The SIFI search: Some dangerous misconceptions about mutual funds

Transcription

1 The SIFI search: Some dangerous misconceptions about mutual funds Vanguard Commentary April 2014 Research conducted for the Financial Stability Oversight Council concludes that mutual funds and the management companies that provide services to them could be systemically important financial institutions (SIFIs). SIFIs are subject to bank-like prudential regulation and supervision by the Federal Reserve Board. We believe this conclusion is false. We review the structure of mutual funds and the statute that governs them to demonstrate that mutual funds and their managers lack the mechanisms to transmit risks to the broad financial system. The actions of mutual funds and mutual fund investors through a variety of isolated and systemic crises substantiate this claim. Designation as a SIFI would mark a destabilizing paradigm shift in the regulatory model that has governed the mutual fund industry for nearly 75 years. The application of bank-like regulation to mutual funds would do nothing to limit systemic risk, but it would threaten to disrupt the capital markets and drive up the cost of investing for millions of Americans who use mutual funds to invest for retirement, college, and other long-term goals.

2 Since the financial crisis, regulators have grappled with the challenge of identifying companies and activities that pose risks to the broad financial system. The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 established the Financial Stability Oversight Council (FSOC), which has authority to designate systemically important nonbank financial institutions, or SIFIs. 1 SIFIs are subject to bank-like prudential regulation and supervision by the Federal Reserve Board. As FSOC has begun to exercise this authority, we ve become concerned that the related concepts of systemic importance and systemic risk lack the specificity and precision to serve as a basis for regulation. A troubling example of the broad and ambiguous application of these concepts is a September 2013 report, Asset Management and Financial Stability, produced by the Office of Financial Research (OFR), which supports FSOC. The report concludes that mutual fund redemptions and the activities of mutual fund managers can introduce vulnerabilities that pose, amplify, or transmit threats to financial stability. 2 In a comment letter to the Securities and Exchange Commission about this report, 3 we dispute these findings. We review the report s significant shortcomings, including incomplete or misstated facts, generalizations lacking empirical support, and omissions about existing regulatory safeguards. 4 Our detailed comments reflect a broader observation: A regulatory regime designed for highly leveraged and interconnected institutions such as banks is inappropriate, even unworkable, for unleveraged mutual funds and the management companies that provide services to them. Such a regulatory mismatch would do nothing to enhance the stability of the financial system, but it would threaten to disrupt the capital markets and drive up the cost of investing for millions of Americans who use mutual funds to invest for retirement, college, and other long-term goals. In this paper, we attempt to refocus the regulatory discussion on institutions that may pose risk to the financial system. We address three important issues. First, we distinguish between systemic risk and idiosyncratic risk, two concepts that have been conflated in the regulatory discussion. Second, we demonstrate that the structure of mutual funds and the regulations that govern the mutual fund industry limit their ability to transmit risk across the financial system. Third, we examine mutual fund redemptions, an activity that has emerged as a source of regulatory concern and confusion. We emphasize that our focus is on mutual funds 5 not investment banks, 6 separately managed accounts, or hedge funds. 7 There are material differences between the regulatory framework and investment profile of mutual funds and their registered investment advisors and those of other investment pools and their managers. Nor do we focus on money market mutual funds. In 2010, the SEC adopted significant changes to the rules governing money market mutual funds. In 2013, the SEC proposed significant additional changes that would fundamentally alter the way institutional money market mutual funds, the source of money market problems in the financial crisis, price their shares. These reforms are intended to reduce the likelihood that investors would redeem their shares in a disruptive manner in the future. The SEC is expected to adopt additional changes later this year. 1 Vanguard s views on Section 113 of the Dodd Frank Act and Advanced Notice of Proposed Rulemaking Regarding Authority to Require Supervision and Regulation of Certain Nonbank Financial Companies can be found in Vanguard s comment letters to the FSOC dated November 5, 2010; February 25, 2011; and December 19, The OFR Report, at 1. 3 Although neither the FSOC nor the Treasury Department solicited public comment on the OFR Report, the SEC did. See Public Feedback on OFR Study on Asset Management Issues, SEC press release (Sept. 30, 2013). 4 Vanguard s comment letter to the SEC, dated November 26, 2013, can be found at 5 As used in this paper, the term mutual fund refers to an investment company, including an exchange-traded fund, registered with the SEC and classified as an open-end management investment company or unit investment trust ( UIT ) pursuant to Sections 4 and 5 of the Investment Company Act of As used here, the term does not include other types of registered investment companies, including closed-end funds and business development companies, although this omission should not be interpreted to mean that Vanguard believes such investment companies potentially pose more systemic risk than open-end management investment companies and UITs. We express no opinion on that topic. 6 For example, Bear Stearns was a global investment bank, engaged primarily in capital markets activities such as underwriting, trading, wealth management, and clearing services. 7 A hedge fund is a pooled investment vehicle, typically available only to qualified buyers, that is not regulated under the Investment Company Act of

3 What is systemic risk? The OFR report, and the debate about SIFIs more generally, fails to make an important distinction between systemic risk FSOC s focus and idiosyncratic risk a risk that has minimal impact on the broader financial system. An idiosyncratic risk is an event that affects a limited number of entities. 8 Investment losses or significant redemptions in a single mutual fund, in all the funds managed by a single mutual fund manager, or in a number of funds with a similar investment objective are examples of idiosyncratic risk. The consequences are largely confined to a single fund, a single mutual fund manager, or asset class. A systemic risk is one so grave that, if left unattended, its consequences would require government intervention and potentially taxpayer dollars to rescue the private enterprises exposed to such risk. It begins in one institution and is then transmitted, typically in arrangements involving leverage, across the financial system to other institutions, impairing financing throughout the economy, and posing an excessive threat to financial stability. As noted by former Federal Reserve Board Chairman Ben Bernanke, a systemic risk is not that which affects just one or two institutions. 9 The sources of systemic risk The history of financial panics, including the financial crisis, demonstrates that systemic risks typically originate in entities that possess at least one of two characteristics: Significant leverage and interconnections with other systemically important companies through such leverage. A significant mismatch between the terms, or maturities, of assets and liabilities. These characteristics act as mechanisms that can transmit financial distress from one institution to others and, potentially, to the financial system as a whole. Non-U.S. risk-limiting regulatory regimes We note that concerns over asset managers and systemic risk are not confined to the United States. In January 2014, the Financial Stability Board of the G released a consultative document entitled Assessment Methodologies for Identifying Non-Bank Non-Insurer Global Systemically Important Financial Institutions, 11 in which it proposes a highlevel framework and specific methodologies for identifying global systemically important financial institutions.the document is advisory only, with no binding legal authority. Although discussion of the document is beyond the scope of this paper, we recognize that the effects of systemic risk can be global in nature. At the same time, it is important to emphasize that in most jurisdictions regulated collective investments such as mutual funds are subject to risk-limiting restrictions. Typically, these regulatory regimes include risk-limiting provisions such as restrictions on leverage, daily mark-tomarket valuation, and disclosure requirements. In fact, many of these regulatory regimes are modeled after the Investment Company Act of 1940, as the U.S. fund industry is perhaps the most mature. Leverage and interconnectedness Leverage and interconnectedness can transmit risk across the financial system by compelling forced sales. If an institution is unable to meet margin or capital calls (money due on derivatives or other financial obligations, such as liquidity commitments), it may be forced to sell assets at dislocated prices. These sales can potentially lead to broad asset price declines, causing more institutions to face margin or capital calls. 8 See also The Federal Register, Vol. 77, No. 169, August 30, Idiosyncratic risk arises from changes in risk factors unique to that position. 9 Former Fed Chairman Ben Bernanke defined systemic risk as developments that threaten the stability of the financial system as a whole and consequently the broader economy, not just that of one or two institutions. Ben Bernanke, letter, addressed to Senator Bob Corker, October 30, The G-20 refers to a forum for international economic cooperation and decision-making made up of 19 countries and the European Union. 11 See Assessment Methodologies for Identifying Non-Bank Non-Insurer Global Systemically Important Financial Institutions, released by the Financial Stability Board on January 8,

4 If these institutions must in turn sell assets to raise funds, they can accelerate a downward spiral in asset prices that puts other leveraged institutions at risk. In many cases, systemic risk requires government intervention to break the cycle of forced sales and asset price declines. As former Federal Reserve Board Chairman Alan Greenspan explains in The Map and the Territory, leverage can transform a risk that harms a single group of investors into a threat to the financial system: It was not subprime mortgages alone that caused the crisis. Subprimes were indeed the toxic asset, but if they had been held by mutual funds or in 401(k)s, we would not have seen the serial contagion we did. It is not the security that is critical, but the degree of leverage of the holders of the asset. 12 Asset-liability mismatch In an asset-liability mismatch, an institution s long-term assets (such as home mortgage loans to customers) are funded with short-term liabilities (such as demand deposits). If the institution experiences a sudden, largescale withdrawal of other funding sources (a loss of access to the commercial paper market, for example), it can experience a run on the bank. In this scenario, depositors fear the institution s failure and race to withdraw their funds before other depositors. The institution s mortgage loans and other assets, meanwhile, can t generate enough cash fast enough to redeem the deposits. The result of this mismatch can be default and, depending on the institution s degree of interconnectedness, the transmission of stress across the financial system. Vanguard believes that designation as a SIFI should be reserved for institutions that are highly leveraged and linked to other leveraged institutions and/or subject to a significant asset-liability mismatch. These mechanisms can transform an event at a single institution into a threat to the financial system. Mutual fund regulation mitigates systemic risk As policymakers consider regulatory approaches that can safeguard the financial system, the Investment Company Act of 1940 ( 40 Act) can serve as a model of effectiveness. The 40 Act, which has governed the mutual fund industry for nearly 75 years, is a distinguished example of regulation appropriate to the activities of the regulated. The 40 Act severely limits the ability of mutual funds and their managers to engage in activities that could transform an idiosyncratic risk such as investment losses or the bankruptcy of a fund manager into a risk that threatens the financial system. Limits on leverage The 40 Act restricts the ability of mutual funds to engage in leveraged transactions short sales, the purchase of securities on margin, derivative transactions unless those transactions are covered by liquid assets or offsetting transactions. 13 Figure 1 compares the leverage of a representative U.S. bank and a U.S. mutual fund, as measured by their assets/equity ratio. The bank holds about $11 in potentially risky assets for every $1 in shareholder s equity. The mutual fund, by contrast, has almost no leverage, about $1 in assets for every $1 in equity. Stringent liquidity requirements Mutual funds must hold at least 85% of their assets in liquid securities, securities that can be sold within seven days at a market price. By contrast, a bank s assets such as mortgage loans are mostly illiquid. Daily mark-to-market valuation of fund assets Equity and bond mutual funds must value their assets on a daily basis based on market values. If market values are not readily available, a fund s board of trustees must ensure that the fund has a disciplined, accurate process for determining a security s fair value. 12 Greenspan, Alan, The Map and the Territory: Risk, Human Nature, and the Future of Forecasting. New York, N.Y.: Penguin Press. Quotation is from an edited excerpt, available at: 13 Funds are permitted to enter into leveraged transactions provided they maintain a continuous asset coverage ratio of at least 300% during the term of the transaction. The SEC does not require daily calculated 300% asset coverage in respect of a transaction if the fund (a) covers its exposure by entering into an offsetting transaction, or (b) segregates liquid assets equal in value to a fund s obligation under the transaction. The value of segregated assets is marked to market on a daily basis. 4

5 Figure 1. Leverage of a bank and a mutual fund $2.5 $165 $ Trillions $2.42 $2.20 Bank Assets/equity: ~11.44x Billions $ $ S&P 500 Index Fund Assets/equity: ~1.01x $ Total assets Total liabilities Total shareholders equity Note: Bank is JPMorgan ( K); mutual fund is Vanguard S&P 500 Index Fund (2013 annual report). The asset, liability, and equity figures reflect rounding to two decimal places. The ratio is calculated before rounding. Daily valuation minimizes any incentive for one shareholder to redeem before any other shareholder as in a proverbial run on the bank. In the banking sector, by contrast, uncertainty about opaque and infrequently valued assets such as long-term real estate loans can set the stage for a run by depositors. Legal separation between mutual funds and their managers Mutual funds and mutual fund management companies are separate legal entities. Losses or liabilities incurred by one fund are not the responsibility of other funds overseen by the same manager. The 40 Act includes strong and detailed prohibitions on transactions between a mutual fund and its management firm. If a mutual fund manager went bankrupt, the fund manager would have no access to fund assets or the assets of other funds managed by the same advisor. The board of trustees of a fund overseen by that manager would simply hire another advisor to manage the fund. In 2004, when Strong Financial, a mutual fund advisory firm, withered in a trading scandal, the funds boards of trustees hired Wells Fargo to manage the Strong Funds. 14 As with any change in advisor, the transition required no financial support from the government and, ultimately, taxpayers. When a bank collapses, by contrast, the government must pick up the pieces, either through governmentsponsored deposit insurance or, in the case of the financial crisis, taxpayer funds. Separate custodians for fund assets Every mutual fund must maintain its assets with a qualified custodian, typically a U.S. bank. The 40 Act requires the custodian to physically segregate the fund s assets from other assets held at the bank. If the custodian bank went bankrupt, the bank s creditors would have no recourse to the fund securities held in custody. Why focus on funds? A confusion of agent and principal These risk-limiting provisions make mutual funds very different from banks and bank-like institutions. These statutory provisions have been tested over nearly 75 years. They ve been highly effective. And they re widely known. In fact, in its report on asset managers, the OFR acknowledges and makes specific reference to these provisions. 15 Why, then, has this robust regulatory framework seemed to count for little in the debate about which institutions might be systemically important? One possibility is that the concept of an agent, a concept that is central to the mutual fund industry, is inapplicable to the risk-taking 14 Diamond, Randy, One-time powerhouse Strong Financial down to a staff of 1, available at: 15 References to the Investment Company Act of 1940 appear throughout the OFR report. 5

6 Money market mutual funds are distinct from other mutual funds 16 Money market mutual funds are investment vehicles that commonly price their shares at $1 and provide daily liquidity for investors cash management needs. These funds invest in highly liquid, short-term government bonds and instruments issued by financial institutions of high credit quality, as determined by a credit ratings agency. These characteristics of money market mutual funds distinguish them from equity and bond mutual funds. Regulators have recognized those differences in formulating rules specific to money market mutual funds. Money market mutual funds are neither FDIC-insured nor insured by their mutual fund advisors. During the financial crisis, one institutional money market mutual fund had exposure to commercial paper issued by Lehman Brothers, which caused the fund s investors to suffer a loss of 1 cent per share when Lehman filed for bankruptcy. Institutional prime money market funds experienced high levels of stress as shareholders redeemed their fund shares at alarming rates. As a result of this experience, in 2010 the SEC instituted regulatory changes for money market mutual funds that significantly bolstered all money market funds ability to withstand significant shareholder redemptions. The reforms include daily and weekly liquidity minimums, portfolio maturity limitations, enhanced disclosure of portfolio holdings, and stress testing. 17 The SEC is expected to adopt additional regulatory changes in the way many money market mutual funds may price their shares and/or may limit shareholder redemption when a fund has limited liquidity reserves. Those regulatory changes are expected to further mitigate the risks associated with redemptions from institutional money market funds. activities of the banking sector and thus unfamiliar to regulatory bodies attuned to the risks of investors acting as principals, rather than as agents for their clients. If a bank holds $100 billion in assets, $100 billion in assets sits on the bank s balance sheet. The bank manages those assets as a principal, seeking to maximize the return on its shareholders investment (equity) in the enterprise. If those assets produce a profit, those profits accrue to the bank s public or private shareholders. If the value of those assets deteriorates, the decline reverberates through the bank s balance sheet, eroding the value of its equity. If the losses are large enough to wipe out the shareholders equity, the bank can pose a risk to the financial system. This is the world of the Federal Reserve and other bank regulators. The mutual fund industry is different. Mutual fund management companies act as agents to the funds. They provide management services to the funds in a fiduciary capacity, obligated to act in the mutual fund shareholders best interest. If a mutual fund manager oversees $100 billion in assets, that $100 billion never appears on the manager s balance sheet. The manager simply provides a service to the mutual fund shareholders who own their proportionate share of that $100 billion in assets. If the fund produces gains, those gains belong to the fund shareholders. If the fund produces losses, those losses belong to the fund shareholders. And with $1 of capital for each $1 of assets, a mutual fund can absorb significant in effect, complete losses and still remain solvent. The profits and losses experienced by fund shareholders have no direct impact on the mutual fund manager s financial stability. Idiosyncratic risks have remained contained Our exposition of the mutual fund structure and the regulatory regime that governs the mutual fund industry has thus far operated in the realm of logic and abstraction. Is there any evidence suggesting that these risk-limiting provisions have in fact limited risk to the financial system? Yes. Like any economic actor, mutual funds and fund management firms can experience significant losses and financial stress, perhaps leading to significant shareholder redemptions. Because of the mutual fund 16 These comments focus solely on U.S. money market mutual funds, not non-us domiciled money market mutual funds. 17 See 17 CFR Parts 270 and 274; SEC Release No. IC-29132, Money Market Fund Reform. The applicable rule governing money market mutual funds is rule 2a-7 under the Investment Company Act of See also Vanguard Comment Letter to the Securities Exchange Commission, dated January 10,

7 Figure 2. Long-term net cash flow of asset manager versus industry $ $215.9 $209.8 $192.0 Billions $129.1 $ $ $ $ $ $19.21 Industry Asset manager Note: Asset manager is Putnam Investments. Data does not include money market funds. Source: Vanguard calculations based on Morningstar data. industry s structure and regulation, however, these risks have remained idiosyncratic, posing no greater threat to the broad financial system. In late 2003, for example, federal and state securities regulators filed civil fraud charges against one of the largest mutual fund companies. 18 The company s portfolio managers had market-timed its mutual funds, a breach of their fiduciary duty that diluted the returns of the mutual fund shareholders. 19 Although investors responded to the news with significant redemptions of their mutual fund shares, this idiosyncratic risk failed to produce a systemic wave of redemptions across the mutual fund industry, as demonstrated in Figure And we ve found no evidence that the activity led to broad declines in asset prices. From October 2003 through December 2003, in fact, the stock market rallied. Bond prices held steady. Nor was there evidence of systemic risk arising from that mutual fund manager s decline in reputation, even though the manager was a prominent name in the mutual fund industry, with more than $100 billion in assets under management, according to Morningstar. The mutual fund shareholders redeemed their fund shares and presumably moved their investments to other mutual funds. The idiosyncratic risks remained contained, harming the firm s mutual fund shareholders and the management company, but posing no threat to the financial system. The example is illustrative, but not surprising. Unlike banks and highly leveraged institutions, mutual funds and their managers have no way to amplify an idiosyncratic risk into a threat to the broader financial system. The myth of a run on funds This example counters another premise that has confused the debate about SIFIs: that there can be a destabilizing run on a fund, analogous to a run on the bank. 21 A bank makes a guarantee that it will return the depositor s money in full, plus any accrued interest, upon demand. Deposits are thus short-term liabilities. Bank assets such as mortgage loans, by contrast, generate returns and provide the bank with cash over decades. This significant asset-liability mismatch can 18 McCabe, Patrick E., The Economics of the Mutual Fund Trading Scandal, Finance and Economics Discussion Series Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, Washington, D.C., , at Ibid. p. 8, citing Professor Peter Tufano s analysis of the full cost of the Putnam trading scandal. 20 From October 28 to November 7, 2003, almost $6 billion was withdrawn from Putnam by public pension investors. Withdrawals from Putnam Set Heavy Pace, The New York Times, November 7, 2003, available at 21 This premise is examined on pages 12 and 13 of the OFR report. 7

8 Figure 3. No evidence of a run on stock funds Net flows to stock mutual funds as percentage of stock fund assets 6% Source: Investment Company Institute. Monthly net flows as a percentage of stock fund assets at the start of the month. create systemic risk. If a large number of depositors demand the return of funds that are invested in relatively illiquid long-term assets, the bank can default. This risk is the motivation for two key features of bank regulation: The requirement that banks hold capital to create a cushion between their assets and liabilities so that depositors can be repaid; Government deposit insurance through the Federal Deposit Insurance Corporation (FDIC) and access to the Federal Reserve s discount window and other sources of liquidity in the Federal Reserve System. These provisions were put in place to ensure financial stability. FDIC deposit insurance and access to liquidity are important protections for the U.S. banking system. Since 1934, more than 4,000 banks have required FDIC assistance, and more than 3,400 have failed, or become insolvent. 22 A run on a fund is impossible for structural reasons. Fund assets are financed entirely with shareholder capital. A mutual fund satisfies redemptions from the assets of the fund itself. And because stock and bond mutual funds use daily mark-to-market valuation, accelerated redemption of fund shares offers no advantage to an investor. Redemptions are satisfied at the current markto-market valuation. To quote former Federal Reserve Board Chairman Ben Bernanke, equity mutual funds are not runnable. 23 Is it possible that, in the event of an unprecedented financial crisis, mutual fund investors could redeem their shares en masse, placing destabilizing pressure on the capital markets? Although the OFR report speculates about the possibility of mass redemptions, the prosaic reality is that such a run has never materialized, even during the most alarming episodes of financial market distress. Mutual funds are owned by tens of millions of individual investors, each with their own time horizons, risk preferences, and investment goals. Figure 3 shows historical redemptions from equity mutual funds as a percentage of mutual fund assets. Even in periods of profound financial stress, this diverse group of investors has shown no tendency to act in unison. For example, during October 1987, when the S&P 500 Index returned 21.5%, stock fund investors made net redemptions totaling about 3% of stock fund assets. From October 31, 2007, to February 27, 2009, the S&P 500 Index returned 50.9%, the worst stock market decline since the Great Depression. Over this same period, investors redeemed a net $281 billion from equity mutual funds, just 4.1% of equity assets at the start of the period. Bond fund activity tells a similar story. From February 1994 to February 1995, the Fed raised its target for short-term interest rates by a full 3 percentage points. Bond prices 22 Source: Federal Deposit Insurance Corporation. 23 Bernanke, Ben, 2014 AEA Annual Meeting Webcasts of Selected Sessions, January 3-5,

9 Figure 4. No evidence of a run on bond funds Net cash flow as a percentage of bond fund assets Net cash flow as a percentage of assets 2.5% % Total return Net cash flow (LHS) Total bond return (RHS) Source: Investment Company Institute, Citigroup. Net new cash flow to bond funds plotted as a 3-month moving average of the share of net new cash flow in previous-month assets. Data exclude flows to high-yield bond funds. Total return is year-over-year change in the Citigroup Broad Investment Grade Bond Index. declined, as yields marched higher. Over the 12 months, the Citigroup Broad Investment Grade Bond Index returned 2.2%, a jarring break with the previous ten years, when the index had produced an average annual return of 11.8%. As Figure 4 indicates, bond fund shareholders made steady redemptions. From February 1994 to February 1995, net redemptions amounted to 11.3% of bond fund assets at the start of the period. That s a notable figure, but hardly a mass exodus. The data from are consistent with previous experience: a relatively subdued response by bond fund shareholders to the worst financial crisis since the Great Depression. Redemptions are a normal function of capital markets Because shareholder redemptions have emerged as a source of regulatory concern and confusion, we offer a few final points of perspective on this activity. A redemption is a decision on the part of an investor to sell his or her investment at the current mark-to-market valuation. Investors may redeem their shares for any number of reasons: To switch mutual fund managers (because of a manager s deteriorating reputation or performance, a desire for lower fees, or the need for better services); To change their asset allocation (for example, to switch from stocks to bonds); To obtain cash (for example, to make a down payment on a house). Redemptions constitute the behavior of the investor, not the asset manager. An investor s decision to reallocate assets or raise cash would occur whether he or she held assets in a mutual fund or held stocks and bonds directly. Redemptions are unlike forced sales, which are driven by leverage and interconnectedness and can result in a spiral of rapid price declines. Any price declines driven by redemptions are simply evidence of a basic capital markets function: to discover the price at which buyers and sellers are willing to exchange risk. The goal of systemic risk regulation should not be to prevent market price declines. Rather, regulation should aim to ensure that financial institutions are resilient to market price fluctuations. 9

10 Conclusion The financial crisis exposed the need for more effective regulation of some capital-markets activities. It also reinforced a lesson imparted by almost every financial crisis in history: that systemic risks originate in institutions that have significant leverage, interconnections with other highly leveraged institutions, and/or a significant mismatch between the maturities of their assets and liabilities. Mutual funds and mutual fund management companies exhibit none of these characteristics. Like any economic actor, a mutual fund or a mutual fund manager can experience idiosyncratic risk. As we ve demonstrated, however, the structure and regulation of mutual funds mean that this risk remains contained. If the Financial Stability Oversight Council hopes to promote the financial stability of the United States, to end too big to fail, and to protect the American taxpayer by ending bailouts, as the preamble to Dodd-Frank urges, a focus on mutual funds and their managers is misplaced. 24 Indeed, the application of a bank-like regulatory regime to mutual funds would do nothing to limit risks to the financial system, but it would threaten to diminish the strengths of an investment vehicle used for decades by tens of millions of Americans to invest for retirement and other long-term goals. Glossary Asset-liability mismatch: Situation in which the maturities of assets and liabilities are not aligned. For example, the liability of a bank deposit is due on demand by the customer, but the loan extended by the bank will only generate proceeds to the bank over a longer period, creating a significant misalignment. Collateral: Cash or securities provided to a lender of securities in exchange for the market value of the securities. Custodian bank: A bank that provides third-party collateral management and settlement services. Demand deposit scheme: The method by which banks take deposited funds and seek to generate profit by lending those funds at a higher interest rate than the rate paid to the depositor. Depositors can demand return of their funds at any time. Forced sale: A sale of assets that occurs because the seller is unable to meet margin or capital calls (money due on derivatives or other financial obligations) and therefore must sell assets at dislocated prices, potentially resulting in a spiral of rapid price declines. Idiosyncratic risk: A risk that is isolated, involving a much more limited impact to individual investors or institutions. It may, for example, affect a single asset manager, single asset class, or single fund. Leverage: (1) Borrowing money to gain a return greater than the borrowing costs, or (2) initiating or holding financial positions with little to no capital to gain exposure to potentially large risks and rewards. Redemptions: A basic capital markets function, in which investors express their decision to sell at the current mark-tomarket valuation. Investors may, for instance, choose to redeem to switch asset managers (for reasons such as reputation, performance, or lower fees), to change their asset allocation (for example, to switch from stocks to bonds), or to obtain cash (for example, to make a downpayment on a house). Run on the bank: A situation in which bank depositors withdraw their deposits more quickly than the bank can get back the proceeds of loans. Runs on bank-like entities can take place when institutions have significant mismatches between their assets (loans) and their liabilities (deposits). Systemic risk: The risk that an institution can cause or accelerate a significant threat to financial stability. For a risk to be systemic, it must be the type of risk that, if left unattended, would require government intervention and potentially taxpayer dollars to rescue the private enterprises exposed to such risks. For a financial institution to pose systemic risk, it must (1) be significantly leveraged and interconnected with other systemically important companies through such leverage, and/or (2) have a significant mismatch between its assets and liabilities. 24 Dodd-Frank Wall Street Reform and Consumer Protection Act Pub. L. No (2010) 10

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