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Is BlackRock too big to fail?

December 4, 2013: 12:41 PM ET

The largest asset managers should become simpler, smaller and less interconnected.

By Sheila Bair

131203172154-blackrock-620xaFORTUNE -- Hark. Do you hear it? That sound of ringing bells coming from the nation's capital as we enter the holiday season? Is it Salvation Army Santas taking to the street corners? Church campaniles playing "Carol of the Bells?" Or maybe angels getting their wings a la the Christmas classic It's a Wonderful Life?

Nope. It's the ka-ching of K Street lobbyists ringing up the billable hours as they pile into the newest industry battle against financial reform. I am speaking of nascent efforts to regulate the multi-trillion dollar asset management industry. This war promises to be even bigger than the one megabanks have waged against the Volcker rule's proposed ban on speculative trading.

The shot heard 'round the beltway was a seemingly innocuous report by a government research group called, appropriately, the Office of Financial Research or "OFR." The OFR was created by the Dodd-Frank financial reform law to -- among other things -- conduct and sponsor research related to "financial stability." That seems reasonable after the 2008 financial crisis nearly brought down the world economy.

The OFR was asked by its parent agency, a group of major financial regulatory heads called the Financial Stability Oversight Council or "FSOC," to look at potential risks associated with asset managers. These entities -- which include mutual funds, private equity and hedge funds, as well as the asset management divisions of insurance companies and banks -- collectively control about $53 trillion of assets. Ten firms each individually control over $1 trillion in assets with the largest, by far, being BlackRock (BLK), which manages $4.1 trillion.

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While acknowledging the lack of complete data to conduct the analysis, the OFR report had, I thought, some useful observations about things asset managers do that are frighteningly similar to the kinds of things that banks did in the lead-up to the financial crisis. You know, things like excessive leverage (yes, a number of them do use significant leverage to enhance returns), taking big risks to reach for yield, mismatching assets and liabilities, and putting assets in separate accounts that are not transparent to regulators or their public investors.

Was the report perfect? No. Is anything? But its primary purpose, as I understand it, was simply to help FSOC look outside of the regulated banking system to learn more about the business and activities of asset managers so it could determine if there were any risks that might threaten markets and the economy. That is what the FSOC and OFR are supposed to do.

People love to beat up on the big banks (and I do my fair share), but believe it or not, they were not the root of all evil in 2008. Asset managers and insurance companies also created significant problems. As you will recall, taxpayers had to risk trillions in government support to bailout both the American Insurance Group, a.k.a. AIG (AIG), as well as the money market/mutual fund industry. What's more, it is important to understand that when we bailed out the banks, we also bailed out these nonbank institutions, as some were heavily invested in bank debt or were standing on the other side of bank derivatives trades. Without the bank bailouts, these nonbanks could have taken big losses.

Yet, based on the fund industry's holier-than-thou attack on poor OFR, you would think they were trying to protect Cindy Lou's Christmas against the evil Grinch. The industry's biggest fear seems to be that this report is the precursor to the FSOC designating big firms like BlackRock and Fidelity as "systemic" meaning (gasp) that they would be subject to tougher regulation by the Federal Reserve Board.

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I think the industry is jumping to conclusions. If I were they, I'd save my money for employee Christmas bonuses and tell the lobbyists to stand down. The FSOC is only beginning to analyze the issues identified in the OFR report, and there are many different ways the regulators could respond. Some of the issues could be addressed with better disclosure. Others, like leverage and liquidity, could be addressed with some simple, basic standards set by the Securities and Exchange Commission (SEC). The SEC already regulates the big asset managers to protect those who invest in their funds. The agency has not, traditionally, looked at this industry from the standpoint of broader risks to the financial system, but that doesn't mean it couldn't start.

True, the FSOC might ultimately decide that some individual asset managers are too big and interconnected to fail without disrupting the broader economy. But the answer is not necessarily to designate them as "systemic" and push them into the arms of the Fed.

A better alternative would be for those firms to become simpler, smaller, and less interconnected. Dodd-Frank's "systemic designation" was meant to put large firms on the government's "naughty list." Intrusive Fed supervision was meant to be their lump of coal. Under the law, they still have the option of getting on the "nice" list of un-systemic institutions by restructuring and downsizing.

Now wouldn't that be a nice Christmas present for us all?

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About This Author
Sheila Bair
Sheila Bair
Contributor, Fortune

Sheila Bair is a Fortune contributor, and a former chair of the FDIC, and former member of the Basel Committee. She is also the author of the New York Times bestseller Bull by the Horns, Fighting to Save Main Street from Wall Street and Wall Street from Itself.

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