SEC Enhancing Regulatory Monitoring of Asset Managers

Increased focus on portfolio composition, operational risks

by Ron D’Vari, CEO, & James Frischling, President, NewOak

NewOak is an independent financial services advisory firm built for today’s global markets. Led by a team of experienced market and legal practitioners, NewOak provides a broad range of services across multiple asset classes, complex securities and structured products for banks, insurers, asset managers, law firms and regulators, including financial advisory and dispute resolution, valuation, credit and compliance, risk management, stress testing, model validation and financial technology solutions. We have analyzed or advised on more than $4.5 trillion in assets to date. Visit

The asset management industry is evolving rapidly and so are the regulatory environment and tools that govern and support it. The larger managers had thought they had received a reprieve by the Financial Stability Oversight Council’s decision not to designate individual asset management firms as Systemically Important Financial Institutions (SIFIs), but instead focusing its attention on potential risks within asset managers’ activities and products they offer.

As a result, the giant asset managers are spared from Federal Reserve. In an apparent response to that, the SEC is increasing focus on the asset management industry. In a speech on December 11, SEC Chair Mary Jo White referenced new initiatives to address portfolio composition risks and operational risks of asset managers. Portfolio composition risks include liquidity and leverage risks of a fund’s holdings and operational risks encompassing inadequate or failed internal processes and systems.

The heightened SEC monitoring will include expanded data reporting and enhanced controls on risks related to portfolio composition and liquidity management. A more comprehensive approach will be taken to monitor the risks associated with the increasingly complex nature of fund holdings and the use of derivatives. Additionally, the SEC will be looking into “transition planning” and stress testing, both market and operationally. Asset managers will be expected to safeguard against the impact on investors of a market stress event or when an investment adviser is no longer able to serve its clients.

There has been a significant increase in the use of derivatives by funds in general. More and more, fund managers are using derivatives to adjust or obtain exposure to a market sector more efficiently. However, the risks of implied leveraged exposures and potential illiquidity in derivative instruments can be opaque or underestimated.

...the risks of implied leveraged exposures and potential illiquidity in derivative instruments can be opaque or underestimated

As a result, management of liquidity and redemption and the use of derivatives in widely distributed mutual funds, ETFs and separately managed accounts are becoming key areas of focus by the SEC. The SEC staff will be watching for significant risks of inadequate controls in those areas, to the funds and their investors, as well as potential impact on the overall financial system. Asset managers will be required to manage risks of not being able to meet redemptions under stressful market scenarios.

This means that not only the giant managers have to meet enhanced composition and liquidity regulatory requirements; the entire asset management industry needs to.

If banks won’t lend, who will?

The banks won’t lend. That’s the lament from many quarters and on the short list of reasons for the sluggish U.S. economic recovery. Small businesses and the general public continue to find the banking community more willing to lend to troubled and levered companies than the very taxpayers that bailed them out during the financial crisis. The audacity! The nerve! This is wrong! This is unfair! Wait a second, this makes complete sense.

The largest banks have shied away from a number of consumer-oriented markets, including the mother of all consumer markets: the private-label residential mortgage market. The banks have also reduced their presence in the business of small-balance lending. Their departure from certain asset classes has resulted in the proliferation of non-bank lenders, which take on many forms. The boom in the business of peer-to-peer lending has certainly been the beneficiary of the banks apparent lack of interest in small-balance lending, and the myriad of non-qualified mortgage players also indicates that when there’s demand for capital, business will find it.

So why aren’t the banks interested in areas of the market that non-regulated players find so appealing? The answer is because that’s what was supposed to happen as a consequence of the financial crisis. Regulated financial institutions and deposit-takers took on risks that, when they went wrong, contributed to putting the financial system at risk. A historic government bailout, a massive regulatory overhaul and a massive tidal wave of financial litigation has been the response to the Great Recession. Is there any wonder why banks are reluctant to lend?

For those looking for banks to spur more economic activity, there’s light at the end of the tunnel. The search for yield and the need to deliver returns for shareholders is of paramount importance. Borrowers will seek capital and capital will seek those who need it. The source and cost of capital will fluctuate from time-to-time, but, in the end, the capital will be there.