A Better Grasp of Non-financial Risks

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

2. The Rise of Non-financial Risks in the Fund Industry

restrictions. 10

restrictive (by a factor of the square root of two if one assumes twenty business days a month). Less restrictive again is Portugal, which requires a ten-day holding period and a 95% confidence interval. France, by contrast, requires a 95% confidence interval and a one-week period, but a 5% maximum VaR limit that makes VaR restrictions more restrictive than in neighbouring countries. In addition to the absolute VaR constraint, stress tests are generally required (in Luxembourg and Germany they must be done at least once a month). Legislative proposals in 2009 (EU 2009c) address weaknesses in macro- and micro-prudential supervision by creating different two systems of supervision, the European Systemic Risk Board, in charge of macro-supervision, and the European System of Financial Supervisors (ESFS), for the supervision of individual financial institutions. The ESFS will include the European Securities and Markets Authority (ESMA), whose role will involve contributing to consistent application of technical Community rules, direct supervisory powers for credit rating agencies, coordination in emergencies, and the creation of a common supervisory culture in European countries. Even supposing that level 1 and level 2 of European regulations are made clear and that the ESMA ensures a homogeneous implementation of EU regulations, the supervision of funds and investment firms will be a country prerogative, and country competition will still be possible. Country competition: from level 3 to effective supervision

A great current discrepancy in eligible assets seems to lie in the practical regulation and supervision of the 10% investments in other securities, informally known as the trash ratio. It is understood (EC 2008) that regulators and market practices are diverging and that in France and Luxembourg—though not so much in Ireland—the trash ratio can be invested in hedge funds. There are greater variations in the implementationsofECrecommendations,such as that of the 2004/383/EC recommendation (EU 2004) that clarifies the measure of leverage to be used by sophisticated UCITS, a self-explanatory word that designates UCITS that have developed the methods to assess market risk with VaR and that have sophisticated risk management and risk measurement tools. The EC recommends that the monthly 99% Value-at-Risk of sophisticated funds not exceed 20%. 11 Some countries, largely as a result of the absence of industry demand, have not defined sophisticated funds at all. Although the general EC/CESR guidelines (99% VaR with a one-month holding assumption) have been adopted by most, the measurement of leverage differs slightly from one country to another. In Ireland the holding period must be no more than one month, which suggests that a less restrictive weekly or daily holding period can be assumed. However, industry codes of practice are such that a monthly holding period must be input. Austria, Denmark, Germany, and Spain (on paper at least) require a ten-business-day holding period. In that sense, they are less

11 - The EC also recommends that a relative VaR limit be used where the monthly 99% Value-at-Risk should be less than twice the VaR of a derivative-free benchmark, but this has proved less relevant. Until 2004, UCITS III had not spelled out the way to measure exposure (see art. 21).

In UCITS IV (EU 2009a), the simplified prospectus is to be replaced by the key

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An EDHEC-Risk Institute Publication