FSOC Urges Stronger Liquidity Practices for Mutual Funds

WASHINGTON — The Financial Stability Oversight Council on Monday released an update of its examination of the asset management industry, providing new details on areas the council says warrant greater scrutiny, such as mutual fund liquidity and the leverage of hedge funds. But the new document stopped short of regulatory proposals to restrict asset manager activities.

In the update, the FSOC noted that its nearly two-year inquiry into the asset management industry has been narrowed to certain discrete areas that need to be studied further or where data is lacking. In general, the council deferred regulatory action to the Securities and Exchange Commission, which has regulatory authority over much of the industry and has begun issuing new rules.

"Our job is to ask questions which may or may not lead to the conclusion that action is required, and to be driven by data and analysis in forming our judgements," said Treasury Secretary Jack Lew, the FSOC's chairman. "While not a primary regulator, the council has a clear mandate to look across the system for potential threats to financial stability, so it's important that the work of the council and the work of the other regulators — particularly, in this case, of the SEC — are complementary."

The document highlighted liquidity and redemption as the area that required the greatest share of ongoing attention from the council. The update centered primarily on potential mismatches between fund investor redemption rights and the liquidity of the underlying assets.

"The magnitude of potential spillover effects from liquidity transformation in mutual funds is uncertain," the update said. "However, potential risks would appear to be more significant in funds that invest in less-liquid asset classes, and under stress scenarios, when bid-ask spreads are widest and market illiquidity concerns are often more pressing." 

The other four broad categories focused on in the document were: leverage, operational risk, securities lending and resolvability.

The FSOC's update called on mutual funds to adopt "robust liquidity risk management practices" in order to reduce the risks posed to the financial system, as well as for regulators to establish clear guidelines "addressing limits on the ability of mutual funds to hold assets with very limited liquidity." The council also sought "enhanced reporting" on mutual fund liquidity profiles to facilitate and allow mutual funds to reduce the advantage of early redeemers over later redeemers, and to examine similar issues in collective investment funds, exchange-traded funds and other vehicles.

The update also called for the establishment of an interagency working group to examine the extent to which leverage among certain hedge funds may be a source of systemic risk.

The council said that while the aggregate level of leverage among hedge funds appears not to be of notable concern, what leverage there is in the sector appears to be concentrated within a few actors. A senior council official said that though such concentration may not in itself be a problem, the council and its members simply do not have the data to know one way or another whether greater oversight is appropriate.

The issue of a lack of data was endemic in the council's examination of securities lending risk as well — the council simply lacks the data to know whether it poses a risk or not. The Office of Financial Research, the SEC and the Federal Reserve have attempted a pilot program to look into the area, the update said, but "data collection efforts should be expanded to include a greater number of market participants."

The FSOC's dive into the role of operational risk was focused on the extent to which various asset managers rely on the same third-party service providers to complete transactions or otherwise conduct business, and what systemic risk may be posed if such a third party provider were to suddenly cease operations. While the senior council official said this inquiry includes cybersecurity threats —a longstanding area of interest on the council — it could apply to other issues as well where there are high levels of outsourcing and a low number of key providers.

With respect to resolvability, the council noted that the SEC has begun developing a rule that would address transition planning for registered investment advisers and stress testing for large RIAs and registered investment companies. To that end, "the council welcomes the SEC's efforts in this area and will monitor the effects of any regulatory changes and their implications for financial stability," the document said.

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