I would like to express my thanks to Jiri Krol and his colleagues at the Alternative Investment Management Association for the invitation to speak at today’s Global Policy and Regulatory Forum.
In my remarks this morning, I will:
- survey the growth of the alternative investment management industry over the last twenty years and consider its role in the chain of financial intermediation;
- discuss the main drivers for regulatory change in industry; and
- offer some thoughts on how industry might tackle future challenges.
I should stress at the outset that the views I am expressing are my own and may not necessarily be shared by my fellow regulatory colleagues.
How did we get here?
Over the last twenty years, global economic (nominal) growth averaged 5% and the growth of global financial assets has averaged 7%.1
Growth in the hedge funds sector (measured by assets under management (AUM)) has averaged 20%.2 That is a phenomenal increase by any standards.
This growth underscores the resilience of the sector. Consider the economic and market turbulence during that period – a period which has seen:
- the LTCM/Russian default crisis of 1998,
- the bursting of the dotcom bubble in 2000/01,
- the corporate scandals which broke in 2002,
- the second Iraq war in 2003; and
- the once in a century financial crisis of 2007/08 which has imposed a significant financial burden on generations to come.
The growth in AUM also underlines the fundamental attractiveness of a sector which offers solutions that support risk-taking, which enhances the opportunity set of investors and which provides diversification from more traditional investment management strategies.
(As an aside and by way of contrast, UCITS products had their golden years during the 1990s where 18% compound average annual growth was achieved but that sector only grew at an average rate of 4.5% since 2002.3)
Key regulatory changes
Without diminishing the MiFID and UCITS III directives, the significant regulatory changes impacting the asset management industry over the last two decades largely stem from the financial crisis of 2007/08. For most of the people in attendance this morning, AIFMD is the most significant regulatory initiative of consequence. This is a complex directive setting rules in relation to depositories, delegation, interaction with third country AIFMs and AIFs, remuneration, risk management, liquidity management, capital, investor disclosure and regulatory reporting, to name but a few.
But other regulatory initiatives will bear directly on the industry as well, such as the Short Selling Regulations (SSR) and the European Markets Infrastructure Regulations (EMIR).
This is to say nothing about those that have not landed yet such as shadow banking reform, PRIPS and further iterations of the market abuse, MiFID and UCITS directives (ie MAD II /MAR, MiFID II /MiFIR and UCITS V & VI). And we should keep an eye on the indirect effects of regulatory changes in banking and insurance.
(In Ireland, we have introduced Fitness and Probity standards on a statutory basis for all persons performing a controlled function in a regulated entity and the Irish Funds Industry Association has developed a voluntary code for the corporate governance of funds. You will appreciate that these specifically Irish initiatives were a response to wider problems which were prompted by failures with the domestic Irish banks.)
Why this regulatory programme?
Much has been written about the origins of the financial crisis citing loose monetary policies which lead to an asset price bubble supported by collateralized lending with poor underwriting discipline, weak risk management and misaligned incentives.4
There are many drivers for the European regulatory reform agenda in financial services. Some are rooted in the market failures exposed during the financial crisis and some are prompted by the politics of responding to a crisis which has imposed significant burdens on taxpayers and which has challenged the credit-worthiness of sovereigns.
Few people will dispute the fact that substantial regulatory reform was needed. The financial crisis exposed serious market failures. The response by financial authorities to the crisis has been extraordinary 5. The politics of such public sector support – ‘the politics of bail-out’ – is likely to set social, regulatory and fiscal agendas for years to come.
It is difficult to survey the European regulatory reform agenda without over-simplifying a massive corpus of initiatives. But let me make a few observations about some of the key changes:
- MiFID II attempts to tackle a host of concerns related to product distribution practices, transparency of secondary markets and fair access to trading venues as well as meeting Europe’s G20 commitments in terms of market structure;
1. PRIPS seeks to improve the outcomes for investors by simplifying choice and making fees more transparent;
2. Driven by Europe’s G20 commitments, EMIR seeks to reduce systemic risk by simplifying the map of OTC derivatives exposures and largely concentrating the key risks of counterparty default with CCPs and their clearing members;
- The aim of the Short Sale Regulation is to bring greater transparency to short sales activity in secondary markets. I would note that the Central Securities Depositories Regulation is likely to have a more potent effect on market discipline by tightening up the settlement process on short-sales transactions;
- UCITS VI is likely to take a second look at what UCITS funds can invest in;
That is to say nothing about CRD IV (which covers capital, liquidity and
- remuneration in the banking sector) and Solvency II (which deals with solvency in the insurance sector) or the three regulations in relation to credit ratings agencies (CRA I-III); and
- of course AIFMD.
Potential risks arising from this regulation programme
With such an ambitious programme of regulatory initiatives, it is worth highlighting the potential risks. In a recent speech 6, David Wright, Director General of IOSCO, expressed his views on the current regulatory reform agenda from a global regulators’ perspective. I have taken the liberty to summarise the issues that he has identified as follows:
- Poor prioritization;
- Lack of global co-ordination;
- Too many regulators in the kitchen cooking the one meal;
- Overly-consensual decision making diluting the quality of reform;
- Clash of cultures between central bankers and securities regulators;
- Inadequate cost-benefit analysis.
The single biggest risk, I see, is that regulatory fatigue and poor execution of the regulatory agenda will undermine the relationship between end-issuers and end-investors and ultimately may become an obstacle to economic growth 7.
It has been remarked to me:
- that regulatory compliance is now a cottage industry in its own right;
- that industry is ‘punch-drunk’ with the degree of regulatory change; and
- that waves of regulatory initiatives create a very uncertain environment for business planning.
But the economic and political impetus for reform is strong. There were significant market failures. There have been cries of ‘never again’.8 There is a sense that the social pain is not being spread equally.
The challenge to my mind is to articulate clear credible priorities for financial reform, which deliver a coherent package and which are truly effective in the sense of protecting investors, maintaining market integrity and mitigating systemic risk.9 And industry has a significant role is reading the political temperature, highlighting priorities and debating how regulatory intervention takes place.
Where should we be going?
Where should we be going with reform of financial regulation? Let me answer this question with specific reference to the investment management industry (as opposed to the banking, insurance and other securities sectors).
Concerns have been expressed about the capacity of hedge funds to distort prices, especially, the valuations of bank stocks and sovereign CDS. It is fair to say that the veil of secrecy which surrounds the industry has served to raise suspicions further. These suspicions took on a more political dimension when commentators questioned:
- the social value of high-frequency trading,
- the morality of profits generated from short positions on banks bailed-out by sovereigns,
- the rights and wrongs of short CDS on sovereigns bailed out by international public authorities (eg IMF, EU and ECB); and
- the levels of remuneration related to obscure trading strategies.10
Even today, you will be all aware that remuneration is a hot topic whether we are referring to bankers, hedge fund managers or even alpine corporate executives.
Putting these thoughts to one side, let’s focus on some of the key economic arguments for tighter regulation of the funds industry.
Data gaps – financial reporting improves monitoring by financial authorities
Financial authorities realised during the crisis that there were significant gaps in their capacity to monitor the financial system and that this hampered their response to the crisis.11 Concerns were expressed that the interconnectedness of the financial system created an irresolvable network which was vulnerable to contagion effects.12
The hedge fund sector is one of the most opaque and yet most dynamic. It should come as no surprise that AIFMD requires AIFMs to file reports which shed light on their activities and help financial authorities understand the role they play in the financial system.
Banking and Shadow Banking
Financial intermediation has evolved substantially since the first hedge funds were launched over forty years ago and the first UCITS was created back in 1988. Over time, the boundaries between banking, insurance and securities sectors have become blurred as financial products and services have become more fungible 13. As banks with access to the central bank discount window have:
- securitised assets;
- sponsored money market funds;
- borrowed from open-ended fund vehicles; and
- assigned loans to third parties,
The distinction between monetary and non-monetary institutions (defined by whether or not they have direct access to the central bank liquidity) is less clear-cut with the result that central banks now have a keener interest in developments in securities markets and in the investment management industry, in particular.
Let me elaborate with three examples:-
First, where funds invest in residential or commercial mortgage-backed securities (RMBS and CMBS), they are indirectly providing credit to the real economy which is often seen as the traditional domain of banks. The concern here is that the structure of these securities may be of shorter effective maturity compared to the assets being funded and that this credit channel may be vulnerable to interruption if the funds abruptly withdraw.
Second, where promoters seek to create funds which hold loans (as opposed to securities), the traditional functions of loan origination and loan servicing are often carried out at the behest of the promoter. But promoters may not be co-invested in the funds to the degree required of banks which are now subject to the ‘skin in game’ amendment of the Capital Requirement Directive of four years ago.14 Here, there is a potential misalignment between banking and securities regulatory requirements for lending activity.
Third, money market funds provide corporate treasurers with important vehicles for managing their liquidity which emulate deposit accounts but offer greater diversification and often higher returns. Investor runs in parts of this industry during 2008 prompted intervention by financial authorities and have encouraged a vigorous policy debate on the most appropriate reforms.15
To summarise these points, the issues of run-risk leading to credit interruptions and lack of incentive alignment leading to poor loan origination are key concerns for financial authorities in the wake of the financial crisis and have encouraged their heightened interest in the investment management industry and all other sectors that engage in ‘bank-like’ activities.
Global financial wealth (excluding derivatives) measures $225trn 16. Measured by notional amounts outstanding, global OTC derivatives positions are estimated to amount to approximately $639trn 17. Even accepting the fact that many credit exposures arising from these positions are collateralised under two-way mark to market agreements, the collapse of Lehman Brothers highlighted the dangers to the market arising from the failure of a significant derivatives counter-party. EMIR and Dodd-Frank require the central clearing of most OTC derivatives so as to reduce network complexity and concentrate points of possible system failure at known parts of the system: mostly CCPs (though clearing members will also be a source of risk).
There is a theme underlying the three priority areas which I have identified for regulatory reform of the investment industry, namely, that financial authorities need to:
- understand better how the financial system works and specifically how the investment management sector fits into it;
- develop tools to resolve firms that fail; and
- redesign parts of the system so that it can be made safer.
Distribution of funds products
One issue I have not touched on, but which is very relevant to the need for tighter regulation of the investment management industry, is the distribution of funds products. In a world with historically low real and nominal interest rates and where developed world populations are living longer, the challenge of ‘low yields and longer lives’ must be addressed by the industry. Aging populations must provide for retirement and the hedge fund industry is likely to play a greater role over time. Well-functioning securities markets are markets where the end-investor can trust the market to deliver a fair outcome. It is important that the industry recognises that cost transparency and product appropriateness will support a healthy long-term relationship between investors and the industry.
Effective regulatory intervention
Leaving aside the issue of prioritisation of the regulatory agenda, there is still the additional question of execution (or how that agenda is to be implemented). Surprisingly little has been written about effective regulatory intervention. From reading many international policy papers and commentaries one could be forgiven for getting the impression that we are primarily focused on ‘what to regulate’ and less on ‘how to do it’. To my mind, many commentators and policy makers have strong views as to what should be done but are less familiar with ‘the prosaic craft of implementing regulation’. And yet, implementation matters as much as policy content. Ask any architect or engineer, poor quality of materials and bad construction craftsmanship have scuppered many a grand design.
I see the task of delivering effective regulatory intervention as comprising of a spectrum of ever more intrusive activity which:
1. starts with monitoring (through data collection),
2. then analysis (of the data and the business models),
3. then policy formation (which draws in political and social considerations),
4. then regulation (which involves writing a rule book),
5. then supervision (which involves monitoring compliance with the rules),
6. then enforcement (which punishes rule breaches); and
7. finally resolution (to mitigate the real economy effects of failure).
Each of these seven steps is progressively more intrusive – in this sense it is a spectrum of regulatory intervention which becomes progressively more intense as each step is taken. But each step is a distinct step which need only be taken if it survives a cost-benefit analysis.
Since a) data collection and b) business model analysis are the first two steps, these determine the quality of the further steps. In relation to these steps, industry can play an important part in ensuring that meaningful information is provided. Many a time over the last few years, financial authorities have been frustrated at the prospect that a key policy decision is being considered without adequate data.
There are also other pillars to this framework which I would highlight such as:
c) the political and social mandate which determines the appetite to intervene,
d) the supervisory framework (which determines the intensity of supervision and the appetite for enforcement); and
e) the legal system (which provides the toolkit for financial authorities).
And these elements only really apply as we engage in progressively more intrusive regulatory intervention.
What we have seen in recent years is an approach to regulatory intervention where some of the steps in the spectrum have been taken in haste or even in reverse order. As a matter of political process, this is understandable. But the execution risks are significant and this is likely to incur certain economic costs. And spillover effects with other jurisdictions or other rule books (or both) are likely to lead to unintended and potentially undesirable consequences if the right sequence steps are not taken.
This framework suggests that regulatory intervention should be sequenced in a certain way. More intrusive steps should follow less intrusive steps. Due consideration should be given to the benefits and costs of being more intrusive.
Let’s be clear, cost-benefit analysis in the social sciences is notoriously difficult.18 But what is also clear is that in order that financial authorities can improve their approach to regulatory intervention closer monitoring all financial activity – through regular financial reporting – is necessary and indeed beneficial for industry.
I should add that the pillar elements of data, analysis, social mandate, supervisory approach and legal framework can also be used a basis for establishing common ground between different regulatory systems – ranging from cooperation to coordination to convergence to consolidation of supervisory effort. This is important in a world where firms operate in multiple jurisdictions where different regulatory and supervisory frameworks apply.
As a parting note, let’s not forget that the purpose of the wider funds industry is to match end-investors with end-issuers. And the purpose of regulation is to support this activity of financial intermediation and ensure an effective relationship between both. In particular, this means helping all parties to make sensible decisions in the face of uncertainty, aligning incentives and reducing information asymmetries without harming competition all the while allowing risk-taking activity to happen.
The evolving nature of financial intermediation and the blurring of the lines with other sectors will mean that industry attracts greater regulatory scrutiny. Such scrutiny necessarily requires that financial authorities will seek to monitor activities more closely and understand the potential for systemic risks to crystallize.
In a world with low yields, longer lives and greater reliance on self-directed pensions schemes, industry must build a relationship with investors based on trust and regulation must seek to nurture it.
In addition, industry needs to reflect on the political and institutional process driving the content of regulatory reform and also find ways to engage more actively in how regulatory intervention is being delivered.
Financial Stability Board (2009), “The Financial Crisis and Information Gaps”, FSB Report to the G-20 Finance Minister and Central Bank Governors, November 2009.
Haldane, A., (2009), “Rethinking the financial network”, Speech delivered at the Financial Student Association, Amsterdam
Honohan, P., (2009), “Can cost-benefit analysis of financial regulation be made credible?”, chapter 9 in “Handbook of research on cost-benefit analysis”, ef. Robert J Brent, Cheltenham, Edward Elgar
IOSCO (2003), “Objectives and Principles of Securities Regulation”
Laeven, L., and Valencia, F., (2012), “Systemic Banking Crises Database: An Update”, IMF Working Paper
National Institute of Economic and Social Research, (2012), Financial Stability Conference, “NEVER AGAIN?”
McKinsey Global Institute (2013), “Financial Globalization: retreat or reset?”
Murphy, G., and Westwood, R., (2010), “Data Gaps in Financial Stability”, Irving Fisher Conference, Basel.
Tafara, E., (2013), “Observations about the crisis and reform”, foreword in “The Regulatory Aftermath and Global Financial Crisis”, Cambridge University Press
Wright, D., (2012), Remarks by the Director General of IOSCO at the Atlantic Club
1 McKinsey Global Institute (2013)
3 See the EFAMA publication www.vff.no
5 See Laeven and Valencia (2012)
6 See David Wright (2012)
7 See De Larosière (2013)
8 National Institute of Economic and Social Research, 2012.
9 IOSCO (2003)
10 See Murphy and Westwood (2010)
11 See FSB (2009)
12 Haldane (2009)
13 See Tafara (2013)
14 See 2009/111/EC amendments to Article122a
15 See IOSCO October 2012, FSB November 2012 and ESRB January 2013.
16 McKinsey Global Institute (2013)
17 See Bank for International Settlements, November 2012
18 See Honohan (2009)