A Macroprudential Response To Risks In The Asset .
Remarks at the European Central Bank 2nd Annual Macroprudential Policy and ResearchConferenceA Macroprudential Response to Risks in the Asset Management SectorBarbara Novick, Vice ChairmanFrankfurt, GermanyMay 11, 2017IntroductionThank you for inviting me here to discuss macroprudential policies in the assetmanagement sector. I am honored to be speaking today, and I appreciate the opportunity toshare my views.My remarks reflect a paper BlackRock published in February titled MacroprudentialPolicies and Asset Management,1 which is available on the BlackRock public policy website2and on the ECB conference website.3The Global Financial Crisis of 2008 (the Crisis) rightly led to a search for potentialsources of systemic risk as well as a search for tools that can anticipate and thwart this risk.As I will discuss, asset managers and mutual funds are not “shadow banks” nor are theysystemically risky, and we are concerned that the use of macroprudential tools in assetmanagement is more likely to create procyclical behavior than prevent it. I will explore boththe stress tests that are being contemplated in asset management as well as the policy toolsbeing discussed.Bond Ownership by Mutual FundsThe dialogue about systemic risk in asset management began with the belief thatmutual funds were becoming a greater and greater factor in the ownership of corporatebonds. How many of you here today have seen the Federal Reserve Z.1 data that showsthe percentage of corporate and foreign bonds held by mutual funds growing from 12% in2009 to 24% in 2015? Now, how many of you are aware that the Federal Reserve revisedthis data last year? The revised data shows a slightly lower starting point with more mutedgrowth in holdings, and a leveling out of holdings just below 17% in 2013. This revisionreflects an update to the Federal Reserve methodology to take into account matured bondsto more accurately reflect the value of bond holdings by mutual funds.41BlackRock, ViewPoint, Macroprudential Policies and Asset Management (Feb. 2017), available -and-assetmanagement-february-2017.pdf.2All BlackRock ViewPoints, comment letters, and consultations are on the BlackRock public policy website, which isavailable at /public-policy.3ECB, Second annual ECB macroprudential policy and research conference, available 0170511 2nd mp policy research conf.en.html.4Shelly Antoniewicz, ICI, Revised Fed Data Show Mutual Funds’ Share of Corporate Bond Market Is Small and Stable(Aug. 26, 2016), available at https://www.ici.org/viewpoints/ci.view 16 corporate bond share.print.1GR0517G-167067-466405
% of Corporate and Foreign Bonds Held by Open-End Mutual FundsSource: Federal Reserve's Z.1 “Financial Accounts of the United States” Statistical Release. Original data from Dec. 2015 release. Corrected data fromSep. 2016 release. Chart includes quarterly data from fourth quarter 2009 through third quarter 2015 to illustrate corporate and foreign bond ownership bymutual funds following the 2008 Financial Crisis. Graphs represent total corporate and foreign bonds included in Fed Z.1 data.On the topic of data, another common misperception is the concentration ofownership in specific high yield and emerging market debt. Unfortunately, this theory wasbased on incorrect data that has since been restated as well. The updated data shows thatasset managers do not have concentrated positions in these bonds.5Market Risk vs. Systemic RiskCritical to this discussion is an understanding of systemic risk vs. market risk,concepts which are often conflated. Systemic risk propagates across firms and markets,creating “disruption.” In contrast, market risk reflects natural price adjustments. Sometimesmarket events result in “winners” and “losers”, and sometimes the sums earned or lost arequite large.65In October 2014, the IMF revised their data on concentrated holdings in their Global Financial Stability Report. Theoriginal version used data from Moore Capital, which showed the ownership in bonds of specific issuers of high yield andemerging markets debt. This chart suggested concentrated holdings by individual fund families. Unfortunately, this dataturned out to be incorrect. This is a complex topic as not all investors are required to report their holdings, and Moore’sdata was based only on reported holdings which excludes many large institutional investors. Since mutual funds arerequired to report, the data shown grossly overstated the percentage of holdings by these funds. The revised charts showthe percentage of total bonds, which is significantly lower than the bars which show percentage of reported holdings.Likewise, the emerging market data depicted ownership in external debt. In many cases, external debt is a very smallpercentage of outstanding debt so again, the data was not an accurate depiction of concentrated holdings. See IMF,Global Financial Stability Report (Oct. 2014), available g-CurbingExcess-While-Promoting-Growth.6For example, media reports have noted that many hedge funds have closed as a result of losses following market events.There have also been media reports of investors making significant sums. See Madison Marriage, Financial Times,Hedge funds’ move to become family offices is not entirely popular (Oct. 23, 2015), available 71-ba1968cf791a; Katia Porzencanski, Nishant Kumar, and Bei Hu,Bloomberg, Hedge Fund Winners and Losers Emerge as Year Ends on Better Note, Bloomberg, (Dec. 20, 2016),available at on-better-note.2GR0517G-167067-466405
Definitions of Market Risk vs. Systemic Riska.b.c.d.e.ESRB Regulation (Nov. 24, 2010), IMF-FSB-BIS, Elements of Effective Macroprudential Policies, (Aug. 31, 2016), 6.pdf (IMFFSB-BIS).FINRA, Market Risk: What You Don’t Know Can Hurt You Jun. 24, 2016), -what-you-dontknow-can-hurt-you.Federal Reserve Board, Market Risk Management (May 17, 2016), market risk mgmt.htm.EBA, Market Risk, rket-risk.As a large asset manager, we share policy makers’ concerns regarding systemic risk,and we observe that many of the actions taken by regulators post-crisis have made thesystem stronger. Let’s take a look at what has happened to different entities when marketshave moved significantly. In the Crisis, we saw how highly levered banks – many with offbalance sheet structured investment vehicles (SIVs) and large opaque derivatives books –were vulnerable to the market downturn in housing. Many of the post-crisis reforms addressbank capital, leverage, and derivatives trading. Collectively, these rules have led to reducedrisk-taking by banks.Contrast this experience with that of mutual funds and with asset managers. Formutual funds, losses are reflected in the net asset value (NAV) of the fund and are dispersedacross shareholders. Often, the shareholder base is comprised of thousands of individuals.In the Crisis, the stable NAV of money market funds (MMFs) highlighted a structuralvulnerability specific to these funds, which subsequently led to MMF reforms in the US andEurope.For asset managers, the agency business model limits company exposure to marketrisk. No asset managers “failed” in the Crisis or during other historical stress events. In theUS, no asset managers were recipients of Troubled Asset Relief Program (TARP) money asasset managers were not considered to be “at risk”. Simply put, asset managers arefundamentally different from banks, as they do not have balance sheet exposure to losses,funding issues, or solvency issues.3GR0517G-167067-466405
Potential Implications of Market Risk across Different EntitiesImplications of risks discussed are provided for illustrative purposes only. This is not an exhaustive list.Of course, solvency is not the only source of systemic risk. Liquidity is critical tounderstanding risk. A brief survey of historical crises – think Long Term CapitalManagement, Drexel Burnham Lambert, and Bear Stearns – shows a loss of confidence ineach case, resulting in difficulties borrowing. The loss of funding combined with a leveragedbusiness model presents a structural vulnerability, which can be seen in both retail runs onbank deposits and the inability to access wholesale funding markets.On the other hand, a study of mutual fund data, with the exception of stable NAVMMFs, shows that investors do not “run”. While this is the subject of substantial speculation,our analysis demonstrates that actual fund flows during market stress scenarios do notdemonstrate runs, fire sales, or mass redemptions from mutual funds. Another importantconsideration is that fund managers actively monitor market conditions and redemptionpatterns as part of their liquidity risk management programs. And, asset managersthemselves are not exposed to liquidity issues, which reflects a fundamental difference frombanks.Potential Implications of Liquidity Risk across Different EntitiesImplications of risks discussed are provided for illustrative purposes only. This is not an exhaustive list.To put this in perspective, think about some of the major market events of the pastfew years. No banks have failed, which we believe reflects the effectiveness of post-crisisreforms. While no funds have failed, I would be remiss not to address the recentexperiences of Third Avenue Focused Credit Fund and UK Property funds.4GR0517G-167067-466405
In December 2015, Third Avenue Focused Credit Fund, a daily open-end fundinvesting in distressed credit, suddenly announced it would cease meeting customerredemptions.7 The fund had massive illiquid assets but was marketed as a “high yield fund”.Fears of widespread contagion did not materialize. Looking forward, the new SEC rules onfund liquidity risk management limit the inclusion of illiquid securities, effectively addressingthis issue. Likewise, we expect the upcoming IOSCO consultation will cover fund liquiditytools and liquidity risk management.Following the Brexit vote, a number of UK Property Funds announced dealingsuspensions or redemption deferrals, and some adjusted their NAV or increased theredemption charge. These were extraordinary measures being used in extraordinarycircumstances. This experience highlights the importance of robust liquidity riskmanagement, transparency to investors, and tail risk tools to address tail risk events. Thiswas a serious situation. Oddly enough, this is an example that demonstrates the importanceof a broad fund liquidity toolkit. While media reports suggested these funds were the “canaryin the coal mine”8 and bond funds might be next, in fact, this did not happen. Even moreinteresting, investors understood the decision to protect remaining shareholders from theimpact of those wishing to redeem and investors did not file complaints. Within a few weeks,these funds were able to return to normal operations.9 Finally, I should note that the FCAhas issued a discussion paper on illiquid assets and open-ended investment funds.10Stress TestingLet’s turn now to stress testing. Three different types of stress testing in assetmanagement are actively being discussed: (i) system-wide stress testing, (ii) stress testingacross funds, and (iii) a top down stress test for asset managers. Each of these approachespresents serious challenges.First, we need to recognize that asset owners control asset allocation. There isincredibly diversity of asset owners, and many asset owners manage their assets internally.Even more importantly, different asset owners have different investment objectives andconstraints. For example, an insurance company aims to match its liabilities and earn aspread. Most insurance companies pay taxes, and the typical insurance company portfoliois heavily weighted toward fixed income assets. Pension funds similarly seek to fundprojected pension liabilities. Unlike insurance companies, many pension funds are taxadvantaged. Similarly, other asset owners have specific objectives and constraints.7SEC, Third Avenue Trust and Third Avenue Management LLC; Notice of Application and Temporary Order (Dec. 16,2015), available at dith Evans, Financial Times, Investors pull 1.4bn from UK property funds in Brexit month (Aug. 2, 2016), available 70-badea1b336d4.9Art Patnaude, The Wall Street Journal, U.K. Real-Estate Funds Reopen After Brexit Shut Down (Sep. 12, 2016), availableat -reopen-after-brexit-shut-down-1473686100; Patrick Collinson, TheGuardian, Property funds back in business after Brexit vote closures (Sep. 24, 2016), available operty-funds-back-brexit-vote-closures; Association of Real EstateFunds, A review of real estate fund behaviour following the EU referendum (Apr. 24, 2017), available haviour%20following%20the%20EU%20referendum Apr17.pdf.10UK FCA, Discussion Paper, Illiquid assets and open-ended investment funds (Feb. 2017), available 17-01.pdf.5GR0517G-167067-466405
Asset OwnersSome assets may be double counted as part of the assets of Mass affluent, HNWI and UHNW will be invested with insurance companies andpension funds.a.OECD Global Pension Statistics. As of 2014. Includes private pensions in both OECD and non-OECD countries; does not include publicpensions. Available at lpensionstatistics.htm.b.IMF Global Financial Stability Report as of April 2016: pdf/c3.pdf.c.Sovereign Wealth Fund Institute. As of Jun. 2016.d.Represents largest 25 Banks. Source: http://www.relbanks.com/worlds-top-banks/assets. As of Jun. 2016.e.McKinsey & Company Performance Lens. As of 2015.f.BCG Global Wealth 2016: Navigating the New Client Landscape. Ultra-High Net Worth is defined as those having more than 100 million ininvestible assets, High Net Worth is defined as those having between 1 million and 100 million, and Mass Affluent is defined as those havingbetween 250,000 - 1 million.When thinking about a system-wide stress test, we need to start with anunderstanding of the asset management ecosystem. In addition to controlling their assetallocations and having different investment needs, many asset owners choose to managesome or all of their assets themselves. The Financial Stability Board (FSB) estimates thattwo thirds of all assets are managed internally by asset owners, and one third is managed byoutside asset managers. 11 Clearly, a system-wide stress test is not reflective of the systemif it only covers 30% of the financial assets. The richness and diversity of the universe iscritical to understanding the asset management ecosystem.Looking at external asset management, these companies come in many shapes andsizes. Think of this diversity across three dimensions: product focus, client focus, andcapital structure. Each asset management firm has a different combination of these threedimensions, making it impossible to generalize about even the 30% of assets that areoutsourced to asset managers.11FSB, Policy Recommendations to Address Structural Vulnerabilities from Asset Management Activities (Jan. 12, 2017),available at rabilities.pdf; McKinsey & Company, Financial Services Practice, After a stellar year, time for Europe to be bolder?Global asset management in 2013 (Jun. 2014), available at ent2014-white-paper.pdf.6GR0517G-167067-466405
Asset Managers Come in Different Shapes and SizesFor illustrative purposes only.Now, let’s consider a stress test across funds. Since most of the policy focus is onbond funds, I will start here. Last year, we dedicated an entire paper to this topic titledBreaking Down the Data: A Closer Look at Bond Fund AUM,12 as we wanted to explore theuniverse of bond funds and develop a better understanding of the relevant data. What welearned is Morningstar has 49 categories of US bond funds. This includes high yield funds,municipal bond funds, short duration, intermediate duration, and long duration funds. Thelargest category is “intermediate term bond”, which generally includes US Treasuries,agency mortgage-backed securities, and corporate bonds. It would require extraordinarycircumstances for these funds to experience liquidity issues.10 Largest US Open-End Bond Mutual Fund CategoriesSource: Simfund. As of Dec. 31, 2015. Accessed May 2016. Includes active and index open-end bond mutual funds. Excludes ETFs and fund of funds.Categories defined by Morningstar. Includes bond funds within each category. 1) Total open-end bond fund AUM is the total AUM held in dedicated USopen-end bond funds as defined by Morningstar. Total AUM is 3.15 trillion as of Dec. 31, 2015.12BlackRock, ViewPoint, Breaking Down the Data: A Closer Look at Bond Fund AUM (Jun. 2016), available ond-fund-aum-june2016.pdf.7GR0517G-167067-466405
We also studied the flows from funds in various stress scenarios. Not surprisingly,the diversity of bond funds results in different patterns of redemptions and subscriptionsacross the various types of funds. In our review of the largest bond fund categories, nocategory experienced runs, fire sales, or mass redemptions during a quarterly period goingback to 1988, even during stress events. Instead, we saw flows both into and out of variousfunds and no systemic events.In part, this is because actual experiences of bond markets reflect the interactionsbetween a wide range of market participants. For example, following the closure of ThirdAvenue Focused Credit fund in December 2015, we saw 9.6 billion in redemptions fromhigh yield bond funds,13 yet simultaneously, several of our institutional clients added to theirhigh yield allocations, viewing the sell-off as an attractive buying opportunity.Stress tests that assume massive aggregate outflows from funds are reliant uponassumptions that contradict actual observed behavior through multiple market stressscenarios. Further, stress tests that aggregate multiple funds will not provide meaningfulresults because each fund’s risk is managed at the individual fund level, in line with thefund’s redemption terms and investment strategy. Even within one company’s fund family,each fund is a separate legal entity and the assets of one fund cannot be used to supportanother fund.A third idea under discussion is a top down stress of individual asset managers,along the lines of bank stress tests. This is both challenging and easy. Since the assetsunder management are not on the asset managers’ balance sheet, a stress test would berelatively easy to design and implement. Notably, losses on client investment portfolios donot result in losses to the asset manager’s balance sheet. The challenge here is that a topdown stress test of the asset manager will not reveal much with regards to systemic risk.Challenges of Applying Macroprudential Tools to Market FinanceIn earlier discussions at this conference, we heard that stress testing is far
For asset managers, the agency business model limits company exposure to market risk. No asset managers “failed” in the Crisis or during other historical stress events. In the US, no asset managers were recipients of Troubled Asset Relief Program (TARP) money as asset managers were not considered to be “at risk”.
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