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News April 20, 2015 Issue

Don’t Let Asset Managers Be Regulated Like Banks: Gallagher

Not unlike Paul Revere warning of the arrival of the British, SEC commissioner Daniel Gallagher has issued a clarion call warning asset managers that the prudential regulators are coming.

"Their goal is to subject the so-called ‘shadow banking’ markets, of which the asset management industry is a significant part, to bank-like regulation under the prudential regulators. … Without bold leadership and a dose of regulatory rationality to oppose this effort, it will happen," he told his listeners in an April 10 speech, "Bank Regulators at the Gates: The Misguided Quest for Prudential Regulation of Asset Managers," at the University of Virginia Law School in Charlottesville, VA.

This is not the first time Gallagher has warned of the imposing encroachment of prudential regulators – institutions that would impose the kind of regulation involved in the oversight of banks and other parts of the financial system where risk is expected to be minimized. He issued similar comments as part of an October 2014 speech at Fordham Law School in New York City focusing on the SEC’s next 80 years. The April 10 speech, however, was totally devoted to the subject.

Singling out the U.S. Financial Stability Oversight Council (FSOC) and the Switzerland-based Financial Stability Board (FSB) as the "worst offenders" in an attempt to place prudential regulation on asset managers, he said the two bodies "have launched a series of broad-based workstreams aimed at designating asset managers, or the activities of asset managers, as systemically important in order to subject them to oversight by the Federal Reserve and other prudential regulators."

Why? Because prudential regulators "and the policymakers they have captured, adhere to a false narrative of the financial crisis that says capital market regulators like the SEC failed, and the markets and market participants overseen by capital markets regulators were a major cause of the financial crisis," something he said was not the case.

The true causes of the financial crisis were the failed federal housing policy, failed banks, and taxpayer dollars that propped up too-big-to-fail commercial banks, Gallagher said. "To borrow a phrase from Al Gore, these were inconvenient truths," he said. "And they certainly haven’t impeded the enlightened progress of the regulatory illuminati."

Attempts by FSOC and the FSB to characterize asset managers and their activities as systemically risky are "nothing more than a ploy to wrest control of a hugely important sector of the capital markets from the SEC."

What may come

Gallagher’s suggestion that "bank-like regulation" of the asset management industry may occur if not prevented by leadership and a different approach toward regulation is quite possible, said Willkie Farr partner and former SEC Division of Investment Management director Barry Barbash. "The systemic approach among regulators is so prevalent that there’s going to be some kind of action to one degree or the other. When there is a market downturn, policymakers want to respond, and I think we are seeing that."

"I think he speaks for a lot of people," Barbash said of Gallagher’s comments. "My impression is that there are people in the SEC building who feel the same." The problem, he said, is that "the bank regulators and the European regulators don’t have a detailed appreciation of the asset management industry."

"Regulators have not made a clear and persuasive case for prudent regulation of the asset management industry," said Stradley Ronon partner Lawrence Stadulis. "The historical record to date just does not support it. Those supporting prudent regulation tend to focus on what could happen in the future, absent prudent regulation of some sort. These scenarios are difficult to defend against or counter because, in theory, they could happen. Thus, those opposed to prudential regulation are placed in the difficult position of disproving something for which there is no proof in the first place. Who wouldn’t want to prevent the next financial crisis? However, it also has its weaknesses. It may prove unnecessary and costly. It also is difficult to prove in the cost/benefit analysis portion of any rulemaking initiative. The data just isn’t there."

"The debate here is largely a political one with important implications," he said. "The winner will likely be the side with the greatest political will to prevail. At least some modicum of prudential regulation will most likely happen."

Other voices

Efforts to label the asset management industry as systemically risky have also drawn criticism from other quarters. The Investment Adviser Association and the Securities Industry and Financial Markets Association, in a March 25 comment letter sent to FSOC, said that there was no systemic risk in the asset management industry and, even if there was, it would be the SEC’s responsibility to look into it, not FSOC’s. The letter was sent in response to a FSOC notice seeking public comment on its evaluation of potential risk in the asset management industry.

"The SEC, as the primary regulator of the asset management industry, has the responsibility and expertise for assessing where potential new data, regulations or other tools are necessary," the two associations said. "In this context, FSOC has an important role but one that should be considered as supportive of the SEC, to serve as a forum for identifying and studying systemic risks."

SEC chair Mary Jo White weighed in on the issue when, in a December 11, 2014 speech on asset management regulation (ACA Insight, 12/22/14), she said that while FSOC "is an important forum for studying and identifying systemic risks across different markets and market participants," the SEC brings a "market perspective" that is "an essential component of FSOC’s efforts. And FSOC’s current review of the potential risks to the  stability of U.S. financial system of asset managers is a complement to the work we are now undertaking."

Another SEC commissioner, Michael Piwowar, sounded a note similar to Gallagher’s when he addressed the issued in a March 16 speech before the 2015 Mutual Funds and Investment Management Conference. "Despite incontrovertible evidence to the contrary, there is a continuing false narrative that one reason for the financial crisis was ‘the expansion of a largely unregulated ‘shadow banking system’ rivaling the traditional banking sector in size,’" he said. "Yet capital markets have always been about risk and, in the United States, where capital markets are subject to a comprehensive system of regulation overseen by the Commission and the Commodity Futures Trading Commission, capital market-based financing has dominated bank-based financing."