Are Asset Managers Now Too Big to Fail?

Dodd-Frank comes under renewed criticism, including from one of its authors, over talk of declaring large asset managers ‘systemically important’

Former Rep. Barney Frank at TDAI Elite Advisors Conference. Former Rep. Barney Frank at TDAI Elite Advisors Conference.

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Nearly three and a half years after passage, the sweeping Dodd-Frank Wall Street Reform and Consumer Protection Act remains a subject of intense controversy.

The two retired legislators for which the law is named will appear together at a conference for independent investment advisors on Wednesday — the MarketCounsel Summit in Las Vegas.

And two widely disseminated commentaries on the law published this week — both of them critical — may set the tone for questions that advisors and journalists will be asking former Sen. Christopher Dodd and former Rep. Barney Frank, both Democrats.

The Wall Street Journal devoted all of its above-the-fold lead editorial space Monday to a criticism of an idea vetted by the Dodd-Frank-created Financial Stability Oversight Council (FSOC) that  would expand the definition of systemically important financial institutions to include asset  managers.

The Journal editorial draws a sharp distinction between the world of investing, where risk is expected and desired, and the world of banking, where safety is paramount. It notes that the dot-com bust of 2000, which saw the Nasdaq drop more than 60%, did not lead to a systemic crisis because it was private money that was lost.

“An asset manager decides where to invest money on behalf of clients. The profits or losses on these investments accrue to the clients, not the manager. A market decline shouldn't threaten an asset manager or the larger financial system,” the Journal writes. This contrasts with banks, whose customers expect to be able to writhdraw every penny of their deposits, for which taxpayers are liable through federal deposit insurance.

Were the U.S. Treasury, which chairs FSOC, to rope in the likes of BlackRock or Fidelity as “systemically important,” then asset managers, too, will become too big to fail, their new status will raise regulatory costs paid for in investor fees, and taxpayers will be on the hook for potential bailouts, the Journal argues. The editorial warns that Treasury has already breached the nonbank distinction by designating Prudential and AIG, two large insurers, as systemically important.

Perhaps most devastating, the Journal called Frank as chief witness. It quoted the law’s co-author speaking a conference last month panning the new FSOC idea: “[FSOC]  has enough to do regulating the institutions that are clearly meant to be covered — the large banks. I have not seen the argument made yet to cover [the] very plain-vanilla asset managers," he told a New York gathering of bankers.

On the same day, another leading financial journal, Investor’s Business Daily, ran a lengthy critique of Dodd-Frank by Nicole Gelinas, a CFA and fellow at the free-market-oriented Manhattan Institute think tank.

Gelinas takes a broader view of Dodd-Frank, arguing that its biggest failing is perpetuating, rather than curtailing, “too big to fail.” Rather than allow systemically important financial institutions to go under safely, the law seeks to “make the world safe from bankruptcies,” she writes, noting that “bankruptcy is a natural, healthy occurance in a capitalist system.”

Gelinas also fingers FSOC as particularly harmful because its mandate of identifying market risks and promoting market discipline is inherently contradictory. “Why should investors monitor big firms if the government is already doing it for them?” she writes.

She quotes Dallas Fed President Richard Fisher in testimony he gave Congress this summer warning that “as soon as a financial institution is designated as systemically important … it is viewed by the market as being the first to be saved.”

The privilege that creates in the marketplace has fueled the growth of large banks, whose four largest representatives have assets amounting to 50% of GDP in 2011, compared to just 9% in 1990, according to Fisher.

Gelinas shows how under Dodd-Frank large financial institutions are shielded from bankruptcy. The law’s Orderly Liquidation Authority (OLA), rather than declare insolvency and work out an equitable arrangement between creditors and debtors, is actually authorized to inject taxpayer funds — a bailout, in other words — to keep the institution alive.

Gelinas quotes President Barack Obama as saying, at Dodd-Frank’s 2010 signing ceremony, that “there will be no more tax-funded bailouts—period” under the law.

The Manhattan Institute scholar laments the law’s sweeping approach — the bill was criticized for its 2300-plus pages — as opposed to enacting discrete technical fixes to the problems that caused the 2008 financial crisis, such as repealing a law that prohibited regulation of new derivatives markets.

She cites favorably a 5-page bill advocated by the Fed’s Fisher that would end any government guarantee or subsidy and notes that Sens. Elizabeth Warren, D-Mass., and John McCain, R-Ariz., have introduced a 30-page bill that would bring back Glass-Steagall’s separation of investment and commercial banking.

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