A Better Grasp of Non-financial Risks

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

1. Large Non-financial Risks in Retail Funds Finally Make a Mark on the Regulatory Agenda

1.1 Introduction: Motivation for and Plan of the Study This research chair on risks and regulations in the European fund industry deals with the regulatory framework in the fund industry in France, the United Kingdom, Luxembourg, and Ireland; regulation in the United States is studied as well. This research examines the rise of non-financial risks in the fund industry, how they came under the spotlight, the differences in country regulations, the risks of badly drafted EU laws, and the ways of protecting unit-holders from non-financial risks, a term that we use for risks in addition to the financial risks made clear in the fund’s prospectus, risks that arise because of failed processes or failed counterparties and that include the risk of assets not being returned at all. The recent crisis has led to large losses in the fund industry. The losses that spread through what was seemingly a single market for funds in Europe, however, were shared by depositaries, investment firms, and distributors in a very different manner across countries. These disparities have revealed regulatory loopholes and inconsistencies. Until the Madoff fraud and the demise of Lehman, the role of the custodian and depositary “was not understood outside the circle of practitioners who are professionally involved with custody and settlement activities” (Oxera 2002, 5). But the European Commission is now working on a set of rules for depositaries and proposing new regulations for investment funds. The EU proposals and regulations will have a major impact on the fund industry and on the supply of investment funds.

The first section of the study illustrates the failure of regulatory authorities, the fund industry, and investors to take non-financial risks into consideration until the Madoff fraud and the Lehman bankruptcy thrust these risks into the spotlight. The second section of this study reviews the reasons for the rise of non-financial risks in investment funds, from the enlargement of available assets, through misplaced confidence in regulatory certifications, to country competition in the application of EU regulations and in supervisory practices. The third section of this study focuses on country regulations in Europe as they are explained by legal origins, on EU laws that give a central role to depositaries in the protection of unit-holders but contain loopholes; we also comment on the risk of depositaries’ being forced to take on exorbitant responsibilities in future EU regulations, and on the risk of a concentration of the industry if supervisors are tempted to rely on well-capitalised firms. In the fourth section of this study, we review the means of shielding investors from non-financial risks: higher capital ratios for investment companies, the evaluation of non-financial risks involved in investment funds, insurance against non-financial risks, insurance whose pricing could rely on these ratings, or simply more transparency. Last, improving governance should result in better management of non-financial risks such as counterparty risk, liquidity risk, and sub-custody risks. The conclusion summarises the main ideas expressed in this study and suggests that a survey of investment professionals would

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An EDHEC-Risk Institute Publication