A Better Grasp of Non-financial Risks

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

Executive Summary

retail unit-holders, as put forward in the European Commission (2010) legislative proposal for a thorough revision of the investor compensation schemes directive (ICSD). Linking the strengthening of capital requirements and the improvement of information to the evaluation of non-financial risks. Risk-sensitive capital requirements and insurance of non-financial risks must be based on a measure of non-financial risks involved in funds, on what we call ratings of non-financial risks. Ratings of non-financial risks are necessary to shed more light on non-financial risks arising from sub-custody risk, as well as from investments in other funds or in derivatives on other assets not currently reported. The rating of the non-financial risk of a fund should, together with financial risk, represent the riskiness for investors. In opposition to the aforementioned notion of insurance of non-financial risks, a notion that, in spirit, clearly corresponds to the assumptions of total protection of the retail investor as this protection is formulated in civil law and, implicitly, in part, in European law, is the notion, dear to common law, of informed parties, and thus of transparency. Strengthening fund governance and the representation of unit-holders. The strengthening of governance and greater involvement of unit-holders would make it possible for fund management firms to improve the ways they take non-financial risks into account. Eddy Wymeersch, president of the CESR, has sharply criticised (Autret 2009) the governance of the fund management industry and argued that the current practices are far from meeting the recommendations of the

International Organization of Securities Commissions (IOSCO), do not meet the standards of ordinary corporations and that checks and balances should do more than monitor compliance. EU laws impose no fiduciary duties on boards of directors, and the definition of their role is again left at the discretion of country regulators. The fiduciary duty of the board and of the chief compliance officer could be reinforced and include formal responsibility towards end-investors to ensure high standards of governance and best practices in the management of non-financial risks (as for financial risks). Class actions are likewise a means of imposing responsibilities, as investors can, as consumers, pool their resources to bring claims, regardless of the legal structure of the investment fund (investors are currently not greatly involved in daily monitoring of fund management and the unit-holder base is generally too highly fragmented to bring a claim, after the fact, against management). Improving methods of managing non-financial risks. Ultimately, better regulation should lead to improved methods of managing such non-financial risks as counterparty risk, liquidity risk, or sub-custody risk. The needed improvements in the techniques for the management of non-financial risks can be driven by regulatory bodies or industry groups. For the management of counterparty risk, the regulatory technique is to create central counterparties (CCPs), which are a buyer to every seller and a seller to every buyer, and in effect eliminate nearly all counterparty risk. CCPs, however, require that margins be set as cash on a daily basis, and the requirement for cash margins raises the cost of derivatives and results

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An EDHEC-Risk Institute Publication