Since the financial crisis, Washington’s mantra has been simple: no more taxpayer bailouts. This makes it curious and alarming that U.S. and international regulators are proceeding down a path that could put America’s savers—retirement plan participants, parents saving for college and young adults saving for homes—on the hook some day to bail out a “too big to fail” bank.
How could that happen? The Dodd-Frank Act, passed in 2010 in response to the crisis, created the Financial Stability Oversight Council (FSOC) and charged it with identifying potential risks to the financial system. Globally, the Group of 20 nations charged the Financial Stability Board (FSB) with the same task. Both bodies are dominated by bank regulators. Both bodies now are examining whether some asset managers and investment funds — including U.S. mutual funds — should, like the largest banks and insurance companies, be designated “systemically important financial institutions,” or SIFIs.
The answer is emphatically no, they should not. Asset managers do not pose risks to the financial system at large, and they and their mutual funds are comprehensively regulated already by the Securities and Exchange Commission.
If FSOC designates mutual funds as SIFIs, it will impair the single best tool available to average Americans for retirement saving and individual investment, as well as a key source of financing in our economy. The Federal Reserve Board henceforth would supervise the activities of all funds so designated. Under the so-called Collins Amendment to the Dodd-Frank Act, these funds would have to meet bank-level capital requirements. They would have to pay fees to cover costs of the Fed, FSOC and Treasury’s research arm, the Office of Financial Research. Fund investors would pay all these additional costs — but they would be imposed only on the designated funds or fund families, thus distorting competition and investor choice.
The Fed’s power over designated funds would be immense. It could, for example, force a stock fund to increase its holdings of cash, thus impeding that fund’s ability to deliver on the investment objectives and provide the returns that its investors expect. And during times of market turmoil, the Fed might well decide that it is necessary for a designated fund to maintain financing for a troubled company or financial institution — irrespective of the fund’s legal obligation to serve its shareholders’ best interests.
This risk is not purely theoretical. Amid the rescue of Bear Stearns in March 2008, the collapse of Lehman Brothers in September 2008, and the European banking crisis of 2011, bank regulators harshly criticized funds for pulling back financing from these institutions. Bank regulators apparently expected that, in the interests of the banking system, funds would ignore credit risk, accept avoidable losses, and “take one for the team” — in disregard of the fiduciary duty that all managers and directors owe to the shareholders of their funds.
And then there is the prospect of a bailout. Under Dodd-Frank, if a failed institution’s assets won’t cover its debts, the government can assess all SIFIs — including any designated mutual funds — to support the Orderly Liquidation Fund. Retirement savers and other shareholders in large mutual funds could see their assets tapped to pay for a failing bank. That’s just a taxpayer bailout by another name.
How long could fund investing — rooted in the trust of investors — thrive under such conditions?
None of these consequences can be justified in the name of reducing systemic risk — because all the evidence shows that mutual fund managers are not systemically risky.
The structure and comprehensive regulation of mutual fund managers ensure that they do not create or transmit systemic risk. Fund managers invest as agents, not principals; they do not put their own money at risk, and do not need capital to absorb investment losses. A fund’s investment returns belong to its shareholders, who knowingly accept investment risk and act as “shock absorbers” for the financial system. Mutual funds generally hold diversified, tradable securities and must mark each holding to market every day, which helps funds meet redemptions in a fair and orderly manner.
Funds use little or no leverage — the fuel for financial crises. Mutual funds do not “fail” in the way other financial institutions do. Both funds and managers regularly close up shop without any government intervention or taxpayer assistance. Nor do stock and bond fund investors run from declining markets. As demonstrated in every period of market turmoil since World War II, shareholders in stock and bond funds tend to stay the course. In fact, stock and bond mutual funds by and large are repositories of permanent capital — not “fast money,” as bank regulators suppose.
The fund industry supports efforts to make the financial system more resilient — but through the use of appropriate, targeted regulatory tools. To that end, we are and have been working with regulators on a variety of efforts to reduce the level of risk arising from specific activities — the money market, derivatives trading, securities lending and trade settlement, for example — and to provide information that will enhance regulators’ ability to monitor financial developments.
Failures of banks and bank regulation were at the root of the 2008 financial crisis. It would be a bitter irony if, as a result of that crisis, the FSOC imposes bank-type regulation on mutual funds — the part of the financial system that arguably weathered the crisis best of all. More than 90 million Americans entrust their savings to mutual funds, with the expectation that funds and their managers exist to serve the best interests of investors. If need be, Congress should act to make certain that the FSOC does not destroy that trust.
Paul Schott Stevens is president and CEO of the Investment Company Institute, the national trade association for mutual funds.