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

risk with swaps to which Lehman was counterparty suddenly found themselves with a huge interest rate risk on their balance sheet, just as the crisis was provoking a flight to quality and sharply falling interest rates. Investors who had relied on AIG for protection from credit risk found that they were likewise exposed. The main items used to hedge financial risk, financial derivatives, could become useless to end-users exactly when they are most needed, during times of crisis, and increases in systemic risk triggered a swift regulatory response: regulatory bodies proposed an extension of the role of central counterparties to derivatives, i.e ., clearing houses that do not just match transactions but also assume counterparty risk associated with derivative instruments. Richelieu—KBC AM and the poor practical requirements for liquidity risk management in UCITS KBC, Belgium's second-largest financial- services company, acquired French fund manager Richelieu Finance, with € 4 billion under management at the end of 2007, which after investing heavily in small caps found itself unable to honour redemptions after a fall in market prices. Paris-based Richelieu commented that it had remained profitable despite the redemptions, with shareholders’ equity of € 100 million, but that it was seeking a partner to be able to maintain the liquidity of its funds. That redemptions cannot be honoured easily during market crises for UCITS funds such as those specialised in small capitalisation stocks underscores the vagueness of the practical definition of liquidity requirements for UCITS funds.

industry, and the regulators allowed funds to isolate illiquid assets in separate accounts called side-pockets if in the interest of investors (for France, order of 23 October 2008 implementing articles L. 214-19 of the monetary code for corporate-form investment funds—SICAVs—and article L. 214-30 for contractual funds—FCPs). Real estate investment funds in Europe and cash+ funds in France: liquidity risk management and reputation risks In the UK, real estate funds—usually real estate investment trusts—are not UCITS since they rely heavily on illiquid investments. They are, however, regulated as retail schemes. As the fall in housing prices in the UK triggered surrenders in property funds in early 2008, many investment firms, in accordance with the law, barred investors from withdrawing cash. After all, in these funds, redemptions may be suspended as long as the reasons for the suspension and the expected duration of the suspension are clearly spelled out to investors. Real estate funds in general pose valuation, transparency, and distribution or advertising problems because they rely on potentially illiquid assets and on mark-to-model rather than mark-to-market valuation. In 2005, German property funds had experienced a liquidity crisis, and at the time, promoters of property funds had made good on investor losses by injecting money into funds or by buying back the units of funds with their own capital. In 2010, some German property funds were frozen and others were liquidated. These problems are best illustrated with money-market funds partly invested in real estate or mortagage-backed securities. In France, cash+ funds (money- market funds that were partly invested

Six months later, the effects of the crisis were rippling through the fund management

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An EDHEC-Risk Publication