The FSOC will hold its public conference on the asset management industry on the afternoon of May 19. The conference will cover investment risk management by asset management firms; asset management and risks across the broader financial system; and operational issues and resolvability. Academics will participate in each of the three panels. The following does not cover the entirety of the professors’ work; however, it may provide a snapshot of the viewpoints they may share during the panel discussions.
Investment Risk Management by Asset Management Firms
Kent Daniel is a professor of finance at Columbia Business School. He previously served as Co-CIO at Goldman Sachs and was head of Quantitative Investment Strategy equity research. Professor Daniel’s research interests focus on behavioral finance and asset pricing. Momentum Crashes , a paper he co-authored, won the Swiss Finance Institute Outstanding Paper Award for 2013. The paper discusses the “pervasive” use of momentum strategy, which relies on the premise that past returns will predict future returns. According to the paper, the strategy holds across asset classes by numerous quantitative investors, including mutual funds. The paper finds that while momentum strategy generally has strong positive average returns and Sharpe ratios, the strategy does experience occasional but predictable crashes. The crashes generally occur during periods of market stress when volatility is high, but when market prices are beginning to rebound. The paper proposes an optimal momentum strategy which could have important ramifications for asset pricing and portfolio management.
Itay Goldstein is a professor of finance at the Wharton School of the University of Pennsylvania. In a 2010 paper, Professor Goldstein and his co-authors seek to provide empirical evidence that when an investor is more likely to make a decision based on whether the investor believes others will make the same investment decision, a multiplier effect occurs (or “complementaries”). Such theories are used to explain bank runs, bubbles and crashes in financial markets, and currency attacks. The paper looks to flow data from open-end funds for its empirical foundation. The paper finds that the open-end fund shareholders’ ability to redeem their shares on demand “is responsible for the strategic complementaries and their destabilizing consequences.” The paper finds a close link between the liquidity of a fund’s assets and how destabilizing these complementaries are and suggests that funds with highly illiquid assets should be organized in closed-end form. It also finds that the issue also exacerbates mispricing in the markets by preventing open-end funds from conducting profitable arbitrage activities. According to the paper, fund shareholders are “subject to strategic risk due to externalities from other investors’ redemptions.” An older paper from Professor Goldstein also explores how investors’ decisions can affect other investors in the market place. The paper finds that diversification can, in fact, increase correlations between returns in different countries, creating self-fulfilling crises because agents believe that crises will occur.
Asset Management and Risks Across the Broader Financial System
David Scharfstein is a professor of finance and banking at Harvard Business School who focuses on financial services and financial regulation. In a March 2014 working paper, Professor Scharfstein and his co-authors evaluated the FSOC’s money market reform proposals. The paper suggests that money market funds were a “source of considerable instability during the financial crisis of 2007 – 2009, resulting in extraordinary government support to help stabilize the funding of global financial institutions.” Assuming the main goal of proposed money market fund reform is to promote financial stability, the paper evaluates reforms to determine whether they would reduce risk-taking as well as reduce the possibility of runs. The paper finds that the capital buffers “could generate significant financial stability benefits.” While acknowledging that a floating NAV could have certain benefits, the paper finds that it “may not be sufficient to address instability associated with money market funds and global shadow banking.”
Kermit (“Kim”) Schoenholtz is a professor of management practice at the New York University Stern School of Business and directs the Stern Center for Global Economy and Business. He previously served as the chief economist for Citigroup. Professor Schoenholtz recently co-authored Market Tantrums and Monetary Policy, which studies fixed income fund flows and their interactions with price changes to study market “tantrums.” The paper explores whether market tantrums, where risk premiums in market interest rates experience extreme volatility, can be driven by non-bank market participants moving in and out of risky assets at the same time. The paper finds that these tantrums can take place in transactions that do not involve leverage or leveraged intermediaries. The paper concludes that “the absence of leverage may not be sufficient to ensure that monetary policy can disregard concerns for financial stability.” The paper finds that although the collapse of a credit bubble is more destabilizing to the economy and that unleveraged investors may not be too big to fail or may not risk failure, these channels should not be ignored when considering financial instability. Further, the paper questions whether the tools used to deal with leveraged intermediaries can be used to counteract the instability caused by non-leveraged investors. The authors do not share their view on whether the Federal Reserve’s stimulus policies were correct, but do conclude that “there is a genuine tradeoff: stimulus now is not a free lunch, and it comes with a potential for macroeconomic disruptions when the policy is lifted. “
Operational Issues and Resolvability
Andrew Metrick is the deputy dean and professor of financial and management at the Yale School of Management. In 2009 – 2010, he worked for the Council of Economic Advisors. In a 2010 paper, he found that “[t]he “shadow” banking system played a major role in the financial crisis, but was not a central focus of the recent Dodd-Frank Law and thus remains largely unregulated.” The paper describes three institutions of shadow banking and outlines legal and regulatory changes that allowed the institutions to grow significantly since 1980 – money market funds, asset securitization, and repurchase agreements. The paper discusses the difficulties each of these areas experienced during the financial crisis. The authors use “lessons from successful regulation of traditional banking to infer principles for the regulation of shadow banking.” With respect to money market funds, the paper agrees with the Group of Thirty proposal that money market funds be either regulated as “narrow savings banks with stable net asset values” or “conservative investment funds with floating net asset value and no guaranteed return.” Those money market funds opting to offer bank-like services coupled with a stable net asset value would be required to reorganize as “special purpose banks, with appropriate prudential regulation and supervision, government insurance, and access to central bank lender-of-last-resort facilities.”