A Better Grasp of Non-financial Risks

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

3. Risks and Responsibilities in the Fund Industry

from serving again as board members in Luxembourg. Because of the monitoring role of the board in Luxembourg, shareholders of corporate-form investment funds should be better protected than unit-holders of contractual funds. 3.2 The Central Role of Investment Firms and Depositaries in the Protection of Unit-Holders Investment firms are regulated; they must have sound procedures to prevent conflicts of interests and manage risks. They are directly responsible for collateral management and pricing. The main responsibility for decisions and for compliance with regulatory obligations lies with asset managers themselves. A central role—that of safe-keeping assets and checking the regulatory compliance of UCITS funds and firms—has been given to depositaries in the protection of unit-holders. This central role has been defined in Europe partly under the influence of civil law (there are more countries of civil-law origin in Europe than there are of common-law origin) and of the French regulator (France is the largest domestic market for funds in Europe). This central role of the depositary is the result of several factors, above all the greater belief in rules drawn up by government authorities than in contracts. In the French system, ultimate responsibility lies with a

well-capitalised party such as a depositary, to the detriment of a protective system involving all the risk-taking parties in the fund management industry. The industry was conceived as an industry without own capital and not at all liable for the financial consequences of the financial— the firm need only follow the rules—and non-financial risks it takes (in the end, that a purportedly well-capitalised party will foot the bill fosters the illusion that any wrongs are righted when the depositary makes immediate reparations for damage). Finally, the European directives have made depositaries supervisory auxiliaries that must check compliance of investment policy with the prospectus and with regulation; in several respects, these checks are a major element in the protection of the interests of investors. In general, professional investors are believed to have the means to select and oversee the execution of fund investment policies, but the same is not generally believed of so-called retail investors. This argument applies by default to small investment firms that do not always have the set of oversight tools that professional investors may be seeking. In addition, the fund management industry is characterised by an absence of investor participation; for this reason, a third party to which some of the monitoring not done by investors can be entrusted is especially important. In European laws, this monitoring is entrusted to the depositary alone; the role of the board is spelled out only in country regulation.

Box 3: The lack of activism in the investment fund industry Some of the problems often encountered in corporations are magnified in the fund management industry. In ordinary corporations, for instance, the shareholder delegates decision rights to the manager to act in the shareholder's best interests

48

An EDHEC-Risk Institute Publication