Memo #
28023

ICI Submits Comments in Response to FSB Consultation on Investment Funds as "Global SIFIs"
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[28023]

April 8, 2014

TO: BOARD OF GOVERNORS No. 2-14
CLOSED-END INVESTMENT COMPANY MEMBERS No. 12-14
ETF ADVISORY COMMITTEE No. 4-14
ETF (EXCHANGE-TRADED FUNDS) COMMITTEE No. 6-14
ICI GLOBAL MEMBERS No. 12-14
INVESTMENT COMPANY DIRECTORS No. 6-14
MONEY MARKET FUNDS ADVISORY COMMITTEE No. 6-14
SEC RULES MEMBERS No. 13-14
UNIT INVESTMENT TRUST MEMBERS No. 2-14 RE: ICI SUBMITS COMMENTS IN RESPONSE TO FSB CONSULTATION ON INVESTMENT FUNDS AS "GLOBAL SIFIs"

 

In January, the Financial Stability Board (“FSB”) published a Consultative Document (“consultation”) entitled “Assessment Methodologies for Identifying Non-Bank Non-Insurer Global Systemically Important Financial Institutions” (referred to as “NBNI G-SIFIs”). [1]  The consultation proposes a high level framework for identifying NBNI G-SIFIs, as well as sector-specific indicators to be applied to investment funds, market intermediaries (securities broker-dealers) and finance companies.  The consultation further proposes a process by which FSB, the International Organization of Securities Commissions and national authorities will apply the methodology in assessing the global systemic importance of investment funds and other NBNI financial entities.

ICI has filed a lengthy comment letter with the FSB explaining why G-SIFI designation of regulated funds, organized in the US and in jurisdictions around the world, is unnecessary and inappropriate.  The executive summary of the comment letter is provided below, and the complete letter is available through ICI’s website. [2]

Executive Summary

  1. ICI and its members, both in the United States and globally, long have favored sound regulation to address risks to investors and the capital markets.  We actively have supported US and global efforts to address abuses and excessive risk taking highlighted by the global financial crisis and to bolster areas of insufficient regulation.  It is important, however, to think critically about where and how risks appear—and to choose the right tool, out of the many that regulators have at their disposal, to address risks appropriately and effectively.  As the consultation recognizes, the risk profile of investment funds—and certainly of regulated funds—is starkly different from that of banks or insurance companies.  Designation of regulated funds as “systemically important financial institutions” (“SIFIs”), whether in the US or other jurisdictions, is neither necessary nor appropriate as a means to address concerns about stability of the global financial markets, and the consequences of doing so would be highly adverse to the designated fund, its investors, the overall fund marketplace and fund investing at large. 
  2. The Financial Stability Board (“FSB”) has defined non-bank, non-insurer global SIFIs (“G-SIFIs”) as 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.”  Application of these concepts outside the world of banking and insurance requires a more robust and informed understanding of investment funds than is reflected in the consultation.  Our detailed comments, including our empirical research, seek to help fill that gap by examining each element of the FSB consultation in the context of the structure, regulation, and historical experience of regulated funds in the US and other jurisdictions.  (Our comments generally address regulated stock and bond funds, but SIFI or G-SIFI designation also would not be appropriate or effective for money market funds, which currently are subject to separate regulatory actions.)
  3. We sincerely appreciate the opportunity to comment on the consultation, as we do previous opportunities to comment on the work of the FSB.  That said, we continue to have serious concerns about many aspects of the assessment process, a process that is not expressly sanctioned by any provisions of US or other law and that lacks sufficient transparency.  The process appears designed to permit the FSB, other international regulatory bodies, and central bank representatives to exercise maximum discretion over matters with very serious potential consequences for regulated funds and other affected entities, without specific authorization in law or requirements for “due process.”  We would urge the FSB, as well as the Financial Stability Oversight Council (“FSOC”) in the US, to adopt procedures that assure greater transparency and accountability and that promote greater public and industry confidence.  
  4. As for the substance of the consultation and the proposed methodology for investment funds, we submit that size is not a per se indicator of risk.  The consultation proposes a “materiality threshold”—set at US $100 billion in assets under management—to define a “practical and manageable number” of investment funds to be analyzed under the proposed methodology.  It incorrectly theorizes a linear relationship between size and risk in this context.  In fact, the size of an investment fund—in contrast to a bank—by itself reveals very little about whether that fund could pose risk to the global financial system.  Based on their investment objectives and policies and their portfolios, two funds of the same size can present sharply different risk profiles.  We submit that any initial threshold for evaluating investment funds should include balance sheet leverage—the “interconnection”’ that speeds the transmission and heightens the impact of risk among institutions, and the essential fuel for financial crisis. 
  5. The proposed per se materiality threshold does not serve to filter the universe of investment funds in any way that would usefully advance the stated objectives of the Group of 20 (“G20”) and the FSB.  It produces an assessment pool of 14 funds—all regulated US funds—as the only funds worldwide that automatically would be subjected to further examination.  Moreover, the proposed threshold clearly is at odds with the FSB’s stated goal of maximizing the consistency of treatment of different types of financial entities.  That threshold in fact produces a pool of investment funds that are orders of magnitude smaller than global systemically important banks (“G-SIBs”).  Far from promoting consistency, the consultation in fact proposes to apply a unique and more sweeping standard to investment funds, without any justification for this difference in treatment. 
  6. In sharp contrast to banks, these 14 funds have virtually no leverage (see Figures B.1 and B.2, Appendix B).  Their balance sheet leverage ratio, calculated under the FSB’s definition, averages 1.04.  At this rate, for a regulated US fund to achieve the same dollar amount of indebtedness as the smallest US G-SIB, the fund would have to hold US$ 5.4 trillion in assets under management.  As former Federal Reserve Chairman Alan Greenspan recognized in analyzing the global financial crisis, mutual funds do not serve to fuel “serial contagion”—in other words, systemic risk—precisely because of their lack of leverage.  In addition, the 14 large regulated US funds pursue investment strategies that are comparable to literally hundreds of competing funds in the US market.  As is typical for regulated US funds, their portfolio holdings are highly diversified.  These funds are, in short, highly “substitutable.” All of them have simple capital structures, and their business and operations are straightforward and transparent.  Thus, they lack the “complexity” that the FSB offers as a crucial element of its G-SIFI definition. 
  7. The concepts of “distress” and “disorderly failure”—stemming directly from the FSB’s concern with “too-big-to-fail” institutions—are derived from experience with banks and have little relevance to investment funds.  Investment losses do not constitute “distress”: unlike bank depositors, fund investors are not promised either a gain on their investment or a return of their principal.  Some investors may react to losses by selling their fund shares.  The ability to redeem shares on a daily basis, however, is a defining feature of US mutual funds and underlies many of these funds’ regulatory requirements and operational practices—notably including daily valuation of fund assets and liquidity requirements. 
  8. The concept of public “bailouts” likewise has little relevance to investment funds.  Literally hundreds of regulated US funds exit the business through liquidation and merger each year, without any government intervention or taxpayer assistance.  As the consultation recognizes, “even when viewed in the aggregate, no mutual fund liquidations led to a systemic market impact” for the period from 2000 through 2012.  When a mutual fund liquidates, it follows an established and orderly process to distribute its remaining assets pro rata to its investors and wind up its affairs, in accordance with provisions of federal and state law and under the oversight of the fund’s board of directors or trustees.  Thus, such funds have no need for bank-like “resolution planning,” and regulators have no need for additional authority to cope with “disorderly failures” of these funds.
  9. The FSB posits circumstances under which an investment fund “has to liquidate its assets quickly, [which] may impact asset prices and thereby significantly disrupt trading or funding in key markets.”  Since the inception of regulated fund investing in the US almost seventy-five years ago, the historical evidence is consistent and compelling: stock and bond funds have never faced such a scenario, not even during the global financial crisis of 2007-2008 (Appendix F).  Indeed, across a range of adverse market events and conditions, sales of stocks and bonds by regulated US funds represent a modest share of overall market activity—a fact that reflects the nature today of their largely retail investor base and the long-term financial goals of most fund investors. 
  10. While the FSB consultation does not specify what policy measures would apply to investment funds designated as G-SIFIs, the Dodd-Frank Wall Street Reform and Consumer Protection Act in the US prescribes a comprehensive set of requirements for non-bank SIFIs.  Most troubling is the prospect of capital requirements (perhaps as high as 8 percent) for “loss absorption.”  Unlike banks, regulated funds simply have neither the need nor the ability to meet capital requirements.  Their “capital” comes from investors who own fund shares and who fully accept that they will absorb investment gains and losses on a pro rata basis.  Mechanisms for “loss absorption” would be antithetical to funds’ basic nature and purpose, would introduce moral hazard, and would lessen market discipline.
  11. Capital requirements and assorted fees assessable to nonbank SIFIs under the Dodd-Frank Act would put a designated fund at a distinct competitive disadvantage and distort the market.  The 14 regulated US funds singled out by the FSB’s materiality threshold are highly efficient, relatively low-cost funds within their asset classes: they have an asset-weighted average expense ratio of just 31 basis points.  Investors in regulated US funds are highly sensitive to fund costs and their impact over time on fund returns.  It would not take much in added regulatory costs to condition the investors in these funds to avail themselves of one of the many competing funds not subject to these costs.  The Dodd-Frank Act also authorizes assessments of nonbank SIFIs if needed to reimburse the US Government for costs of resolving a distressed financial institution—e.g., a large bank holding company—under the Act’s Orderly Liquidation Authority.  The purpose of the Orderly Liquidation Authority provisions was to avoid having the costs of “bailouts” fall on US taxpayers.  Designation of a regulated US fund raises the prospect that this burden would fall on individual investors, many of whom would have entrusted the fund with their retirement savings—in substance, a taxpayer bailout.
  12. Prudential supervision by the US Federal Reserve also could affect the management of a designated fund’s portfolio and how the fund serves its investors.  It sets up the potential—arguably, the likelihood—for a clash between the goals of prudential supervision and the fiduciary duty that the fund’s manager and board of directors owe to the fund.  In the interest of mitigating risks to the financial system at large, the Federal Reserve could impel a fund’s manager to maintain financing for banks or other counterparties, to remain exposed to certain markets, to avoid exposure to certain issuers, or to maintain excess levels of cash or cash equivalents in the fund’s portfolio—regardless of whether such actions, in the judgment of the fund’s manager, serve the interests of the fund and its investors. 
  13. As an alternative to designation of individual regulated funds, to the extent that regulators believe specific activities or practices pose risks to the market or to the financial system, they should use their considerable rulemaking authority to address those risks through activity-based regulation.  In the US and other jurisdictions, post-crisis legislation has augmented regulators’ broad authority by adding many new tools to address abuses and excessive risk-taking.  Regulators already are making notable use of these authorities.  The approach currently being taken with respect to money market funds is an example of an activity-based focus on risk mitigation, which is a more promising approach to asset management more generally.  In the US, these efforts include, for example, regulatory reform for securities lending and repurchase agreement transactions and changes in the way swaps are traded, cleared and settled.  Of particular note, the US Securities and Exchange Commission is working to strengthen its oversight of US asset managers and regulated funds—an effort we welcome.  In addition, ICI’s Board of Governors has endorsed a voluntary industry initiative to shorten settlement cycles for a range of securities from trade date plus three days (T+3) to T+2. Globally, the FSB itself, along with other global bodies, is playing an active role in efforts to mitigate risk in the financial system.  Together with our members, ICI is engaging across this range of initiatives to help advance efforts to make markets and market participants more resilient to future shocks, without imposing undue costs and burdens on regulated funds and their investors.

 

Frances M. Stadler
Senior Counsel - Securities Regulation

Rachel H. Graham
Senior Associate Counsel

 

endnotes

[1] See FSB, Consultative Document: Assessment Methodologies for Identifying Non-Bank Non-Insurer Global Systemically Important Financial Institutions (8 Jan. 2014), available at http://www.financialstabilityboard.org/publications/r_140108.htm.

[2] The letter is available at http://www.ici.org/pdf/14_ici_fsb_gsifi_ltr.pdf.