Morgan Stanley and consultancy Oliver Wyman said regulators are likely to require stress testing of some funds to ensure financial stability.

In their Wholesale and Investment Banking Outlook, Morgan Stanley and Oliver Wyman said policy makers will impose more regulations on asset managers as they are concerned about the risks to financial stability as interest rates start to rise and as market structure changes.

The outlook said that since 2006 sell-side revenues have fallen by 20%, or $55bn, while buy-side revenues have increased by 45% or $135bn. In addition assets under management in daily redeemable funds have grown 76% since 2008, and more than 45% of all globally managed assets now in these funds.

“Our base case is the initial set of reforms follow an incremental approach that involves stress testing of select funds and a range of micro reforms,” said the report. “This could add an extra cost of 1% to 5% to asset managers, albeit the largest firms are already well placed on this.”

The stress tests could lead to asset managers having to hold more liquidity in funds to protect against a tail risk event, just as banks have been required to hold more capital.

The report said: “Policy makers we have met are trying to assess what are the implications of mutual funds owning 3x the share of US credit since 1994 as well as the reversal of the unprecedented monetary stimulus and the impact of reduced secondary market liquidity today.”

As a result Morgan Stanley and Oliver Wyman said smaller asset managers may also need to invest more in trading and execution capabilities, collateral management, and risk management to adapt to the new environment.

“In terms of the broader operating model we find that many asset managers still operate across relatively strong asset class silos,” added the report. “While cash and collateral requirements ultimately impact the underlying funds, we see leaders further building centralised expertise on managing cash and collateral, understanding that these are scarce resources which require active management with dedicated expertise.”

Increased regulations could also accelerate flows to exchange traded-funds and support a shift to funds with lock-up periods, such as alternatives.

“In our view, the mid-sized asset managers and captives will be hardest hit and consolidation would have to ensue,” added the report.

Another concern is that smaller fund mangers could also become more squeezed as banks focus on their most profitable accounts. The report said the top 100 asset managers generate twice as much revenue for the sell-side as the next 1000.

“Taking recent history as a guide for the future, we believe that, beyond scale, asset managers’ ability to innovate in terms of fund and product categories will be a key differentiator,” said the outlook.

For example, in the UK more than half of asset inflows are related to multi-asset and income funds in 2014 and managers who launched these products still have the top three positions in these products.

Swift, the payments provider, said in a survey this month that regulation was identified as the most important challenge facing investment management operations today. Three quarters of managers surveyed said it was an operational pain-point and the greatest single source of expenditure. “It is clear that significant operational challenges remain, particularly related to know your customer, anti-money laundering and sanctions screening compliance,” said the survey.

Swift interviewed the heads of investment operations and fund distribution at six of the ten largest investment management firms last year and 30 other fund managers completed a questionnaire.

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