In the wake of the 2008 financial crisis, regulators have kept close tabs on America’s largest banks, subjecting them to regular stress testing and imposing new rules meant to ensure their safety during periods of financial turmoil.
These new rules may have made the banking system safer, experts say, but they have also fueled the growth of a shadow financial system that is providing a growing share of financing for U.S. companies and taking on new, difficult-to-measure risks in the process.
“The riskiest loans are currently outside the banking system,” Christina Padgett, head of leveraged finance research at Moody’s Investors Service, told 江湖电竞最新版比赛(江湖电竞投注app网站).
Policymakers are taking notice. Securities and Exchange Commission Chairman Gary Gensler noted earlier this month that the private fund industry — including hedge funds, private equity and private credit funds — has grown by 150% since 2011, and that these funds’ strategies have “evolved in terms of business practices, complexity of fund structures, and investment strategies and exposures.”
These trends were the motivation behind a January rule proposal by the SEC and a joint proposal earlier this month with the Commodity Futures Trading Commission to expand the types of information private fund advisers must report to regulators and to increase the frequency of reporting through revision of the disclosure document called Form PF.
The Financial Stability Oversight Council — a body comprising the heads of the top U.S. financial regulators mandated with spotting systemic risks to the U.S. economy — also saw fit to point out the growing importance of private funds in its most recent annual report .
FSOC highlighted the rapid growth of private equity in particular, as the industry’s gross asset value rose to $8.3 trillion in the final quarter of 2021 — the most recent data available — up 118% over five years.
The regulator also expressed concern over concentration in the private equity industry and the growing trend of private equity managers extending credit to private companies, helping double the global market for private debt to $1 trillion between 2015 and 2020.
There are restrictions on a private credit arm lending to companies owned by a private equity arm of the same asset manager, according to Mark Wasden, Padgett’s colleague at Moody’s. But the concentrated nature of the private equity industry and the lack of regulator insight into these markets still gives cause for concern, he said.
“Our concern is that you find pockets of risk buildup that is outside the view of regulators and isn’t even observable by many market participants until it is too late,” Wasden said.
Treasury market trouble
Stress in the market for U.S. government debt is another reason why financial regulators say more data is needed on the activities of private funds.
In a February statement on the role of nonbank financial institutions on financial stability, FSOC said that hedge funds “materially contributed to the Treasury market disruption” in the COVID-driven market stress of March 2020.
FSOC said that hedge funds were major sellers of U.S. government debt
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“Private funds have become increasingly important in the Treasury markets,” Scott Farnin, legal counsel for the financial reform advocacy group Better Markets, told 江湖电竞最新版比赛(江湖电竞投注app网站). “In March of 2020 we saw Treasury markets seize up and a lot of the liquidity run dry,” and FSOC needs detailed and timely information on such events in order to monitor systemic risk effectively, he added.
SEC mission creep
The SEC and CFTC’s attempts to expand their surveillance of private funds has attracted the criticisms of not just the industry, but former and current regulators and outside observers.
The proposed changes to disclosure rules “are not related to the monitoring of systemic risk and the protection of investors, and are therefore inconsistent with the primary Congressional and agency intent for which Form PF was adopted,” wrote Jason Mulvihill, chief operating officer of the American Investment Council, a private equity and private credit trade group, in a March letter to the SEC.
The Milken Institute’s Michael Piwowar, former acting chairman of the SEC, said in an interview that following the passage of the Dodd-Frank Act the agency has been engaged in “mission creep” as it grapples with the growth of private markets that has been fueled in part by Dodd-Frank itself.
“There are some data items that they’re proposing to collect that would arguably be useful in their regulatory oversight role that aren’t really related to systemic risk,” he said.
Kelley Howes, who heads the investment management group at the law firm Morrison Foerster, said regulators “aren’t even trying to hide the ball” and state in their rule change proposals that the additional data will help with routine regulatory examination of investment advisers.
Another concern raised by SEC Commissioner Mark Uyeda is whether the information collected on private funds will remain confidential as required by law.
“The information collected on Form PF is proprietary and highly confidential in nature,” Uyeda, a Republican, said in a statement opposing the August proposal to amend private-fund disclosure rules.
“Inadvertent disclosure of such information could cause significant damage,” he added. “In addition, it is simply not possible for the many employees of the Commission, Office of Financial Research, and member agencies of the FSOC who have access to Form PF data to unlearn what they have seen when they leave federal employment and pursue positions in the private sector.”
Howes argued that many of the proposed rule changes would greatly increase compliance costs for funds, costs that will ultimately be borne by pension funds and other investors who purchase these products.
The new rules would require private funds to report within 24 hours certain “key events” like extraordinary investment losses and significant default and redemption events. Such rules would require funds to greatly expand their compliance departments in order to engage in “constant monitoring” to avoid running afoul of new regulations, Howes said.
The comment period has closed on the SEC’s January proposal. The public will have until Oct. 11 to comment on the joint SEC and CFTC proposal, after which the regulators will revise the rule proposal and vote on its implementation.
The enigmatic FSOC
Opponents of the new rule proposals also point out that it isn’t clear what FSOC is doing with the data it has already collected and how its efforts would be improved with more granular data.
When FSOC was created by the Dodd-Frank financial reform law, many imagined it would be a consequential institution, given its power to designate nonbank financial institutions as “systemically important” and therefore subject to strict oversight by the Federal Reserve.
FSOC did initially designate four such institutions as systemically important, but one company shrank itself to achieve de-designation and during the Trump administration the other three were also de-designated. President Joe Biden’s Treasury Department has not moved to reverse these changes.
“FSOC has not become the powerful regulator that people expected,” David Zaring, who teaches financial regulation at the Wharton School of the University of Pennsylvania, told 江湖电竞最新版比赛(江湖电竞投注app网站). “FSOC is supposed to be an information gatherer that identifies risk and somehow takes steps to accommodate it.”
But it’s unknown to the public whether FSOC is serving this role and whether the data it collects is worth the cost of collecting it. The COVID crisis, Zaring said, was attacked through close collaboration between the Federal Reserve and the Treasury Department, and FSOC’s role in that process is unclear.
Karen Petrou, co-founder of the banking advisory firm Federal Financial Analytics, Inc., said in an interview that the steady march toward greater surveillance of private funds is the inevitable outgrowth of regulations aimed at ensuring financial stability.
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Nevertheless, she is skeptical that FSOC will make effective use of the data it intends to collect on private funds.
“Regulators and FSOC have a very bad history of gathering data, which they do nothing until the data goes into the red zone,” she said. “At that point its usually too late.”
