Asset Managers Face Rising Regulatory Scrutiny

By Gerold GrasshoffZubin MogulThomas PfuhlerNorbert GittfriedCarsten WiegandAndreas Bohn, and Volker Vonhoff

This is an excerpt from Global Risk 2017: Staying the Course in Banking. The full report is available for download in PDF format.

Banks with asset management operations may soon experience a sense of regulatory déjà vu. Although global regulators focused their reform efforts on large banks and other systemically important financial institutions in the wake of the 2007–2008 financial crisis, they have since been increasing their scrutiny of asset managers—both independent and bank owned—looking for activities and products that might pose systemic risk.

We believe that it is a matter of when—not whether—asset management activities will face rigorous regulatory scrutiny.

Indeed, asset managers themselves have started to formalize a collective view of risk management frameworks and best practices through industry forums such as the Global Association of Risk Professionals. (See Global Asset Management 2016: Doubling Down on Data, BCG report, July 2016.) Such efforts will assist the industry in preparing for further regulatory inquiry.

Emerging Proposals

The evolving proposals by regulators emphasize issues that are most closely related to systemic failure and investor protection, and they would require independent risk functions and ongoing risk governance.

EU regulatory frameworks—such as the Undertakings for Collective Investment in Transferable Securities (UCITS), the Alternative Investment Fund Managers Directive (AIFMD), and the Markets in Financial Instruments Directive (MiFID)—are ahead of those in the US, where an initial set of three rules has been issued by the Securities and Exchange Commission (SEC), with more to come.

With basic risk management frameworks and governance now a norm, the three SEC rules, plus an additional proposal, focus on the key topics for mitigating systemic risk:

  • Liquidity Risk Management. This requirement aims to reduce the likelihood that a fund would be unable to meet redemption obligations and thus would dilute the interests of its shareholders. It applies to open-end mutual funds and certain exchange- traded funds (ETFs).
  • Swing Pricing. This rule creates an option for open-end funds (excluding money market funds and ETFs) to adjust their net asset values per share, thus effectively passing on the costs from purchase and redemption to the transacting shareholders. The tool serves to protect existing shareholders from dilution associated with shareholder purchases and redemptions.
  • Registration and Reporting Forms. This measure mandates enhanced data reporting and additional disclosure of liquidity risk measures.
  • The Use of Derivatives. Still a proposal, this regulation would restrict excessive fund leverage resulting from the use of complex derivatives. It would apply to all types of registered funds.

Additional proposals by the SEC, along with international recommendations by the Basel-based Financial Stability Board, cite the importance of measures such as liquidity stress testing, business continuity, transition planning, anti-money-laundering, and proper controls for securities-lending activities.

In the US, mixed messages during the presidential campaign suggest that twists and turns lie ahead for US regulatory policy and postcrisis financial reform efforts.

Nevertheless, on balance, we believe that there is strong bipartisan consensus on the need to address market liquidity and leverage. These goals are embodied in the new SEC rules and the additional proposal described previously, which would require formal risk management of liquidity and derivatives, as well as extensive regulatory disclosure and reporting on individual funds.

Readiness Gaps

While asset managers, especially the larger and more complex organizations, have generally made progress in developing risk management frameworks, the level of readiness across the industry as a whole is still very low. The largest readiness gaps are in liquidity risk, leverage through the use of derivatives, stress testing, and reporting.

Given the expected regulatory changes, asset managers with SEC-regulated funds—both independent and bank owned—should act now to do the following:

  • Assess the strategic impact of new and proposed risk management regulations on the operating model—overall and by business line.
  • Perform a readiness check, identify missing capabilities, and develop a strategic roadmap for meeting new requirements and incorporating them into decision making.
  • Develop a more formal and comprehensive risk management framework to meet new and emerging regulatory requirements—including a state-of-the-art framework for enterprise risk, covering governance, processes, data, and IT and establishing an independent risk function.
  • Establish appropriate organizational and technical capabilities for governance, people, processes, data, and technology and prepare the implementation of a comprehensive risk management framework.
  • Develop effective challenge and oversight processes that allow fund boards to be both more informed and involved in risk management.

The most effective and proactive asset management firms are beginning to prepare for the regulatory changes of tomorrow. In doing so, they should leverage the experience of banks and other financial institutions with regard to previously implemented regulations in the wake of the financial crisis. Using stress-testing concepts in risk management, for example, would improve a firm’s resilience in the face of severe events regardless of regulation. Consequently, best-in-class firms will invest to accommodate the emerging trends in asset management that affect investors well before regulators take action.

This article is an excerpt from Global Risk 2017: Staying the Course in Banking.