Last month the Office of Financial Research-an under-the-radar, but ambitious Dodd-Frank bureaucracy-released a report on the link between asset management and financial stability. The report's stunning revelation was that the asset management industry is deeply integrated with the financial system and not immune from shocks.
The Financial Stability Oversight Council, which commissioned the study, undoubtedly will use that newsflash as the basis for its next round of systemically important financial institution designations, and the Federal Reserve will add large asset managers to its already bloated regulatory portfolio. In the process, the risks to the financial system will only be exacerbated.
Among OFR's worries is that asset managers, such as investment advisers and pension plan managers, compete based on returns, which means they have to take investment risks. They end up herding into the same securities as their competitors. Investors in mutual funds and other collective investment funds could run during a crisis. Once a run starts, redemptions will spread to the asset manager's other products and the rest of the industry. There will be fire sales in order to meet redemptions. Because asset managers are interconnected with one another and many other financial firms, a failure by one manager could bring down the rest of the financial industry with it.
The theme running through the thirty-page report seems to be that asset managers are a ticking time bomb and need to be regulated just like banks. The OFR's solution? Macroprudential regulation-which is a 21st century way of saying that the Fed gets to centrally-plan the financial system. In order to do that, though, the Fed needs power over every component of the system. That's where the OFR's study comes in handy. Based on the study's alarmed rhetoric, the FSOC will initiate designation proceedings for large asset managers at the end of which the Fed will have regulatory authority over them.
Is the Fed really up to the job of running the financial markets? Can the Fed's team of really smart economists and lawyers process, analyze, and transmit information as effectively as market prices can? Today's financial regulators-undaunted by their recent record of regulatory failure-think the answer to both questions is yes. Macroprudential planners don't trust the markets, populated as they are with investors who like to earn returns and firms that are willing to help them do that. The Fed, motivated by the good of the collective, believes it can see more clearly than short-term, self-centered investors and asset managers. That is why the Fed will not rest until it has the entire financial system under its control. Fed Governor Dan Tarullo hinted as much in his recent paean to macroprudential regulation.
The OFR is right that asset managers are big players in the markets and that their actions can have widespread effects. The SEC already regulates many of these firms. More importantly, discipline comes from the investors and firms with whom asset managers deal and from their competitors. As the OFR points out, reputation matters a lot in the asset management industry, so there is a strong incentive to behave prudently. Herding behavior does occur, but markets reward people who have the courage to walk away from the herd. Ironically, having the Fed regulate all the big firms may increase herding behavior. Everybody will be seeking to get a gold star from the same regulator, so the assets the Fed likes will be the ones into which everyone crowds.
Given the OFR's admitted lack of data, it is somewhat surprising that it did not seek public input on its report. But the Securities and Exchange Commission, which regulates asset managers, has asked for comment on the OFR's study. It is wise to ask now, because once the FSOC's designation machine grabs hold of a specific asset manager and starts churning, there is almost nothing anyone can do to turn it off. Let's hope that cooler heads prevail before the whole financial system is in the Fed's clutches.