How Are Asset Managers Regulated Post-Financial Crisis?
Investment managers are fiduciaries of their clients meaning they are obligated to act in the best interests of the clients. This could in the form of seeking the best strategy possible based on due diligence in understanding the clients’ goals, objectives, risk constraints, and requirements [1].
Investment managers are responsible for:
- Transparent and consistent reporting practices
- Compliance with regulatory and ethical standards
- Independent and unbiased governance of the firm
Now we know what the responsibilities of an investment manager are, it is also important to understand which key regulations they and the wider financial industry are subjected to.
Regulation is largely shaped by the Global Financial Crisis as the cause was attributed to regulatory failure as a result of policy loosening after the dot com bubble burst. The decade since the GFC, regulatory reforms have touched almost every financial firm, predominantly asset managers, and their product offerings and activities to reassure investor confidence in the industry [2].
Regulations are centered on increasing capital requirements, liquidity, transparency, risk management, portfolio management, and corporate governance.
 Figure 1: BlackRock produced summary of regulations post GFC
MiFID II
MiFID (Markets In Financial Instruments Directive) II was commissioned by the EU (European Union) to further protect investors from activity within Eurozone markets after the 2008 financial crisis. This piece of legislation covers both assets and professions in the industry including off-exchange and over the counter trading (OTC) with the aim of increasing transparency for investors.
The original MiFID was enacted in November 2007, however, the 2008 financial crisis revealed that investors were risk as MiFID focussed primarily on the stock market and not on other asset classes such as bonds, forex, and derivative products. Another weak point was the directive failed to address activities of firms outside the EU resulting in their actions to be regulated by individual nations [3].
Improving on MiFID I, MiFID II corrects the weak points previously mentioned by creating measures that equally regulate all member states. Thus any product available on the financial markets is regulated by MiFID II even if the trader buying or selling is not in the Eurozone. Some of the measures include additional stringent reporting requirements increasing transparency and stamping out the use of private financial exchanges that do not require investor’s identities otherwise known as dark pools.
Dark pools under the new regulation now limit the volume of stock traded within a dark pool to 8% over an annum. High-frequency trading as witnessed during the 2008 crisis as a result of mass investor panic causing irrational market moves has been curtailed by the implementation of circuit breakers [4]
Furthermore, MiFID II also extends to regulate the actions of professionals in the financial industry within the EU.
The key regulations include:
- Restrictions on investment managers receiving inducements from any parties related to services provided to the client
- Banks and brokerage can no longer bundle investment research alongside transactions
- Brokers to provide price and volume information on their trades through providing all communications
The additional compliance costs for firms was estimated at $2.1 billion estimated by Expand and IHS Markit. These costs result in decreasing margins for asset managers, with added pressure on fees from the rise of passive investing, this has resulted in consolidation within the industry as we have with mergers like Standard Life and Aberdeen Investments, as well as Janus Capital with Henderson Global Investors [5].
Dodd-Frank Wall Street Reform and Consumer Protection Act
The Dodd-Frank was a piece of Financial reform legislation enacted in 2010 after the 2008 financial crisis that aimed to more heavily regulate specific sectors involved in causing the crisis such as investment banks and mortgage lenders.
The Volcker rule fundamentally changed the activities of investment banks by restricting speculative trading and completely eradicating proprietary trading (now only done now by select Hedge Funds). The same act also covers derivatives such as the credit default swaps through creating centralized exchanges that required greater transparency.
Under the Dodd-Frank, many new institutions were established to create oversight across the financial services industry including [6]:
1. The Financial Stability Oversight Council who observes the stability of major financial firms deemed as too big to fail so that an incident similar to the collapse of Lehman Brothers does not reoccur
2. Orderly Liquidation Authority dismantles financial firms so assets can be liquidated and paid back to creditors
3. Consumer Financial Protection Bureau (CFPB) has the role of regulating mortgage lending to prevent the subprime mortgages causing another crisis in addition to consumer lending market (credit/debit cards)
Basel III
Basel III was introduced by a consortium of 28 central banks (Basel Committee on Banking Supervision) in 2009 globally to reform international banking risk through banks to not to have too much debt on their balance sheets. This was done by implementing leverage ratio and reserve capital requirements.
Banks generally have two tiers of capital with Tier 1 consisting of the core capital, equity, and reserves that can serve to cushion the bank during times of financial crisis. On the other hand tier 2 is a bank’s supplementary capital for instance undisclosed reserves and unsecured subordinated debt instruments. The combination of tier 1 and tier 2 gives the bank’s total capital. Basel III warrants the total capital ratio to be at least 12.9%, with the minimum tier 1 and tier 2 capital ratio must be 10.5% and 2% of its total risk-weighted assets respectively. The leverage ratio (calculated by dividing tier 1 capital by the total of on and off-balance assets minus intangible assets) is capped at 3% so that banks do not excessively borrow and have adequate liquidity during times of financial crisis.
In order for banks to withstand the economic cycle, Basel III established regulatory capital requirements, in instance during credit expansion banks must have additional capital. Whilst in credit contraction capital requirements can be loosened [7].
An Emerging Area of Regulation Within Asset Management
ESG integration in particular climate transition risk is unsurprisingly the top of all regulatory agendas. The European Commission has recently adopted the Taxonomy regulation which defines the criteria for business-related activities to be regarded as environmentally sustainable. Policies such as these aim to reduce funds that are green-washing which means they label their funds as ESG compliant as a marketing tactic however, they may only have 2-5% of the portfolio to be ESG leading companies. To further combat this the European Commission’s Joint Research Centre has proposed mandatory criteria for retail funds such as [8]:
- Bond funds to have 70% investing in Green bond Standard-compliant bonds
- Equity funds to apply the three-pocket approach:
- 20% of the fund’s portfolio in companies that derive 50% of their revenue from green economic activities
- 0-40% must be invested in companies deriving 20-49% of their revenue from green economic activities
- The remainder of the portfolio must be invested in companies deriving 20% of their revenue from green economic activities
References
[1] https://www.cfainstitute.org/en/advocacy/issues/investment-management-products-regulation
[4] https://finfoc.com/2020/06/dark-pools-the-playmakers-of-off-exchange-trading-part-2
[5] https://www.ft.com/content/06135b66-5627-4f4b-bef2-5818164afd8b
[6] https://www.investopedia.com/terms/d/dodd-frank-financial-regulatory-reform-bill.asp
[7] https://www.investopedia.com/articles/economics/10/understanding-basel-3-regulations.asp
[8] https://home.kpmg/xx/en/home/insights/2020/01/a-new-agenda-for-a-new-decade.html