INTRODUCTION
Since the 2008 financial crisis, global regulators have made it a priority to fashion a set of issues presumably contributing to systemic risk that would help identify key players in the financial services industry potentially posing significant risks to the financial system. The foundation of this regulatory model is to designate certain firms as systemically important financial institutions (SIFIs) and to subject them to greater regulatory scrutiny and enhanced regulatory requirements.
WHO IS AFFECTED?
Regulatory compliance—plus the financial and reputational consequences of non-compliance—is now indisputably a front-and-center issue for boards and senior management of any company doing business in the financial services industry. Firms must not only interpret and satisfy the gamut of current regulation, but must also effectively anticipate future compliance demands in a constantly evolving regulatory landscape. Moreover, compliance obligations of various sorts now spill over into virtually every operational area of the typical financial services firm. Against this backdrop, the board and senior management are ultimately responsible for the company's implementation of all appropriate systems required to ensure regulatory compliance, and to drive any cultural change required in the organization to make such compliance meaningful and effective.
SUMMARY
SIFI Designations
In the United States, the Financial Stability Oversight Council (FSOC), and its research arm, the Office of Financial Regulation (OFR), have been assessing various risks and going about the business of identifying SIFIs, which U.S. banking regulators will then oversee and further regulate. Some non-bank financial service institutions that were unregulated before 2008 could receive a SIFI designation. The SIFI designation could also be applied to institutions already subject to substantial regulation. In either case, it would seem logical that the heavy hand and added costs of substantially increased government involvement should be preceded by a significant justification for additional regulation and a matching of any new regulations to systemic risks not already addressed by existing regulations.
The OFR and FSB/IOSCO Reports
In late 2013 the OFR issued an Asset Manager Report that outlined a series of theoretical risks to investment funds, struggled to identify those risks in a broad range of asset management and investment fund businesses, and characterized these would-be risks as a major threat to financial stability.
The OFR Report, which has been widely discredited for its lack of intellectual rigor, was published a few months in advance of the Assessment Methodologies for Identifying Non-bank Non-insurer Global Systemically Important Financial Institutions (NBNI G-SIFIs) published jointly by the Financial Stability Board (FSB) and the International Organization of Securities Commissions (IOSCO).
Similarly to the OFR Report, the FSB/IOSCO Report finds that systemic risk can be spread through three basic transmission channels: (i) an exposures/ counterparty channel; (ii) an asset liquidations/market channel; and (iii) a critical function or service/substitutability channel.
The Problem of Risk Profiles
The FSB/IOSCO initiatives logically categorized NBNI G-SIFIs separately from global systemically important banks and global systemically important insurers. Banks and insurance companies provide investor guarantees and assume all or most of the investment risk of the underlying assets necessary to satisfy those guarantees. By design, banks and insurance companies do not have sufficient underlying assets to pay depositors or contract holders all at once. The U.S. government guarantees U.S. bank deposits up to $250,000; if the bank is unable to pay depositors, U.S. taxpayers will.
Investment funds, unlike banks and insurance companies, are intended to shift the investment risk from the financial institution to its investors. Investors own an undivided share of the assets in the fund; they have no interest in the assets of the fund manager. Yet, there are many forms of investment funds, subject to fundamentally different regulatory restrictions currently, that present radically different risk profiles.
Neither the OFR Report nor the more reasoned FSB/IOSCO Report sufficiently distinguishes the risk profiles of different types of investment fund businesses outside of the bank and insurance company context. Both instead defer to a functional analysis of risk through factors such as size, interconnectedness, and substitutability—without considering the operational structure of the business model or the ameliorating impact of current regulation.
CONCLUSION
Developing rational standards of regulation going forward will require a focus on the diversity of risks posed by these different forms of investment funds, and this process would benefit from the input of all players in the financial system. The failure of both the OFR Report and the FSB/IOSCO Report to categorize investment funds according to levels of existing regulation and transparency threatens to severely limit the usefulness of current attempts to assess the risks associated with investment funds, and this threatens to undermine the merit of regulatory decisions, while establishing a misleading international consensus that such funds are systemically risky. Until the SIFI designation construct integrates the important distinctions in risks posed by various different non-bank financial institutions, the next steps—identifying entities for SIFI designation and developing policy measures that would apply to non-bank SIFIs—will be both over- and under-inclusive, and the protections against future dynamics of systemic failure will be flawed.
Industry input during comment processes can provide a broader knowledge base for both standard-setting bodies and regulators to incorporate into the analysis.
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