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

several dozen times greater than that of the capital bases of these depositaries. In other words, unconditional liability for assets under sub-custody could lead to an extremely sharp increase in capital requirements. 3.5 The Risk of Reliance on Big Names The temptation of the supervisory authorities to rely on such highly capitalised parties as the investment firms’ parent companies to protect investors is also a source of risk for the fund management industry, as it could penalise independent investment firms and concentrate risk on the largest parties. The concentration of risk on the largest parties is exactly what regulators are trying to avoid by controlling systemic risk and, in the United States, by breaking up several banking activities. It is impossible to want to rely on big names and to have a world that could work without them. Concentration and reputation risks arise for want of regulations that spell out the rules applicable to all parties. After all, during the financial crisis, for many funds that failed to provide overnight liquidity, regulations were powerless to protect end-investors, and the banks that owned investment firms compensated unit-holders for their losses only because they feared for their good names. In short, unsuitable regulation cost large conglomerates dear. In addition, formalising the support parent companies offer investment firms would lead to higher capital charges for these companies (reputation risk is an integral part of operational risk, and a formalisation would lead to a weight for this risk much heavier than has hitherto been the case).

For want of laws on legal liability, the absence of regulatory protection would lead to greater reputation risk, as was made clear during the recent crisis, which would in turn lead to higher regulatory capital under Basel III. 36 To rely on the large capital reserves of a parent company without penalising independent investment firms, EU regulations should define the role of the sponsor and require that a well-capitalised sponsor, which, as in Ireland and Luxembourg, can be rented, participate in the creation of the fund and offer a guarantee on top of that provided by depositary controls and depositary bookkeeping. Such an explicit additional guarantee could improve the governance of investment funds. This sponsorship role could be enshrined in European law. As we have seen, the influence of French regulatory culture on European law may result in the placement of exorbitant responsibilities on depositaries; the failure to define clearly the role of the depositary and the responsibilities of all parties to the fund management industry, by contrast, may lead to regulatory competition between the member states of the EU and greater reputation risk for the shareholders of the investment firms; the UCITS label may also be discredited. Although cultural differences may make it hard to draw up precise level-1 and level-2 regulations (and may be partly responsible for the delays in preparing the AIFM directive), convergence is not entirely 3.6 Conclusion: The Possible Convergence of Country Regulations and Risk-Management Practices

36 - In the standardised approach, the charge for operational risk is a percentage of the gross income of each business line, but banks are required to do their own assessment of risks; additional capital needs for risks not identified in the standard approach may be needed. Banks that have implemented the advanced measurement approach need to formally measure the risks that arise from reputation, sub-custody, and so on.

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An EDHEC-Risk Institute Publication