Opinion

James Saft

Funds too lame rather than too big to fail: James Saft

April 8, 2014

April 8 (Reuters) – It isn’t true that the asset management
industry is too big to fail but it may well be that it is too
lame to be tolerated.

Noting the rocketing growth of the global asset management
industry, which is on track to more than quadruple in size by
2050 to $400 trillion, Bank of England executive director for
financial stability Andy Haldane argued that funds may require
closer and tighter supervision by regulators.

“Their size means that distress at an asset manager could
aggravate frictions in financial markets, for example through
forced asset fire sales,” Haldane said in a speech last week in
London.

“It is possible to identify a set of market-wide conventions
or regulatory practices which have the potential to drive common
behaviour among asset managers and their institutional client
base. These have the potential to turn idiosyncratic market
frictions into systemic market failures.” (here)

The idea that asset managers are too big to fail, that their
sheer size makes them a particular threat, is at best unproven,
as Haldane acknowledges. Not only do asset managers employ far
less leverage than banks, they mostly play with other people’s
money, making those that flame out more a source of private
grief than public strife.

And though there have been notable instances of large asset
managers causing market distress and malfunction, there is
little doubt that they are not immune to the consequences of
their actions in the same way as the very largest banks.

As a thought experiment, imagine an asset manager which had
made as egregious a series of mistakes and miscalculations as
has Citigroup over the past 15 years or so. You can’t,
because such an institution would have ceased to exist, several
times over. Or at best, sunk into insignificance.

Citibank was bailed out by the U.S. government in November
2008 with the government taking a 36 percent equity stake, a $45
billion credit line and a guarantee covering losses of more than
$300 billion.

This is not at all to say that asset managers don’t
represent a threat, of sorts; much less that they do a good job
allocating capital in a way which helps the economy and secures
retirements. Quite the opposite, in many ways.

Asset managers, and their clients, tend to chase returns,
exacerbating market mispricings like the ones which brought on
the last two recessions and which now threaten a third.

I’d argue that this is mostly the result of a mix of human
frailty, self-serving career management by fund mangers and
poorly thought-through existing regulation producing perverse
results.

A CENTRAL BANKING TOOL

One of the prime dangers caused by asset management is
herding, the phenomenon whereby many managers all behave the
same way at the same time. The mania for Internet stocks in the
late 1990s is an excellent example, as may well be the current
vogue for social media companies.

Why does herding among asset managers happen? Because
managers don’t only manage your money, they manage their
careers. If a bubble in a particular sector is driving strong
market performance, the typical manager sits it out at her own
peril.

It is easy to get fired if you lag the market, even for very
sensible reasons.

The irony, of course, is that central bankers are well aware
of this phenomenon and use it themselves as a tool by which to
effect policy. Narayana Kocherlakota, President of the Federal
Reserve Bank of Minneapolis, argued as much a year ago,
maintaining that very low rates may have to persist for quite a
long time for the Fed to reach its aims.

“For a considerable period of time, the FOMC may only be
able to achieve its macroeconomic objectives in association with
signs of instability in financial markets.”

It wouldn’t change human nature, but if we want better asset
management, therefore, perhaps we ought to have better central
banking. Standing as we are on what may be the brink of another
bout of market instability, this is an important point.

Haldane also details the rather monumental error made by
many pension funds during the most recent downturn.

While prudent fund management dictates that when you have a
crash you ought, if you can afford it, to buy a bit more of what
just went down the most and sell a bit of what didn’t, we saw
quite the opposite. Pension funds which were well funded, which
had enough money to meet their obligations, cut their equity
holdings sharply, while those without enough tended to increase
theirs.

The well funded were cutting risk while the relatively needy
were taking it on. That’s not doing a good job, either for the
economy or for savers.

Reform seems much needed, but it will take a profound change
in the approach of central bankers if it is to do much good.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be
an owner indirectly as an investor in a fund. You can email him
at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

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