A Better Grasp of Non-financial Risks

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

4. Which Possible Protection of Unit-Holders?

4.1 Higher Capital Requirements Higher capital requirements should be envisaged for all parties to the fund management industry, beginning with the party—the investment firm—that has the greatest responsibility. The notion that depositaries alone should have own capital should be scrapped; capital requirements should be based not on assets under management or in custody but on risk. The models for allocating capital in financial conglomerates and investment firms should be reviewed, as should prudential regulations (capital requirements for limited operational risks should give way to a requirement for restitution risk). The point of this approach is to create greater incentives to manage risks, as own capital should not be considered, as it is in the banking and insurance industries, insurance against the risk of loss. Investment firms, after all (most of all small firms or firms specialising in a particular asset class or strategy), will never be able to diversify their risks well enough for reasonable amounts of own capital to cover them. The capital requirement should be set in such a way as to ensure that the marginal incentive to manage risks is greater than the marginal rise in fees charged to investors as a consequence of the rise in the cost of capital. Setting capital requirements wards off the risk of an investment firm’s failing to monitor large risks or to inform shareholders and clients of them. For all parties to be held liable for their actions, they must hold capital to give them incentives to manage the risks their decisions contribute to. Today, capital requirements are particularly small for investment firms: roughly, an investment firm managing UCITS must

have € 125,000 of capital as a minimum, plus two basis points per euro of assets under management in excess of € 250 million. Depositaries, since they are banks, are usually subject to Basel regulation. Their capital requirements, though large in absolute terms, are usually a very small fraction of clients’ assets (0.05% is a reasonable ratio of capital to assets under custody), because the only risk involved is operational risk, and because it was believed that, for depositaries, these risks were, in the main, granular. Reliance on the reserves of depositaries to make good on the disappearance or immobilisation of assets at a large sub-custodian, which is likely to hold assets of a value many times that of the reserves of the depositaries, is not sufficient; capital requirements should be made of all parties to ensure that each manages some of the non-financial risk. The Financial Services Authority, in its recent supervisory review, has questioned the internal capital adequacy assessment process (ICAAP) of investment firms, and concluded (Waters 2009) that “operational risk analysis has in some cases failed to quantify risk exposures at an appropriate confidence level” and that even though “it has never been our intention to increase the level of capital requirements across the whole of the industry through our Pillar 2 assessment framework […], we will recommend additional capital to be held”. Capital is no more a barrier to entry than are the requirements that UCITS investment firms have sophisticated risk management and reporting systems; lines of capital could be provided by sponsors, too. Capital, however, has a cost, so the capital requirements should be sufficient to provide incentives but set so as to limit the rise in fees charged to investors.

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An EDHEC-Risk Institute Publication