The FSB's recommendations provide general direction; in order for these to be translated into concrete supervisory standards, some further technical work needs to be carried out. Most of these recommendations will therefore be further specified and operationalised by the International Organization of Securities Commissions (IOSCO). IOSCO is to implement the recommendations relating to liquidity mismatch by the end of 2017, and those relating to leverage by the end of 2018. The FSB will regularly review progress in the operationalisation and implementation of the recommendations.

Regulation of market-based financing

The recommendations are part of a broader initiative by the FSB to strengthen the regulation of resilient, market-based forms of finance. Although the asset management sector – aside from money market funds – did not reveal any significant financial stability risks during the financial crisis, the FSB considered, nevertheless, that it would be appropriate to examine the sector more closely, as global assets under management have grown rapidly in recent years. This figure was 53.6 trillion US dollars in 2005, and had already gone up to 76.7 trillion US dollars by 2015. That equates to approximately 40 percent of global financial system assets.

Greater market-based intermediation can help to increase competition and improve the efficiency of fund allocation. However, in recent years the persistently low interest rates have led to increased investment in less liquid asset classes. Investment funds which have invested in these asset classes and at the same time permit short-term redemption of units could be forced to liquidate assets at a considerable markdown in the case of significant unexpected outflows of funds. Under certain conditions, this could lead to increased market volatility and contagion effects on other asset classes. In the worst-case scenario, there is the threat of negative effects on the whole of the financial and real economy.

Liquidity mismatch

Risks arising from liquidity mismatch can occur in particular when open-ended investment funds invest in illiquid assets while also permitting short-term, for example daily, redemption of units. In order to better assess these risks, the FSB recommends increasing transparency and improving requirements for disclosure to the competent supervisory authorities and to investors.

Other recommendations are essentially aimed at providing fund managers and supervisory authorities with additional tools to restrict levels of liquidity transformation. One recommendation is that the investment strategy of a fund should in principle be consistent with the terms and conditions governing redemption of units; the supervisory authorities should develop corresponding requirements or guidance for the funds. The FSB also considers it important that the competent authorities create the appropriate conditions for fund managers to be able to use the tools to limit liquidity transformation in stressed market conditions as well.

Leverage

The FSB identified leverage as another possible structural vulnerability. Funds can generally increase their leverage in different ways, for instance via borrowing or securities lending. Derivatives may be used in order to create synthetic leverage.

The use of leverage can contribute to greater levels of risk and an increased danger of contagion for other market participants and markets. Most, but not all, FSB member states therefore monitor and regulate leverage build-up in funds. The FSB's assessment also revealed that the methods and approaches used to measure leverage are sometimes very different. In particular, there are differences in how netting and hedging effects are recognised¹.

The FSB therefore recommends that IOSCO develop consistent measures of leverage in funds in order to facilitate a more meaningful monitoring of leverage for financial stability purposes. The competent supervisory authorities should collect, evaluate and aggregate the required data and forward them to IOSCO. The global data collection should be established by the end of 2019 at the latest.

Operational risk and securities lending activities

Operational risk can arise, for example, when client money is transferred to another asset manager in stressed market conditions. Here too, the FSB therefore recommends that the national supervisory authorities develop corresponding requirements or guidance which are directed at the risk management of the asset manager.

Finally, the FSB recommends that supervisory authorities monitor the risks in asset managers where they act as agent lender and provide borrower indemnifications in the context of securities lending activities to their clients. Where necessary, competent authorities are to ensure that potential losses from these activities are adequately covered.

Results of the consultation

The FSB published its recommendations for public consultation in summer (see BaFin Journal July 2016, only available in German) and received over 50 responses. Following the assessment of these responses and an industry meeting, some aspects of the recommendations were revised.

For example, the recommendations now make it clearer that the information required to be disclosed to supervisory authorities may differ from the information required to be disclosed to investors. The FSB also clarified that a staged procedure was to be used for assessing the risks from fund leverage. First, consistent measures of leverage are to be used as indicators to identify funds which, in a second stage, are to be subjected to additional assessment using risk-based measures of leverage. Contrary to the draft version, the FSB has also specified that the requirements for managing operational risk do not only apply to particular, systemically important asset managers, but all asset managers, commensurate with the level of risk their activities pose to the financial system.

Background

In July 2015, the Financial Stability Board deferred its work on the assessment methodologies for identifying non-bank non-insurer global systemically important financial institutions (NBNI G-SIFIs) in order to first complete its recommendations to address structural vulnerabilities from asset management activities (see BaFin Journal August 2015, only available in German).

Once IOSCO has implemented these recommendations, the FSB will resume its work on the assessment methodologies for NBNI G-SIFIs. In the case of asset management, the focus is on any residual entity-based sources of systemic risk that could not be effectively addressed in the scope of market-wide activities based regulation.

Footnotes