and from the portfolio companies. It would seem that debt in a portfolio company should not be consolidated to the fund if it’s not recourse to the fund. Similarly, debt in separate funds should not be consolidated since the debt will not be recourse from one fund to another.
Of course the FSOC could take the opposite view and consolidate all of the debt under a fund manager together for purposes of clearing the Stage 1 hurdle and then work on the “too big to fail” analysis in Stage 2.
The Securities and Exchange Commission proposed a new rule that would require advisers to private funds to report information for use by the Financial Stability Oversight Council in monitoring risk to the U.S. financial system. Sections 404 and 406 of the Dodd-Frank Wall Street Reform and Consumer Protection Act requires the SEC to gather this information.
The SEC is proposing a new Rule 204(b)-1 under the Investment Advisers Act that would require SEC-registered investment advisers to report systemic risk information on Form PF if they advise one or more private funds.
Each private fund adviser would report basic information about the operations of its private funds on Form PF once each year. Large Private Fund Advisers would be required to submit this basic information each quarter along with additional systemic risk related information required by Form PF concerning certain of their private funds.
“Large Private Fund Advisers” would be
Advisers managing hedge funds that collectively have at least $1 billion in assets as of the close of business on any day during the reporting period for the required report;
Advisers managing a liquidity fund and having combined liquidity fund and registered money market fund assets of at least $1 billion as of the close of business on any day during the reporting period for the required report; and
Advisers managing private equity funds that collectively have at least $1 billion in assets as of the close of business on the last day of the quarterly reporting period for the required report.
The SEC estimates that approximately 4,450 advisers would be required to file Form PF. Of those, approximately 3,920 would be smaller private fund advisers not meeting the thresholds for reporting as Large Private Fund Advisers.
It looks like the definition of private equity fund for purposes of the Large Private Fund Adviser reporting requirements will exclude real estate funds.
Private equity fund:
Any private fund that is not a hedge fund, liquidity fund, real estate fund, securitized asset fund or venture capital fund and does not provide investors with redemption rights in the ordinary course.
Under the proposed rule, real estate private equity funds will be subject to the annual reporting, but not subject to the more detailed quarterly reporting. This is just a proposed rule, so the final requirements and definitions may change in the final rule when it is issued. In the meantime, you can make comments.
The hard work has begun as federal regulators are trying to implement the provisions of Dodd-Frank. The law pushed lots of the detail out to the agencies so there are lots of unanswered questions.
One of the hot button issues was what to do with financial institutions that were too big to fail. Dodd-Frank came up with the concept of “systemically important.” They created a new entity, the Financial Stability Oversight Council to come up with a definition, figure who should get that designation and design safeguards for those designees.
Private equity lost the battle to get an exemption from registration under the Investment Advisers Act. It may have to fight another battle to avoid the “systemically important” label.
The Independent Community Bankers of America, a major trade group for community banks, said General Electric Co.’s GE Capital and private-equity firms Carlyle Group, KKR & Co.’s Kohlberg Kravis Roberts & Co. and Blackstone Group LP should be tagged as systemically important.
Private equity doesn’t belong in that group, shot back Blackstone spokesman Peter Rose. “We do not trade, we have no leverage at the parent-company level, our investments are clearly disclosed and transparent, our investors are with us for the long term,” he said. “Therefore there is no possibility of a, quote, ‘run on the bank.’ ”
may determine that a U.S. nonbank financial company shall be supervised by the Board of Governors and shall be subject to prudential standards, in accordance with this title, if the Council determines that material financial distress at the U.S. nonbank financial company, or the nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the U.S. nonbank financial company, could pose a threat to the financial stability of the United States.
The term “U.S. nonbank financial company” means
a company (other than a bank holding company, a Farm Credit System institution chartered and subject to the provisions of the Farm Credit Act of 1971 (12 U.S.C. 2001 et seq.), or a national securities exchange (or parent thereof), clearing agency (or parent thereof, unless the parent is a bank holding company), security-based swap execution facility, or security-based swap data repository registered with the Commission, or a board of trade designated as a contract market (or parent thereof), or a derivatives clearing organization (or parent thereof, unless the parent is a bank holding company), swap execution facility or a swap data depository registered with the Commodity Futures Trading Commission), that is–
(i) incorporated or organized under the laws of the United States or any State; and
(ii) predominantly engaged in financial activities, as defined in paragraph (6).
[102(a)[4)]
A company is “predominantly engaged in financial activities” if–
(A) the annual gross revenues derived by the company and all of its subsidiaries from activities that are financial in nature (as defined in section 4(k) of the Bank Holding Company Act of 1956) and, if applicable, from the ownership or control of one or more insured depository institutions, represents 85 percent or more of the consolidated annual gross revenues of the company; or
(B) the consolidated assets of the company and all of its subsidiaries related to activities that are financial in nature (as defined in section 4(k) of the Bank Holding Company Act of 1956) and, if applicable, related to the ownership or control of one or more insured depository institutions, represents 85 percent or more of the consolidated assets of the company.
[102(a)[6)]
Those are some very wide open definitions for who could be considered “systemically important.”
(A) The extent of the leverage of the company;
(B) The extent and nature of the off-balance-sheet exposures of the company;
(C) The extent and nature of the transactions and relationships of the company with other significant nonbank financial companies and significant bank holding companies;
(D) The importance of the company as a source of credit for households, businesses, and State and local governments and as a source of liquidity for the United States financial system;
(E) The importance of the company as a source of credit for low-income, minority, or underserved communities, and the impact that the failure of such company would have on the availability of credit in such communities;
(F) The extent to which assets are managed rather than owned by the company, and the extent to which ownership of assets under management is diffuse;
(G) The nature, scope, size, scale, concentration, interconnectedness, and mix of the activities of the company;
(H)The degree to which the company is already regulated by 1 or more primary financial regulatory agencies;
(I) The amount and nature of the financial assets of the company;
(J) The amount and types of the liabilities of the company, including the degree of reliance on short-term funding; and
(K)Any other risk-related factors that the Council deems appropriate.
[113(a)(2)]
Hearing
Then it takes 2/3 of the voting members of the Council, including the Chairperson, to make the designation [113(a)(1)]. Then the financial company designated as systemically important has 30 days to request a hearing and another 30 days to submit material. [113(e)(2)] The Council has 60 days to make a final determination.
Too Big to Fail
This provision of Dodd-Frank is the Anti-AIG and to some extent the Anti-Lehman Brothers portion of the law.It is one of the many ways the law tries to address Too Big to Fail.
Capital has many forms and is made available in many ways. The U.S. government thought AIG was too big to fail because of its size and interconnectedness. They didn’t think Lehman Brothers was too big to fail, but I think they were wrong about that.
Back to the Finger Pointing
Now that the Financial Stability Oversight Council is trying to define Too Big to Fail as systemically important, the finger pointing has begun. Industries and companies are saying “not me” and saying that others should be included.
The problem is that once you are designated “systemically important” it’s not clear what additional burdens will be placed on you and whether there will be any benefit to the designation. It seems the Council has the flexibility to craft different requirements for different companies and different industries.
It may boost your ego to be considered “systemically important” but it will also lead to a regulatory headache. Private investment firms are not exempt from the designation and could be tagged.
The current draft of the Dodd-Frank Wall Street Reform and Consumer Protection Act has a surprise in it for big hedge funds. By “surprise” I mean tax.
Title XVI: Financial Crisis Special Assessment has a $19 billion fee ready to be assessed against financial companies institutions with more than $50 billion in assets and hedge funds with more than $10 billion under management. This $19 billion in “fees” is being assessed to support the new government initiatives in the financial reform legislation.
Section 1601(f)(2) leaves up to the new Financial Stability Oversight Council to define a hedge fund (in consultation with the SEC). The amount owed by any particular hedge fund manager will depend on a matrix of contributing factors. Section Section 1601(g) lays out thirteen factors the Council will need to take into account.
Before you start handing money back to limited partners to get under the $10 billion threshold you may want to wait for the legislative process to continue. Senator Brown of Massachusetts is opposed to new taxes and is threatening to withhold his vote. (I didn’t vote for him.) With the death of Senator Byrd, the Democrats need to pull in more Republican votes to get the financial reform bill passed in the Senate.
