Leading money managers and mutual funds have a message for Washington: We may be big — but we aren’t too big to fail.
The Dodd-Frank financial overhaul law requires the newly created Financial Stability Oversight Council to identify specific nonbank financial firms — mutual funds, hedge funds, private equity shops — that pose a systemic risk to the financial system. Big bank holding companies like Citigroup and Goldman Sachs have already been designated as “systemically important.” The council has begun looking at nonbank financial firms and will propose criteria by next year.
For those nonbank firms, it is a bit of a scarlet letter to be tagged as “systemically important.” They will face greater scrutiny and regulation from the Federal Reserve. There could be risks for taxpayers, too: some regulatory lawyers say they are concerned that the designation will be an implicit guarantee of future bailouts.
In public letters and private conversations, financial firms and their trade groups are arguing that because they use little or no leverage — or borrowed money — they do not pose a risk to the financial system. During the financial crisis, companies like Lehman Brothers ran into troublebecause many of their investments were made on borrowed money, magnifying losses when those assets fell in value.
Some companies recently took the leverage argument to the oversight council, while BlackRock’s general counsel and chief lobbyist met Nov. 4 with Federal Reserve officials, according to Fed disclosure records. The meeting was reported this week by Bloomberg News.
The BlackRock representatives told the Fed officials, “Unlike a bank, an asset management company acts as an agent for its clients and does not hold investment assets on its own balance sheet,” according to the records posted on the Fed’s Web site.
“It’s a good argument, and if I were in their situation, that’s the argument I would be making,” said Douglas J. Elliott, a fellow at the Brookings Institution who specializes in financial regulatory issues. “Leverage clearly has an effect in how dangerous you are.”
In a letter to the oversight council, which is led by the Treasury secretary, Timothy F. Geithner, executives for Vanguard warned, “Efforts to identify any entity that could impose any degree of systemic risk will be overwhelming and fruitless, and could cause the council to miss the next systemically risky actor that threatens the markets.”
The case for leverage as the main criterion favors asset managers like BlackRock. Surprisingly, however, it is also an argument used by hedge funds, a group that is often associated with using leverage.
“Though hedge funds are often mischaracterized as being highly leveraged financial institutions, the industry is, and has been, significantly less leveraged than other financial market participants,”
Richard H. Baker, the president and chief executive of the Managed Fund Association, a hedge fund trade group, wrote in a letter to the council.
This lack of leverage, among other factors, should “substantially reduce the likelihood that the failure of a hedge fund would have systemic implications,” Mr. Baker said.
Mr. Elliott, once an investment banker for JPMorgan Chase, said that leverage was just one factor in the systemic risk equation. “Size does matter,” Mr. Elliott said, adding that it also is important to determine how risky a company’s business is and whether it is intertwined with other institutions. Some companies made similar arguments when appealing to the council and the Fed.
Mr. Elliott added that the council should tread lightly as it chooses which institutions to focus on. “There’s a moral hazard argument,” he said. “You don’t want to go in and say that everyone is systemically significant. There is a chance you’re setting up an institution to be viewed as too big to fail.”