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

in mortgage-backed securities, including on the sub-prime market) were approved by the regulator as money-market funds, the safest and most liquid UCITS. When the underlying assets became illiquid and could no longer be traded, at least a dozen money-market funds from major French investment firms had to be closed. Shareholders of the investment firms not only provided liquidity to the funds (more than € 8 billion was redeemed in the third quarter of 2009 alone) but also took some of the losses. These shareholders acted not because regulation required them to do so but simply to safeguard their reputations. That the shareholders of investment firms had to bear losses as a result of risks they did not know they were taking highlights the importance of transparency, not only towards investors but also towards shareholders of investment firms (which may also be distributors or sponsors of funds). Regulations without transparency cannot but be a failure, as unit-holders are not informed of the risks they take when they rely on regulations to protect them; they will instead rely primarily on large financial groups attempting to preserve their good names. Some US mutual funds, including money- market funds with a usually constant $1 NAV, “broke the buck” after investments in AA-rated structured products collapsed. Other funds with concentrated investments in debt issued by financial institutions were hit by their bankruptcy (Reserve Primary Fund wrote off $785 million of debt issued by bankrupt Lehman Brothers). US money-market funds and the rating of structured products

As part of the Dodd-Frank Financial Reform Bill, the SEC will have two years to study the establishment of a lottery of agencies to rate securitisations; the regulator will need to define the conditions under which investors will sue agencies, if they have "knowingly or negligently" failed to do their research. The bill also directs regulators to study the conflict of interest that occurs when ratings agencies are paid by the firms issuing the assets they are rating. To limit the practice of “ratings shopping” (by which rating agencies do a preliminary analysis and the rating agency that takes the most favourable outlook is hired) all pre-ratings will be made public. Spalek (2007, 2) writes: “Following the death of Robert Maxwell on 5 November 1991, it became apparent that hundreds of millions of pounds were missing from the pension funds of companies belonging to Maxwell’s business empire, and that the lives of approximately 30,000 Maxwell pensioners across the UK were affected. Robert Maxwell had essentially juggled assets around his business empire, which involved him using company pension scheme assets as collateral for bank loans that were then partly used to fund a lavish lifestyle”. The Maxwell affair, as well as Albion, which had to wind up in 2002 because it did not have the means to make up the shortfall of about £1 million in client assets it had been holding directly, led to stricter segregation requirements in pension funds and investment funds in the UK, as well as to the Financial Services Market Act 2000, after which the FSA became the single financial regulator in the UK. Maxwell, Albion, the importance of the segregation of clients’ assets

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An EDHEC-Risk Publication