Managing the Liquidity Risk Process Fran Reed, Regulatory Strategy April 12, 2016
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Emerging Ideas Webcast Series Fran Reed, Regulatory Strategy
Managing the liquidity risk process In 2015, a well-established investment firm made the decision to liquidate one of its high-yield bond funds, barring redemptions from its investors. This decision to wind down the mutual fund without giving investors all of their cash back could have significant repercussions for both the company and the massive mutual-fund industry. During this 30-minute webcast, we will discuss: 1. 2. 3. 4.
The growing Fixed Income landscape, specifically the more complex, less-liquid areas of the market Industry shift away from banks towards asset managers Perceived liquidity systemic-risk concerns in fixed income markets Lack of regulatory oversight structure and inconsistent liquidity risk management framework in the asset management industry
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Welcome • Today’s event will last approximately 30 minutes • Audio is broadcast through your speakers, or you may join the teleconference • To ask a question, send a message to the presenters in the Q&A window • Technical issues will be addressed right away • Other questions will be answered at the end of the presentation
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Bonds are BIGGER The growth in Fixed Income markets, specifically the more complex, less-liquid areas.
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Fixed Income Markets Massive Growth +235% (2000-2015) U.S. bond market is nearly $40 trillion • 1 ½ x U.S. stock market • 2 x largest 5 non-U.S. equity markets combined
Shifting post-crisis markets: • Zero interest rates 2009 - 2015 • Banking reform Accessing the capital markets Fed has lowered the bar: • Corporate bonds - doubled • Municipal bonds - stagnated
Assets have migrated from BANKS FUNDS Today’s Fixed Income Markets: • • • •
Larger Less Stabile Less Transparent Less Liquid Copyright © 2016 FactSet Research Systems Inc. All rights reserved.
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Today’s Altered Liquidity Landscape Investor direct dealing Market Effects • Sharp increases in new debt issuance and total outstanding debt instruments • No comparable increase in trading volume Regulatory Drivers • Multi-year decline in dealer inventories from raising the costs of warehousing assets • Higher capital charges • Volcker Rule Outstanding U.S. Corporate Debt (Notional in Trillions)
Source: SIFMA
US Corporate Bond Dealer Inventory (Market Value in $ Billions)
Source: Federal Reserve Bank of New York, Primary Dealer Survey
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Relationship of Banks and Fixed Income Liquidity Regulatory reform has strengthened banks, but contributed to reducing market liquidity “Banks unable to function as shock absorbers during periods of market stress.” Findings from a recent BIS survey among 40 dealer-banks - as part of a study on fixed income market liquidity assessing various factors affecting dealers ability to take on market risk and facilitate trading: Survey Results: •
New regulations increasing costs of capital make trading and market-making much more difficult
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BIS estimates a banks gross revenue required to yield a return on capital of 8% under the Basel III rules would have resulted in returns above 20% under Basel II rules.
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Big Banks are “Feeling the Bern”
Source: FactSet Copyright © 2016 FactSet Research Systems Inc. All rights reserved.
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Industry shift away from banks to asset managers The buy-side is the new sell-side
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Asset Managers – Mutual Funds and ETFs Bond fund growth and changing dynamic • Bond funds have tripled in size • $4.4 trillion in 2000 to $12.7 trillion 2015 • Fastest growth in less-liquid sectors: • High Yield, Emerging Markets, Alternative Investments • Leveraged Loans & Sub-Prime Auto Loans • Cross-Ownership Dynamic: • Mutual funds today own 17% of corporate bond assets • Vs. 8% ownership in 2008 (ICI) Mutual Fund & ETF assets: $33.4 trillion global and $17.8 trillion U.S. (% of total net assets, 2015)
Sources: Investment Company Institute and International Investment Funds Association Copyright © 2016 FactSet Research Systems Inc. All rights reserved.
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Fund Growth and Demographics Size • U.S. fund industry: 3x over last 20-years •
Demographics • 90 million Individuals • 53.2 million Households (43.3%) • $7.3 trillion in IRA and DC plans
Source: FactSet
Source: Investment Company Institute – 2015 Fact Book Copyright © 2016 FactSet Research Systems Inc. All rights reserved.
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Perceived systemic-risk concerns Perception – bonds can be more complex than stocks
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Regulators are searching for Black Swans Regulatory • • • •
Size Rapid Growth Complexity Exposures
Systemic Risk
Global Financial Regulatory Objectives
Capital Adequacy & Solvency
Transparency
Compliance
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Global Regulators Running the Show
Financial Stability Oversight Council (FSOC) •
Chaired by Secretary of the US Treasury • Federal Reserve Board • SEC • OCC • CFPB • FDIC • CFTC • FHFA • OFR • NAIC • FIO
Financial Stability Board (FSB) •
New European-based international global standards setting body - Chaired by Mark Carney, Governor - Bank of England
International Organization of Securities Commissions (IOSCO): •
Develops, implements and promotes adherence to internationally recognized standards for securities regulation - with the G20 and the FSB on global regulatory reform agenda. Copyright © 2016 FactSet Research Systems Inc. All rights reserved.
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Systemic-risk concerns - Preventing mutual fund Fire Sales Run on a Fund Fund liquidity mismatch – daily redemption is a defining feature of mutual funds
Market Stress
Redemption Activity
Selling Assets in the open market
Price Pressure
Fire Sales
Perception - funds appear to offer greater liquidity than the markets in which they transact Policy-makers, academics and regulators express systemic-risk concerns: •
The asset management industry is deeply interconnected with the broader economy, mainly as a provider of credit outside the banking system.
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Dangerous combination: • Lower Dealer bond inventories • Increased bond funds and ETFs filling the financing gaps.
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SEC Proposals Update the “40 Act” and develop a consistent liquidity risk management framework for the asset management industry
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Liquidity risk management reform proposals for asset managers U.S. Securities and Exchange Commission Primary regulator for the asset management industry Proposal 22(e)4 - Unprecedented rules-based reform package, includes: •
Six-category liquidity classification system of fund portfolio assets, based on days-to-liquidate “ability to exit a position … at or near current market value”
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Assessment, periodic review, and management of a fund’s liquidity risk
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Determination of a three-day liquid asset minimum
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New governance procedures, including board approval and review
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New disclosure and reporting requirements Copyright © 2016 FactSet Research Systems Inc. All rights reserved.
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Industry expectations of a softer SEC approach Disclosure agency vs a regulatory super-power Feedback: SEC received over 80 comment letters from industry stakeholders Opposition centers on: • Scientific methodology deriving the “days to liquidate at or near current market value” • Three-day liquid asset minimum Critics contend the rules are: • “too cumbersome” • “too subjective” • “create hurdles for high-yield funds to carry out bona fide investment strategies” • “imply a degree of precision which doesn’t exist” • Lack contingency plans Alternative suggestions: • Broader, more subjective liquidity categorization • Creating different rules representing unique ETFs structure
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Fractious SEC within a Fragmented U.S. Regulatory System Political, Bureaucratic and Resource Constrained SEC Investment Company Modernization Proposed Rule 22(e)4 Liquidity Risk Mgmt. Dodd-Frank Act Goal - Financial stability and restore confidence in banking system.
SEC Derivatives proposal
Mutual Funds, ETFs and BDCs - Goal is to reduce leverage through the use of derivatives.
MiFID II
EU Directive – Goal is to strengthen financial markets into a single platform / pre & post-trade transparency.
AIFMD EU Directive – Goal is to regulate and provide transparency in alternative investment funds.
SIFI, G/D-SIB & G/D-SII FSOC and FSB / IOSCO – Possible SIFI or G-SIB & G-SII designations for Asset Managers and Insurance Companies.
Goal – Fund industry transparency, liquidity reforms and consistent industry-wide liquidity risk mgmt. framework.
Resolution Planning Data Integration, Resolution plans “living wills”, shared services entities, simplified legal entity structure, etc.
Consumer Financial Protection Bureau Regulate Market place lenders – pay-day loans, sub-prime auto loans, student loans
Global Coordination Home/Host disruptions and other unintended consequences.
Regulatory Gaps / Over-reach Over-reach , jurisdictional conflicting agendas, or lack of contingency plans - triggering next crisis?
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FSOCs unlimited clout “A Firing Squad on Capitalism” - Michael Piwowar (R) SEC Commissioner, describing FSOC
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Backlash Could the MetLife SIFI victory delay new rules for asset managers?
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FactSet Solution Eliminate Surprises Effective Risk Management through enhanced Data Governance Shifts in asset managers' behavior predate the proposed SEC rules: • Track liquidity more precisely for investment decisions • Monitor portfolio trading activity • Categorize liquidity classifications • Develop enhanced written governance procedures • Adopt new reporting requirements. FactSet will be expanding our offering in the Fixed Income liquidity space by integrating IDC’s liquidity information into Fixed Income Portfolio Analysis. This will allow clients to easily report days to Liquidate and a Liquidity Score.
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Thank You.
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