The Treasury Department issued its third report on financial markets in which it addressed the regulation of asset managers and the insurance industry. The report is based on the Trump Administration’s "core principles" for financial regulation that were announced earlier this year via executive order. Previously, Treasury released reports on banks and credit unions and capital markets that deviated somewhat from proposals made in the Financial CHOICE Act. Likewise, Treasury’s asset manager and insurance report differs from the CHOICE Act and other bills in some respects.
Asset managers. The Treasury report makes a number of recommendations for the diverse asset management industry. The report notes that registered investment companies own 31 percent of U.S. equities and hold double-digit percentages of other asset classes, including U.S. and foreign corporate bonds, Treasury and agency bonds, and municipal securities. Money market mutual funds also provide important services regarding short-term non-financial instruments. (Treasury derived this data from the Investment Company Institute’s 2017 Fact Book—the ICI separately welcomed Treasury’s "several constructive recommendations"). Asset managers’ diversity extends beyond asset holdings to the array of federal regulators that oversee these firms. As a result, Treasury’s recommendations cover a wide range of matters, including the Department of Labor’s fiduciary standard and cybersecurity.
- Systemic risk—According to Treasury, prudential regulations are "unlikely" to help moderate risks posed by asset managers because of how asset managers differ from banks with respect to leverage, balance sheet risks, and maturity and liquidity transformation. The report recommends that federal regulators emphasize systemic risks from asset managers’ products and activities rather than focus on entity-based risks. The report also recommended that the Financial Stability Oversight Council, the agency charged with primary oversight of systemic risks, leverage work done by the SEC regarding the regulation of asset managers.
- Stress tests—The report noted that the SEC has not yet adopted a stress rule under the Dodd-Frank Act for asset managers. Treasury recommended that Congress repeal this requirement for asset managers. The report noted the problems identified by the SEC’s chief economist’s report regarding implementation issues that can arise from the structure of asset management firms. But Treasury also suggested an alternative approach under which the stress testing methods contained in rules for money market mutual funds and for liquidity risk management programs would be deemed to satisfy the "spirit" of the Dodd-Frank Act.
- Liquidity buckets—Although Treasury said it supports the SEC’s recent final rule mandating funds to develop liquidity management programs and imposing a 15 percent cap on funds’ holdings of illiquid assets, the report questioned the use of stringent liquidity buckets required by new Investment Company Act rules. The rules also impose new recordkeeping and reporting requirements, including new Form N-PORT. Instead, Treasury recommended that the SEC mull shifting from a prescriptive rule to a principles-based rule.
- Swing pricing—Treasury acknowledged the possibility that fund shareholders could achieve a first-mover advantage in times of liquidity stress, but the report questioned whether this possibility had been adequately documented with respect to registered investment companies, such as mutual funds. The SEC’s swing pricing final rule, adopted last fall and which becomes effective November 19, 2018, permits funds to adjust net asset value to more equitably apportion the costs of share purchases and redemptions to avoid shareholder dilution. But Treasury also said the rule may be difficult to implement because U.S. fund shares are typically sold through intermediaries such that it may be challenging to sync NAV adjustments to the arrival of data on purchases and redemptions from intermediaries. Treasury recommended additional evaluation of swing pricing.
- Derivatives—According to Treasury, the SEC should reconsider its 2015 proposal to clarify the use of derivatives by registered investment companies. The report observed that the SEC’s proposal was an attempt to collect nearly 30 no-action letters into one source of guidance, but Treasury questioned three aspects of the proposal: (1) imposition of portfolio limits may discourage hedging; (2) reliance on the gross notional amount as the foundational metric could obscure a fund’s true risk (Treasury cited a white paper published by staff in the SEC’s Division of Economic and Risk Analysis); and (3) restricting the types of assets that can be qualifying coverage assets may reduce fund returns. Treasury recommended the SEC mull requiring funds to have a derivatives risk management program and to include a segregation requirement. The SEC, however, should consider whether portfolio limits are needed and whether the proposed limits on qualifying coverage assets are warranted. Moreover, Treasury urged the SEC to mull data it will receive from reports on Form N-PORT as part of its final rule on fund liquidity before finalizing additional derivatives rules for funds.
- Exchange-traded funds—The Treasury report urged the SEC to either re-propose its 2008 rules for ETFs or to propose new rules with emphasis on "plain vanilla" rules for ETFs. Treasury said it was concerned that the existing no-action relief-based process is cumbersome and costly. The SEC’s proposal would have codified existing exemptive relief.
- SEC-CFTC dual registrants—First, Treasury recommended that the CFTC revise its rules to exempt SEC-registered investment companies and advisers from registration as commodity pool operators. The CFTC’s commodity pool operator (CPO) registration requirement for these firms was designed to avoid problems associated with the creation of de facto commodity pools. Treasury urged the SEC and the CFTC to identify a single regulator of currently dually-registered firms. Second, Treasury urged the CFTC to amend its rules to exempt private funds and advisers to these funds that are registered with the SEC from registration with the CFTC as CPOs. Third, Treasury said the SEC, the CFTC, and related self-regulatory organizations should seek to harmonize their separate reporting requirements.
- Cybersecurity—The report contains several mentions of cybersecurity. For one, Treasury recommended that the SEC withdraw a proposal to enhance business continuity planning at investment advisers because existing principles-based rules are sufficient; Treasury also said the SEC should continue to suggest improvements to business continuity plans to address new issues. Second, in a sidebar, Treasury cited reports issued by the GAO and the SEC’s EDGAR data breach as reasons for all agencies that keep volumes of electronic information from registrants to "redouble" their information security efforts. Third, with respect to insurance companies, Treasury recommended private-public sharing of threat information; the report also worried that the cyber insurance market lacks adequate data on risk (lawmakers have also considered the data issue) and that accumulation risk may be a problem (i.e., one event causes loss to multiple policyholders and insurance lines). Fourth, Treasury urged states to adopt the National Association of Insurance Commissioners’ Insurance Data Security Model Law; Treasury also said Congress should legislate data security requirements if states fail to adopt uniform rules under model law within five years.
- Volcker Rule—In previous reports, Treasury had shied away from outright repeal of the Volcker Rule, as would happen under the CHOICE Act, if enacted. Much as Treasury said in its first report on banks, the recommendations for asset managers in this context also focus more on tweaks than repeal. That prior report included recommendations about re-working the definition of "covered fund." FSOC has reviewed the Volcker Rule since the first Treasury report and federal banking regulators have issued what is essentially temporary no-action relief for some foreign funds. Treasury now recommends making this latter relief permanent pending a permanent fix. Treasury also recommends that bank regulators not enforce name-sharing rules applicable to certain funds. Moreover, Treasury called on Congress to re-define "banking entity" to include only insured depository institutions and related entities.
- Shadow banking—The largely unregulated shadow banking system that existed before the financial crisis received attention from the Treasury report in the context of international engagement. Specifically, Treasury recommended that regulators "transition away" from the term "shadow banking," which Treasury said the Financial Stability Board already notes in many of its documents should not be used in a "pejorative" sense; Treasury said the term can imply lack of regulatory oversight or poor industry disclosure practices. Otherwise, Treasury urged U.S. regulators to take leading roles at the FSB and IOSCO, with additional emphasis on re-working the framework for global systemically important financial institutions in order to shape the rules to account for differences among firms, such as asset managers.
- Fiduciary standard—The Treasury report makes a number of recommendations about the Department of Labor’s fiduciary rule: (1) Treasury backs the DOL’s re-examination of its fiduciary rule and recent extensions of the compliance date; (2) Treasury supports conflict of interest rules that preserve investor choice while not disrupting markets or limiting access to financial services; (3) Treasury supports the SEC and DOL working together to resolve issues related to IRA and non-IRA accounts; and (4) Treasury urged the SEC and the DOL to work with state insurance regulators to ensure the viability of annuities markets. Despite having provided some technical support to the DOL, the SEC has not yet proposed its own version of a fiduciary standard. SEC-related legislative proposals have tended to emphasize the SEC’s primacy over the DOL. Moreover, some bills in the current Congress would impose a best interest standard. For example, the Protecting Advice for Small Savers (PASS) Act of 2017 (H.R. 3857), sponsored by Ann Wagner (R-Mo), would repeal the DOL’s fiduciary rule and instead revise Exchange Act Section 15 to provide that a broker-dealer must make recommendations in the best interests of their retail customers. "Recommendation" is defined with reference to FINRA Rule 2111, which speaks of "suitability"; the bill was reported out of the House Financial Services Committee by a vote of 34-26.
Insurance industry. The report also examined the insurance industry and related banking matters. Overall, Treasury noted that the Great Recession had many causes and insurance industry solvency issues and failures were "relatively limited." Still, the government assistance provided to American International Group influenced the creation of Dodd-Frank Act Title V’s insurance reforms, including the creation of the Federal Insurance Office. The report addresses a range of insurance topics, but the following selected topics are of significance to securities practitioners.
- Federal Insurance Office—Treasury proposed to reorganize the Federal Insurance Office (FIO) around five pillars: (1) promote state-based regulatory system; (2) offer expertise to regulators and industry via published analyses; (3) take the lead in coordinating federal-state insurance issues; (4) advise the Treasury Secretary and FSOC on insurance matters; and (5) promote access to insurance products, including administration of the Terrorism Risk Insurance Program. By contrast, the CHOICE Act (Section 1101) would repeal the FIO and replace it with a new Office of the Independent Insurance Advocate, which would be a bureau within Treasury.
- Insurer savings and loan holding companies—The Fed already imposes significant reporting requirements on insurer savings and loan holding companies (ISLHCs). Treasury recommended that the Fed make use of information gathered by state regulators and the NAIC to better harmonize the disparate requirements for ISLHCs. The report also urged the Fed to mull whether existing rules are appropriately tailored based on the scope of business conducted by ISLHCs.
- Consumer Financial Protection Bureau—Treasury observed that the Consumer Financial Protection Bureau (CFPB) has limited duties regarding insurance. But the report recommended that lawmakers act to ensure that the CFPB does not duplicate state regulatory activities.
- Application of HUD rule to insurance—Treasury expressed concern that a rule proposed by the Department of Housing and Urban Development under the Fair Housing Act could require insurers to gather data in violation of state laws. The proposal would apply the "disparate impact" definition of "discriminatory effect" to the insurance industry. Treasury urged HUD to reconsider the proposal.
- SEC insurance role—The report recommended that the SEC propose rules to implement a variable annuity summary prospectus. Treasury cited a report published by the SEC’s Investor Advocate urging Commission action. "Other promising ideas, such as a summary prospectus for variable annuities, have been around for a long time and appear noncontroversial, but they languish behind other rulemaking priorities," said Investor Advocate Rick Fleming.
- Lifetime savings—The Treasury report addressed issues that may impede workers’ accumulation of lifetime retirement income. Specifically, the report cited workers’ lack of preparedness for the possibility that they may outlive assets accumulated while employed (i.e., longevity risk). Part of this problem arises from the distinct features of 401(k) plans (asset accumulation) and pensions (guaranteed income). Another issue is the potential for legal liability if employers offer in-plan annuities. The report recommended that Treasury and DOL develop a plan to certify "independent fiduciary entities" to evaluate the health of annuity providers with an eye to providing ratings that may offer a safe harbor for ERISA plan sponsors regarding annuities.
Companies: Investment Company Institute; National Association of Insurance Commissioners
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