Avoiding Strike Three

Last week, the Financial Stability Oversight Council voted to proceed with rule-making that provides regulators with greater authority to oversee financial companies that are not banks but have more than $50 billion in assets and $20 billion in debt.

This is not directed at mutual fund companies, but it will affect asset management.

This is where "systemically significant firms" will get tighter regulation. A number of criteria about these "systemically important financial institutions" have been proposed such as asset size, the leverage ratio, derivatives liability and the amount of outstanding debt.

But what should catch the ear of fund managers, asset managers and investment consultants is the idea that there is a distinction between assets under management and regulated assets under management.

This is because, before the credit crisis hit, the amount of assets under management was considered to be the amount of assets placed in an account or a fund by an investor or investors. The debt or credit tacked on top, to increase investing "leverage," went uncounted. Or rather, unreported to investors, pointedly at hedge funds.

Now, BlackRock, the big ETF developer, claims asset managers should not be considered systemically important financial institutions because asset managers invest on behalf of clients, not with their own balance sheets, and asset managers largely rely on fee-based income.

Seems reasonable. But "regulated assets under management" will likely come to be the term for any type of asset that a risk regulator has to watch and be worried about.

"This old AUM had blossomed into this thing, with leverage, that created this mass they didn't understand,'' said Jeff Kollin, who leads the financial services advisory practice at Rothstein Kass Business Advisory Services. "This is just their way of putting a wrapper on it so they can understand what's in the marketplace and what's at risk.''

The first time leverage got out of control was in 1998 at Long-Term Capital Management, a hedge fund in Greenwich, Conn. Near its end, LTCM had a leverage ratio of more than 250-to-1. Strike one.

Ten years later, the ratios at investment banks were 30:1 but the market-wide risks much higher. The subprime meltdown was strike two.

No need to wait for a third strike to be thrown.MME

For reprint and licensing requests for this article, click here.
Compliance Money Management Executive
MORE FROM FINANCIAL PLANNING