Regulating Big Asset Managers, Part 1
What do you do with a trillion dollar asset management firm? Actually there are ten of them, and the largest two, Blackrock and Vanguard Group, manage $3.8 and $2.2 trillion respectively. The Office of Financial Research (OFR) issued a report at the end of September that poses the question from a regulatory perspective. The Financial Stability Oversight Council (FSOC) commissioned the report, entitled “Asset Management and Financial Stability”, to determine if large money managers should be subject to heightened scrutiny under the Dodd-Frank law.
The report intimated but did not firmly recommend that the largest firms become subject to “enhanced prudential standards and supervision.” The potential for heightened regulation and the concerns raised by the report were enough to set off a small tempest. As you’d expect, the largest asset managers weren’t all too pleased by the report. But they may have an unexpected ally: the SEC. If the largest money managers were to be subjected to heightened regulation, oversight would fall to the Federal Reserve. The SEC, touting its expertise, wants to retain jurisdiction.
Although the FSOC should be examining the money management business, the conclusions of this report and the reaction of the SEC have sent us in the wrong direction. The OFR report (enjoying the acronyms?) goes off base because it focuses too heavily on size. As I’ll discuss in a moment, size is not a decisive factor in money management when it comes to financial stability. Moreover, the SEC’s reaction is a distraction. Instead of having an informed policy discussion about the appropriate form of regulation of asset managers, we are going to be treated to a regulatory tug-of-war between the SEC and the Fed.
In my view, the source of the problem is the result of two factors. First, the OFR report fails to distinguish between spread and fee businesses in the financial sector. Second, in thinking about systemic risk, the report is too fixated on size. The size of an asset management firm is only one factor in thinking about the potential systemic risk.
The difference between financial businesses that earn their profits from a spread rather than a fee is critically important. In a spread business, such as banking, the financial firm borrows at a lower interest cost, lends at a higher interest cost, and makes a profit on the difference. In a fee business, financial firms earn revenues for managing a service, be it money management or investment banking.
During my career, and particularly at NationsBank, I found that banks did not understand the money management business. They craved the fees and high margins, but as bankers they always mismanaged the money management. The banker’s mentality taught executives to squeeze costs out of the business, because the only way to make significantly more money on a loan without overleveraging was to squeeze out overhead expenses. As a result, bankers were forever wringing expenses out of their trust and money management units, which only drove the talent out the door and ceded the money management business to independent asset managers. I suspect that the authors of the OFR report suffer from the same misunderstanding. Having spent most of their time worrying about spread businesses, they are misperceiving the risks of the asset management business.
Let’s look briefly at Blackrock, the largest asset management firm that manages $3.8 trillion. You’d expect the company to have a massive balance sheet. However, Blackrock’s assets are only $220.4 billion with liabilities of $175.0 billion and equity of $25 billion. In fact, the balance sheet is even tinier, because the assets include $157.8 billion in securities lending assets and $157.8 billion in securities lending liabilities. In other words, Blackrock is in one spread business on behalf of its clients, securities lending, which is a form of short-term lending, and a topic for another blog post. Absent, the securities lending assets and liabilities, Blackrock has assets of only $42.6 billion and liabilities of only $18.2 billion.
Let’s compare Blackstone to JP Morgan, the largest bank, which is in a lot of financial businesses but also has a large spread business. The bank has a $2.3 trillion balance sheet, with $2.1 trillion in liabilities and $200 billion in equity. The reason these
balance sheets look so different is that the bank is a conduit between the assets (loans to businesses and consumers) and liabilities (deposits and borrowings), and an asset manager is simply managing someone else’s assets. An asset manager only needs enough capital to pay compensation and overhead. The idea of scrutinizing an asset manager’s capital levels as detailed in the OFR report and going on to intimate that its business should be subject to higher capital levels makes no sense.
Want further proof that these are fundamentally different businesses? The large money management businesses came through the credit crisis without ever flirting with bankruptcy or distress. Assets under management and profits dropped along with the markets, but the top 20 firms are largely the same companies that dominated the business before the crisis. The same cannot be said for the banking business, where a host of competitors have disappeared, and the industry required a massive bailout.
End of story? No. Asset managers do pose risks to the financial system. As we’ll see in part two of this blog post, the OFR captured some of these risks, although their overall direction is misguided.