1. Resolution of asset management companies Ronald Anderson London School of Economics Remarks at CEPS Task Force on Implementing Financial Sector Resolution 11 December 2015

2. Public policy focus on asset management companies Policy makers and regulators have recently turned to the question of the possible contributions of the institutionally managed funds to financial sector instability. Not new (“regulatory cycle”). – Following LTCM (1998) there was regulatory concern about the systemic importance of big hedge funds and their linkage to banking, largely as a means of providing leverage. – Thought that the next banking crisis could come from hedge fund sector. The experience of the Great Financial Crisis (2007-2008) turned out to be very different from that. Non banks are included in G20 regulatory reform agenda. Issues were brought to light in the FSB’s consultation paper (February 2015) on NBNI G-SIFI designation

3. The concerns raised by FSB in its consultation paper Asset management companies (AMCs )may be “entities whose distress or disorderly failure, because of their size, complexity and systemic interconnectedness, would cause significant disruption to the global financial system and economic activity across jurisdictions.” – Note that difficulty of resolution is central to this. They identified three channels that could transmit distress: – Counter-party channel: The exposures of creditors, counterparties, investors, and other market participants to the NBNI financial entity. – Market channel: The liquidation of assets by the NBNI financial entity, which could trigger a decrease in asset prices and thereby could significantly disrupt trading or funding in key financial markets or cause significant losses or funding problems for other firms with similar holdings. – Critical functions channel: The inability or unwillingness of the NBNI financial entity to provide a critical function or service relied upon by market participants or clients.

4. How determine whether an AMC is a G-SIFI FSB’s general criteria – Size – Interconnectedness – Substitutability (i.e., difficulty to replace critical functions should the entity fail) – Complexity – Global activities (cross-jurisdictional activities). Note this is clearly relevant to G-SIFI designation. But it may also add to complexity when considered at the European or national level.

5. FSB consultation regarding investment funds Investment funds are either 1.funds, 2.family of funds 3.asset managers on a stand-alone entity basis, or 4.asset managers and their funds collectively. Because of data reasons the focus on (iii) i.e., on AMCs. Specific criteria – Size: Net AUM – Interconnectedness: leverage ratio, counterparty exposure ratio, intra- financial system liabilities. – Substitutability: turnover ratio (fund versus funds in same category, strategies with less than 10 players globally). – Complexity: OTC derivatives trading volume, ratio of collateral posted that is re-hypothecated, ratio of NAV managed with HFT, ratio of unencumbered cash to AUM. – Global activities: number of jurisdiction where the fund invests, is sold, is listed or has counterparties.

6. Where things stand Strong and vocal response from participants in the fund management industry largely arguing against the idea that institutionally managed funds pose a threat to financial stability. For now there seems it is not likely that AMC’s will receive G-SIFI designation by FSB. However, there are discussions ongoing in FSB-IOSCO working groups with possible recommendations to be put forward by spring 2016. – [Currently no AMC is designation as a SIFI by FSOC in the US.] Some regulators and some academics are unconvinced by industry arguments and are continuing to argue that regulatory action on AMCs may be required. Even if one concludes that AMCs and investment funds merit the special attention of the authorities responsible for assuring financial stability (FSB, ESRB, FSOC, ESMA, national regulators and supervisors…) the question then becomes what are the appropriate tools: regulation, supervision, stress testing, recovery and resolution planning, special resolution regimes (SRRs)?

7. Is there a case for special resolution of AMCs? The first question: Is a judicial process based on existing bankruptcy law is inadequate for AMCs? Recall the case for special resolution regimes for large banks. – Banks fail because of illiquidity. – If a solvency problem arises or even if it can be suspected, this can provoke a run by depositors or wholesale creditors. If not dealt with promptly this can lead to insolvency (the point of non-viability of the existing institution as a going concern). – Bankruptcy is generally a slow process and this is particularly true when the large bank has a complicated legal structure that involves multiple jurisdictions. – Therefore a special resolution regime is required to allow the bank in resolution to continue to function in banking markets and thus to preserve as much as possible of its going-concern value. Does this hold for AMC’s also?

8. How would SRR for AMC’s work? Recall how special resolution regimes work (broadly, following banking examples..): – SRR takes place before judicial bankruptcy proceedings would be triggered, prior to the point of insolvency. – It involves a regulatory action by a specially designated authority. – It brings about the financial restructuring of the firm through a simultaneous write-down of assets and recapitalization (perhaps through bail-in). – It involves management restructuring – It may require liquidity support from CB.

9. Questions for discussion Does the logic of the SRR case for banks carry over to large AMCs? Should the same SRR apply to AMC’s and banks and/or insurance companies? Should the same authority handle AMC resolution as well as banks?

10. Reasons to think that existing bankruptcy law is adequate for AMCs The AMC manages the clients’ investments in funds but the client money is held in segregated accounts that are bankruptcy remote from the AMC. So if the AMC is insolvent the funds themselves may continue as before and there is no need to liquidate funds that could lead to fire sales and further solvency problems (described as the asset spiral and margin spiral and the fire sale externality of Brunnermeier and Pedersen). The management of the fund can be transferred (sold) to an alternative manager without much difficulty. The AMC’s themselves do not have big balance sheets and are not particularly highly levered. Yes, there can be problems if segregation of client accounts has not been respected. But this is an issue of financial conduct not prudential regulation. Even very big fund managers have failed without major disruptions to the markets. – Example, MF Global managed both customer funds and proprietary funds taking large levered bets in European periphery bonds. Its bankruptcy in 2011 was one of the largest when measured by total assets held. However, its collapse did not result in a crisis. Its bankruptcy was settled in 2013 with claimants receiving 93 cents on the dollar.

11. Reasons why SRR for AMCs may be needed Increase in size of the fund management industry and its increased global interconnection (Haldane,) Some funds use substantial leverage and maturity miss-match. These are therefore similar to banks. The MF Global bankruptcy was not trouble-free. The outcome could have been much worse had there not been an organized effort underway to resolve the sovereign debt crisis. Even without leverage there still may be a problem of herding (see, Feoli, Kashyap Schoenholtz and Shin “Market Tantrums and Monetary Policy”). Fund managers can extend credit to investors. Thus AMC insolvency may trigger fund withdrawals. Managing fund inflows and outflows requires adequate market liquidity. Trend growth of funds in indexes especially with leverage can increase the demand for liquidity while simultaneously diminishing its supply. It is possible that AMCs are providing implicit liquidity guarantees, e.g., they provide liquidity backstops (Cunliffe speech October 2015). AMCs may centralize order execution across funds (e.g., cross trades internally). This process may be disrupted if the AMC fails and its funds are transferred to different fund managers who are unable to quickly reproduce this operating facility. For these reasons, resolution of an AMC through bankruptcy may reduce the value of funds because of loss of liquidity. More generally, failure of an AMC could provoke a withdrawal of investors in the funds they manage simply driven by investor fear because they are unsure about the linkages between the funds and the managers.

12. Now, questions for discussion Does the logic of the SRR case for banks carry over to large AMCs? Should the same SRR apply to AMC’s and banks and/or insurance companies? Should the same authority handle AMC resolution as well as banks?