February 25, 2015

No, Mr. Tarullo, We're Not All Macroprudentialists Now

Hester Peirce

Former Senior Research Fellow
Summary

Federal Reserve Governor Daniel Tarullo recently lauded the "macroprudentialism". However, macroprudentialists' intensifying focus on the asset management industry offers the latest glimpse into how such an approach could undermine financial stability. Regulators are not wrong to think about the stability of the whole financial system. They are wrong, however, to assume that centralized risk management will foster systemic stability. Instead, it will introduce new vulnerabilities into the financial system.

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Federal Reserve Governor Daniel Tarullo began a speech last month by saying, "Standing in front of this audience I feel secure in observing that we are all macroprudentialists now." Having been a member of that audience, I can assure Mr. Tarullo that his statement was inaccurate. Macroprudentialists' intensifying focus on the asset management industry offers the latest glimpse into how such an approach could undermine financial stability.

Mr. Tarullo explained that the macroprudential approach to regulation "focuses on the financial system as a whole, and not just the well-being of individual firms." Regulators are central to the macroprudential approach; only they have the breadth of vision to know how and when-for the good of the collective-to override careful decisions made by individual firms.

The focus of Mr. Tarullo and other macroprudentialists has turned most recently to the asset management industry. Asset managers include the investment advisers and mutual fund companies that manage the investment portfolios of institutions and households. Asset managers control a lot of money-$63 trillion according to a recent speech by Mary Jo White, chair of the Securities and Exchange Commission, which oversees the asset management industry.

Ms. White's colleagues on the Financial Stability Oversight Council-a collection of top financial regulators-are not confident that SEC oversight is adequate. The FSOC and its international cousin-the Financial Stability Board-are on the lookout for particular asset managers and asset management activities that might put the financial system at risk. Dodd-Frank gives the FSOC authority to make recommendations to the SEC about how it should regulate the asset management industry. The FSOC also can designate asset managers for regulation by the Federal Reserve.

The FSOC is soliciting input on a document that runs through worst-case scenarios in asset management. What if asset managers don't manage their funds "in a way that prevents or fully mitigates the risks to the investment vehicle and the broader financial system"? What if asset managers are forced to conduct fire sales, which could drive asset prices down? What if a key industry service provider goes out of business?

The risks the FSOC described pale in comparison to the risks it could create by adding a new macroprudential regulatory layer to asset management. Attempts to centrally mitigate risk likely would create new risks by narrowing the differences in the way assets are managed. There are thousands of asset managers and mutual funds. Even very large mutual fund complexes employ many managers, each of whom takes her own approach to investing. More prescriptive regulation will eat away at that system-strengthening diversity.

Mr. Tarullo envisions a macroprudential regime that "builds on the traditional investor protection and market functioning aims of securities regulation by incorporating a system-wide perspective." Asset managers will have the impossible task of balancing their fiduciary duties to their own funds and investors with regulatory obligations to do what's best for their competitors and the rest of the financial system.

Using tools like stress tests and liquidity requirements, regulators would corral asset managers into similar strategies, assets, and risk management techniques. If regulators make bad choices, the entire industry will be affected. But even if regulators make good choices, making asset managers follow a single formula makes it more likely that the actions of one manager-such as asset sales to meet redemptions-would reverberate throughout the industry.

Moreover, as bank regulators play an increasingly central role in regulating asset managers, the differences that distinguish the banking industry from the asset management industry will start to disappear. Shocks will more easily transmit across the entire financial sector. Imagine the scene as banks and asset managers all fight during a crisis for the safe assets that their common regulatory frameworks permit. When problems arise, taxpayer money will flow to all macroprudentially regulated corners as regulators seek to mask their mistakes.

Regulators are not wrong to think about the stability of the whole financial system. They are wrong, however, to assume that centralized risk management will foster systemic stability. Instead, it will introduce new vulnerabilities into the financial system. These vulnerabilities likely will manifest themselves when the financial system is already under stress. Rather than seeking to extend macroprudential regulation, regulators should emphasize microprudential responsibility. Asset managers, governed by their legal responsibilities to their clients, need to plan for bad events. This is not a task that can be outsourced to government regulators.