Are Pensions Systemically Important?

Janet McFarland of the Globe and Mail reports, Pension plans push back over 'unbelievable' new powers for regulator:
Three of Canada’s largest pension fund managers are protesting powerful new legislation that would include pension plans among the key financial players to be governed by a new regulator overseeing systemic risks in Canada’s capital markets.

The three pension plans, all representing public sector workers in Ontario, argue it is unnecessary and even inappropriate to bring pension plans under the supervision of a proposed new national securities regulator in Canada, which is being given expanded authority to oversee so-called systemic risks that can threaten the stability of Canada’s stock markets.

The Healthcare of Ontario Pension Plan (HOOPP), the Ontario Municipal Employees Retirement System (OMERS) and the Ontario Teachers’ Pension Plan Board submitted a joint comment letter in December to federal Finance Minister Joe Oliver urging officials to remove pension plans from the draft Capital Markets Stability Act, which is still under review and has not yet been adopted.

HOOPP chief executive officer Jim Keohane said in an interview the act gives the proposed new regulator unprecedented powers to order companies or funds under its control to do anything it deems necessary to prevent systemic risks in the financial system.

“This act, as it reads right now, gives this regulator unbelievable powers that no other regulator in the world has,” he said.

“It can prohibit or restrict any business activities that we undertake. It could force us not to trade securities. The regulator can at its discretion order us to do anything it deems necessary to address systemic risk. It’s completely open-ended,” Mr. Keohane said.

The act is one of two new pieces of legislation published together in September that would create a new federal-provincial securities regulator, and separately create a new national systemic risk oversight regime to be managed by the regulator. Public comments on both acts were due in December, but the legislation is still under review.

The systemic risk legislation is aimed at key organizations involved in Canada’s capital markets, including stock exchanges, clearing houses, credit rating organizations, brokerage firms, investment funds and pension funds.

The regulator would have powers to designate an organization as “systemically important” if its activities could pose a systemic risk to the markets based on a variety of criteria, including its size, the volume of trading it conducts, the extent of its “interdependencies” in the market and the complexity of its business.

With approval from the federal finance minister, the regulator would have the power to require systemically important organizations to sell securities, increase capital or financial resources, abandon proposed mergers, implement wind-up plans, terminate business activities or “to do anything else that is necessary to address the risk.”

Breaches of the act carry fines up to $25-million.

Federal Finance Department officials had no comment on the legislation.

Mr. Keohane said he fears the regulator’s broad powers mean it could tell pension plans what to buy or sell, including critical financial instruments that create liquidity when markets are in crisis.

“The way this reads right now, they could designate us as a capital market intermediary and tell us we have to buy assets off a bank,” he said. “This thing says they can tell us to do anything.”

The pension plans argue they do not fit within the mandate of the act, which is intended to control organizations in the business of trading securities. They say they are in the business of paying pension benefits to members, and already operate under regulations requiring conservative investment strategies.

In a Dec. 8 comment letter addressed to federal Finance Minister Joe Oliver, the funds said they are not the same as brokerage firms or banks because they are not highly leveraged, and are indeed generally prohibited from borrowing money.

“We believe that there is no evidence showing that pension entities are potential sources of systemic risk.”

“On the contrary … pension entities are typically seen as buffers against systemic risk,” the letter says.

Mr. Keohane said regulators concerned with risky securities such as subprime loans or non-bank commercial paper, both of which have caused collapses in the financial system in the past, should focus on the dealers that issue them and not investors who hold them.

“Can we lose money on things? Sure. But would that cause a systemic issue? No,” he said. “I understand the importance of creating systemic stability, and those entities that could cause systemic instability should be watched. But we’re not one of them.”

The pension funds also complain there is limited ability to challenge the regulator’s orders under the act. The legislation says the regulator must give organizations “an opportunity to make representations” but there is no suggestion that would include the right to have a full hearing with oral arguments and expert witnesses, nor the right to receive reasons for decisions.

Many securities lawyers have taken issue with the lack of clarity about due process and appeal under both new pieces of legislation, arguing the new regulator is being given expanded powers with less ability to challenge certain types of decisions.

Securities lawyer Phil Anisman said Monday he submitted a comment letter urging revisions to both acts. It argues the right to “make representations” suggests there will be a process that is “less formal and may involve a lesser standard of due process” than the right to a full hearing.

Mr. Keohane said he would not have supported the project to create a new securities regulator in Canada if he had known it would also come with legislation giving the regulator oversight of pension funds as part of its systemic risk mandate.

“To me it’s a bit of a bait and switch. They get you to support a central regulator, and then they put in this,” he said.
When I read this article, I immediately contacted Jim Keohane to ask him "what the big stink is all about?". I told him the Office of Superintendent of Financial Institutions (OSFI) already supervises federally regulated private pension plans, so why not have this new federal regulator supervise Canada's largest public pensions?

Jim emailed me this response:
First, the intent of this legislation is to control the actions of highly levered financial institutions whose collapse can cause systemic problems for the financial system. Due to the long term nature of pension plans, we have the ability to ride out short term market downturns. Short term losses that we may incur may impede our ability to pay pensions decades down the road, but pose no immediate systemic threat to the stability of the financial system, so there is no reason for pension plans to be included as part of this legislation.

Secondly, this Act as it is currently drafted gives the regulator open ended powers that no other regulator in the world has. It would be given powers that allow it to tell us to do anything it deems appropriate.
And he followed up this morning with this response:
I have attached a copy of the joint comment letter submitted to the Minister of Finance jointly by HOOPP, OTPP and OMERS. It provides the rational as to why pension funds should not be covered under this legislation.

As I mentioned in my email last night, this legislation conveys additional powers upon the Federal regulator that go way beyond the powers of any Provincial regulator. Some of these powers are very draconian in nature and could have far reaching negative impacts on pension plans or other money managers who may be deemed to fall under this legislation.

A few key takeaways from the draft law are as follows:
  • Money managers and pension funds can be considered Capital Markets Intermediaries (CMIs).
  • The regulator at its sole discretion can designate any money manager or pension fund as a systemically important capital markets intermediary (SICMI)
  • The regulator can at its discretion require, prohibit or restrict any business activity of a money manager or pension fund, once it is designated as a SICMI
  • The regulator can at its discretion order a money manager or pension fund, as a SICMI, to do “anything” it deems to be “necessary to address the (systemic) risk”
  • The regulator can require, prohibit or restrict any activity involving securities and derivatives it deems to be “systemically important”
  • The regulator may require, prohibit or restrict practices it deems to be “systemically important”
  • The regulator may issue an “urgent order” to prohibit or restrict any money manager or pension fund from doing “anything”
In our opinion this smells of a “bait and switch”. The rationale for a central securities regulator was to improve the efficiency and effectiveness of securities regulation in Canada.
This legislation represents a significant departure from that rationale and creates regulatory powers that do not exist at any of the provincial regulators. These powers can have very significant impacts on pension funds and money managers and on the functioning of the capital markets in Canada.
I am sympathetic to the concerns Jim raises above. It's true that pensions aren't broker dealers, banks or hedge funds. They have long-term liabilities and typically invest accordingly, looking at how to best match these long dated liabilities with long dated assets in public and private markets.

Also, I'm very weary of regulators in Canada and elsewhere meddling in pensions, be it at a provincial or federal level. Most of these regulators never worked at a pension, don't understand their investments and even when they do, they shouldn't be allowed to supersede the investment decisions of a pension fund manager.

I spoke to Jim Keohane earlier today. He told me that while they supported the rationale for a central securities regulator, they would have never supported this new regulator had they known it would have provided this regulator with new, expansive powers to meddle in pension investments.

Jim thinks the proposed legislation as it stands gives too much power to this new regulator and it needs to be significantly revised. He also told me that all provincial pensions in Ontario are already regulated by the Financial Services Commission of Ontario (FISCO) and there would be a lot of duplication on one level. "But FISCO acts a lot like the Bank of Canada does with Canadian banks. It can't tell us what to invest in, it only monitors our activities and can set capital requirements."

I raised the issue of ABCP and how public pensions (mostly the Caisse back then) were huge investors. Jim told me that while this ABCP crisis exacerbated the huge losses at the Caisse in 2008, it didn't impact their ability to pay pensions over the long-term and it was the banks that should have been better regulated to mitigate the issuance of this illiquid paper.

He also mentioned the Bank of Canada published a study last year which showed pensions are countercyclical during a financial crisis and provide much needed liquidity. This point was underscored by Lawrence Schembri, Deputy Governor of the Bank of Canada, in a speech he delivered back in May on pension funds and financial stability:
The simple answer is that, given their size and importance to the Canadian and global financial systems, pension funds contribute meaningfully to financial stability by helping to maintain the diversity of market behaviour.

Diversity across financial market participants underpins well-functioning markets and a resilient financial system by reducing common exposures and procyclicality.

Pension funds contribute importantly to financial diversity because they are among the most varied and thus the most “cool” market players for three main reasons:
  • First, pension funds are market participants with long investment horizons.
  • Second, they are predominantly real-money investors; that is, they fund their investments primarily from contributions, rather than from borrowing.
  • Third, employee and employer contributions are largely locked in.
Allow me a few comments on each of these sources of diversity.

Because pension funds are investing to help fund the retirements of members over a wide age distribution, they have the luxury of patience, of being able to withstand short-term market volatility or liquidity stresses to earn returns over the long term. They are the Warren Buffetts of the financial system. In other words, pension funds can more easily bear market and liquidity risk and earn the associated risk premiums because they can diversify these risks over time.

Their long investment horizons are different from those of most other market participants, who are more focused on short-term returns. Thus pension funds have the capacity to smooth and absorb short-term volatility and act as a net provider of liquidity and collateral to the system, especially in times of stress.

Pension fund rules for asset allocation, position limits and rebalancing work in the direction of smoothing asset prices. Rebalancing encourages pension funds to sell assets that have gained in relative value and vice versa. Consequently, via rebalancing, pension funds can help to mitigate excessive asset price movements.

Pension funds do not rely primarily on borrowing to fund their investments, and are not vulnerable to excessive leverage or significant liquidity and maturity mismatches, which caused many banks, both traditional and shadow banks, to fail during the crisis. Hence, they are, in general, not a source of systemic risk to the financial system.

Finally, because the contributions to most pension funds are locked in, they are not subject to massive withdrawals or runs of the kind we witnessed during the financial crisis, such as Northern Rock or U.S. money market mutual funds.

Given these important differences from other market participants, pension funds have had, in general, a positive impact on financial stability. Although not definitive, there is some anecdotal evidence that pension funds contributed to financial stability during the crisis by acting in a countercyclical fashion, buying assets when their prices fell.
There you have it, the Deputy Governor of the Bank of Canada spelled it out clearly, pension funds in general, "are not a source of systemic risk" and because of their long investment horizon, they are a net provider of liquidity and collateral to the system, "especially in times of stress."

So why would we want to introduce a new federal regulator who has the power to encroach and/or restrict investment decisions made by pensions? While there's definitely a rationale to have a central securities regulator, the proposed legislation needs to be significantly revised, especially as it pertains to pensions.

In my discussion with Jim, I brought up the point that in the past, Canadian public pensions have made unwise investment decisions, and some of them could have exacerbated the financial crisis.  The ABCP crisis had a somewhat happy ending but only because the Bank of Canada got involved and forced players to negotiate a deal, averting a systemic crisis. And we still don't know everything that led to this crisis because the media in Quebec and elsewhere are covering it up.

I also told him we need to introduce uniform comprehensive performance, operational and risk audits at all of Canada's major pensions and these audits need to be conducted by independent and qualified third parties that are properly staffed to conduct them. I blasted the Auditor General of Canada for its flimsy audit of PSP Investments, but the truth is we need better, more comprehensive audits across the board and the findings should be made public.

Another thing I mentioned was maybe we don't need any central securities regulator. All we need is for the Bank of Canada to have a lot more transparency on all investment activities at all of Canada's public and private pensions. The Bank of Canada already has information on public investments but it needs more input, especially on less liquid public and private investments.

Finally, Jim told me that HOOPP had a very decent year in 2014 but I wasn't surprised given their relatively high allocation in bonds. We talked a bit about markets and he told me the plunge in oil is worrisome because the "drop in commodities is so severe that it implies demand factors are driving it."

He added:"If that is indeed the case, with valuations stretched, any shock will have a profound impact as a lot of risk assets are priced to perfection." I agreed but told him even though it will be volatile, I see another melt-up in stocks led by biotech and tech. I wrote my thoughts in my Outlook 2015.

I thank Jim Keohane for taking the time to speak with me on this important issue.You can watch Janet McFarland discuss the proposed legislation on systemic risk in a video clip here. It is important to note that this legislation is far from being passed and there will be a lot more discussions with pensions and banks before it gets approved.

Below, Steve Kandarian, MetLife chairman & CEO, explains why he thinks his company should not be designated as SIFI. MetLife said it would file on Tuesday a lawsuit against regulators subjecting it to tougher oversight, challenging their verdict the firm harbors enough risk to endanger the financial system in a crisis. 

That makes me wonder whether the same thing will happen here in Canada. Hopefully not but the proposed legislation needs to be significantly revised to remove pensions. Instead, we need to introduce the measures I proposed above on better, more comprehensive audits and more transparency to the Bank of Canada on investment activities at Canada's large private and public pensions.