A Better Grasp of Non-financial Risks

The European Fund Management Industry Needs a Better Grasp of Non-financial Risks — December 2010

Executive Summary

approach to the protection of unit-holders is sufficient. Implicitly, EU laws borrow from the civil-law approach by giving a central role to the asset management firm and to the depositary and by failing to provide adequate transparency (no mention of non-financial risks). The influence of the French regulations on EU law involves the risk that, in the current reworking of depositary obligations, excessive regulatory focus on the role of the depositary in the protection of unit-holders will lead to exorbitant practical liabilities for EU depositaries. For international funds, nearly all depositaries resort to sub-custodianship agreements and the workings of the current system mean that thousands of billions of euros are entrusted to sub-custodians. The assets held by the largest sub-custodian of the many large European depositary banks represent several dozen times their capital base; so, significant disappearance of assets at large sub-custodians cannot be paid out of depositaries’ capital, and the recognition of unconditional liability for assets under sub-custody could lead to an extremely sharp increase in capital requirements. For this reason, it is vital that the exemptions to the depositary liability to return assets entrusted with sub-custodians, as provided for in the AIFM directive, be workable. Finally, the regulators’ temptation to rely on highly capitalised parties (such as the parent companies of the fund management firms) to protect investors could also be a source of risk for the fund management industry, as it could penalise independent management firms and concentrate risks on the larger parties. Strengthening incentives to manage risk where risk is created. The regulatory challenge today is to fully take the best of common-law and civil-law systems. A

precise description of depositary controls typical of common-law countries should go together with enhanced fiduciary duties and transparency on non-financial risks. There are alternative and complementary ways to better protect unit-holders from non-financial risks. It is important to consider boosting capital requirements for all parties in the fund management industry, beginning with the party with the greatest obligations (and thus, in theory, the greatest responsibilities), the fund management firm. The models for allocating capital in financial conglomerates and at management firms should be reviewed, as should prudential regulations (capital requirements for limited operational risks should give way for a requirement for restitution risk). The aim of this approach is to create greater incentives to manage risk, as own capital should not be considered, as it is in the banking and insurance industries, insurance against the risk of loss. Fund management firms will never have risks sufficiently diversified for reasonable amounts of capital to insure them. The capital should be set in such a way as to ensure that the incentive to manage risks is greater than the marginal weight of this capital on the costs of management. In addition to the natural incentives to risk management created by the existence of capital requirements, modern regulations use risk-sensitive capital requirements as incentives. Regulators could lower capital requirements for investment firms (if capital requirements are set in the first place) and depositaries that manage these risks well, as well as for institutional investors that invest in low-risk alternative funds. Another way to prevent non-financial risks is to use insurance schemes. One could either require investment firms to seek insurance for the amount of non-financial risks that exceeds their available capital or insure

10

An EDHEC-Risk Publication