Fund Firms Brace For Regulatory Heat

Asset management companies can anticipate regulatory focus to intensify as implementation of the Dodd-Frank Wall Street Reform Act progresses -and not just from the Securities and Exchange Commission.

The Federal Reserve, which will ultimately determine which asset managers should be considered "systemically important financial institutions," has gained broad new authority over the industry, including the ability to examine companies regardless of whether they are designated as systemically important. Washington, D.C.-based Promontory Financial Group's global asset management team monitors regulatory developments closely and advises investment managers on impending changes. Money Management Executive recently spoke with Promontory managing directors David Thelander and Amy Friend about the future of asset management regulation.

What new demands are being placed on asset managers as a result of Dodd-Frank?

Thelander: Dodd-Frank really upped the ante for asset management companies in terms of governance, compliance and risk management oversight efforts. Not only do asset managers have to answer to their traditional regulators such as the SEC-they may now also face significant oversight from the Fed, which has much greater authority to examine asset management affiliates of banks under Dodd-Frank. And the asset manager doesn't necessarily have to be affiliated with a bank or other financial institution to be subject to Fed oversight. In fact, that's going to be one of the most immediately noticeable changes for bank-affiliated asset managers-examinations will require a more holistic risk-based approach to compliance, versus what used to be a more cursory examination of the basic workings of a compliance program.

The SEC's current focus on shock-proofing money market mutual funds is one of the most visible efforts to tighten regulation. The SEC is also placing unprecedented emphasis on examinations and is beefing up its "Risk Fin" group.

The Financial Stability Oversight Council's authority under Dodd-Frank to determine which companies will be designated as SIFIs has received significant attention, but there has been less focus on the Federal Reserve Board's new powers to examine non-bank asset managers. Hand-in-hand with the FSOC's responsibility for designating SIFIs, the Fed gained the authority to conduct "pre-designation" reviews, which means it can examine asset managers where the FSOC sees a need to determine whether the company poses a threat to financial stability and should be designated. Conducting those exams gives the Fed a great deal of latitude to sniff around any aspect of a company's business activities, risk management, or compliance program if they see a need. For example, the FSOC and Fed may well use this power in relation to money market mutual funds if the SEC does not take further action.

One other new player to note is the Office of Financial Research, a new office within the Treasury Department, that can-in consultation with the FSOC or at the FSOC's direction-collect data from any financial institution, to assess emerging threats to financial stability. Before the Fed can conduct any type of pre-designation review of a non-bank asset manager, the OFR may require the company to submit periodic and other reports.

What is fundamentally different about the new regulatory regime that is taking shape for asset management companies?

Friend: What's at play here is very much the result of a philosophical shift in the government's approach to the regulation of funds and the protection of investors. The SEC has traditionally gravitated toward the use of enforcement actions to achieve their objectives, but Dodd-Frank brings an emphasis on prudential supervisory reviews. That's going to bring scrutiny to a host of previously untouched areas, such as governance structures, management quality, and capital adequacy. Bank-like regulation is new to the majority of asset managers, and they are going to have to adjust their mindsets to get accustomed to the way the Fed approaches oversight.

What can asset management firms do to get ready for increasing regulatory scrutiny?

Thelander: The most critical first step is to take a fresh look at enterprise-wide risk-management, compliance, and governance systems and start benchmarking them against industry best practices and emerging regulatory requirements. They also need to put in place processes for identifying, tracking and resolving regulatory issues. And they are well advised to begin training employees to understand the importance of dealing with regulators and how to interact with any new regulators such as the Fed.

Friend: Banking-style supervision is going to feel more intrusive than the enforcement-oriented regime they're accustomed to. It will no longer be sufficient just to be in compliance-increasingly, asset managers will need to be able to articulate why their compliance programs provide management and boards with sufficient assurance that the firm is in compliance. They're going to have to be ready to respond to exam findings and remedy any issues quickly.

Promontory has a well-established reputation in the banking space, but what are your capabilities in asset management?

Thelander: Lots of people know our founder, Gene Ludwig, from his tenure heading the Office of the Comptroller of the Currency. Among other things, Gene was instrumental in creating the regulatory framework for supervising bank sales of mutual funds. But we also have many senior staff with significant asset management experience such as former SEC Commissioner Laura Unger and Pierre de Saint Phalle, who for many years headed the investment management group at Davis Polk & Wardwell, and has served as a mutual fund director. For my part, I have been both an SEC attorney and chief counsel with several major mutual fund companies.