Continuing its ongoing study to determine whether asset managers pose a systemic risk to the U.S. financial system, on December 18, 2014, the Financial Stability Oversight Council (FSOC) issued a notice seeking comments from the public whether asset management products and activities pose potential risks to the U.S. financial system. Once published in the Federal Register, the public will have 60 days to comment.

The 2010 Dodd Frank Wall Street Reform and Consumer Protection Act, commonly referred to as Dodd-Frank, established the FSOC to, in part, identify risks to the stability of the U.S. financial system. In September 2013, the Office of Financial Research, which supports the FSOC, issued a report “Asset Management and Financial Stability.” In May 2014, the FSOC hosted a conference to, “help inform the Council’s ongoing assessment of potential risks to U.S. financial stability.”  Persons from the industry, the Securities and Exchange Commission and others all presented their views. Not surprisingly, the industry was opposed to any possible designations as systemically significant that would subject them to additional oversight by the Federal Reserve Board and possible enhanced prudential standards like capital and liquidity requirements. Review the conference materials.

This new Notice arises out of additional study made by FSOC staff since the May 2014 conference and concentrated on industry-wide asset management products and services and the potential risks they pose to U.S. financial stability. While acknowledging that the asset management industry encompasses a large number of players following different regulatory regimes, the FSOC focuses specifically on four areas in which it is requesting comment.

Liquidity and redemption

The liquidity risk mentioned here is the market risk that an investor will not be able to buy or sell an asset in a timely manner without significantly affecting the asset’s price. The FSOC is focusing on whether pooled investment vehicles (such as private equity funds) that allow relatively flexible redemption rights results in investors behaving in a way that would affect U.S. financial stability differently than an investor making a direct investment in a security.

Leverage

Leverage (transactions that result in an investor’s exposures exceeding capital) is often used as part of an investor’s strategy, and can be obtained in a variety of ways, including margin credit and derivatives. The FSOC wants to know how leverage is utilized and whether use of leverage could increase the potential for forced asset sales, or create exposure to lenders and counterparties to losses or unanticipated market risks, and if so, what implications might there be for U.S. financial stability.

Operational risk

Operational risk refers to the risk arising from inadequate or failed processes or systems, human errors or misconduct or adverse external events. For example, service providers may not be able to provide necessary services when needed. The FSOC specifically is concerned about the risks that may be associated with the transfer of significant levels of client accounts or assets from one asset manager to another; and risks that may arise when multiple asset managers rely on one or a limited number of the same third parties to provide important services, including asset pricing, valuation or portfolio risk management.

Resolution

The final section relates to the potential for an adverse impact on financial markets of the failure or closure of an asset management entity. The FSOC is interested in learning whether there are specific financial interconnections that could present risks to the U.S. financial system if an asset manager, investment vehicle, or affiliate thereof were to become insolvent, declare bankruptcy, or announce an intention to close and liquidate.