By Sarah N. Lynch
WASHINGTON (Reuters) - Federal securities regulators had warned of flaws in a U.S. Treasury draft report that could lead to costly regulations on large asset managers, people familiar with the matter told Reuters on Monday.
Last week the Office of Financial Research released the report, which found that activities of asset managers could pose risks to the broader marketplace.
It sent shockwaves through the industry, because the findings could encourage regulators to designate big asset managers as "systemic" - a tag that brings tough capital requirements and supervision by the U.S. Federal Reserve.
The Securities and Exchange Commission, however, had been quietly advocating for major changes to the study for months, according to the sources.
One of the SEC's chief concerns stems from an earlier draft of the report that the agency felt exaggerated the riskiness of the business. The SEC has also been concerned that the people involved in the study lack a fundamental understanding of the fund industry itself, these people said.
The Treasury's research arm failed to take a number of the SEC's critical feedback into account, said the sources.
As a result, the SEC decided last week to issue the report for public comment, in a move designed to give the industry a way to vent, one person familiar with the matter said.
A spokesman for the SEC declined to comment.
Richard Berner, the director of the Office of Financial Research, said he was not aware of any initial concerns by the SEC during the drafting of the report, but added that his office valued the feedback it received.
"We wanted to make sure we engaged with the SEC among others, so we would incorporate any suggestions or concerns they had about the report and make sure we got the facts right," Berner said in an interview with Reuters.
"I can't speak to any initial concerns because I don't recall any such concerns explicitly being in our discussions with the SEC. What I do recall is a mutual recognition that asset managers are fundamentally different from other kinds of financial services companies or activities...I don't think there was any disagreement about that."
The SEC's decision to seek public comments on the controversial report could lay the groundwork for a turf battle between the SEC, the traditional regulator of mutual funds, and the Financial Stability Oversight Council, or FSOC.
The FSOC, which comprises the heads of the top financial regulators including the SEC, asked the Office of Financial Research to study the asset management industry to help inform it about the selection of "systemic" firms.
Some of the country's largest asset managers, including Blackrock Inc., Fidelity and Vanguard, have been staunchly opposed to such a designation.
Most fund companies contend they are already heavily regulated by the SEC and feel the FSOC should back off and let the SEC do its job.
Some said they were taken aback by last week's report, which found that "a certain combination of fund and firm level activities within a large, complex firm or engagement by a significant number of asset managers in riskier activities could pose, amplify or transmit a threat to the financial system."
According to people familiar with the matter, the SEC has been struggling to convince the Office of Financial Research to change its report for months.
The first draft, which was circulated around the SEC earlier this year, was deeply flawed, according to several people familiar with the agency's thinking, because they said it appeared to be written by people with limited understanding of the industry.
The sources familiar with the SEC position said, for example, that the Treasury researchers overstated risks that are inherent and routine in securities investments. They also failed to understand that when a fund buys shares, it is doing so with investors' money - and is not typically putting its own capital at risk.
"I think they are seeing more risk in the asset management business than anyone at the SEC would recognize," one of those people familiar with the SEC's thinking told Reuters.
INDUSTRY GEARS UP TO FIGHT
Industry sources say firms are gearing up to file critical comment letters with the SEC about the Office of Financial Research's asset management report.
"The report is misleading and inaccurate," on topics such as sponsor report for mutual funds, said a spokesman for Federated Investors Inc.
"Federated is ...considering whether to submit a comment letter to the SEC."
Industry officials also say the report contains basic factual errors about firms, such as their names, organizational structure and assets under management, something that undermines their confidence in the study.
They also say they have broader concerns about how the report examines risk in the sector, claiming it views asset managers through a banking regulatory lens and fails to distinguish adequately between registered funds that are already highly regulated versus unregistered funds that face less regulatory oversight.
Berner acknowledges that there are data gaps about the asset management industry, which is why he said his office had an "open door policy" with trade groups and fund managers.
He said he reached out to all of the trade groups, plus a few asset management firms.
However, he said he is proud of the final product and disagrees that the report failed to distinguish differences between the banking and asset management sectors.
"The truth is, we recognize and the council recognizes that asset management activities in the industry are different from banking activities and the banking industry," he said.
"And that is exactly why we were asked to do this report in the first place."
(Reporting by Sarah N. Lynch; Editing by Karey Van Hall and Ken Wills)