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?

4.2 Rating Non-financial Risks The use of ratings of non-financial risks in risk-sensitive capital requirements In addition to the natural incentives to risk management created by the existence of capital requirements, modern regulations use risk-sensitive capital requirements as incentives. Regulators could lower capital requirements for investment firms and depositaries that manage these risks well (if capital requirements are set in the first place), as well as for institutional investors that invest in low-risk funds (including alternatives). Risk-insurance schemes Another way to lower non-financial risks is to use insurance schemes. One could either require investment firms to seek insurance for the amount of non-financial risks that exceeds their available capital or insure retail unit-holders directly; indeed, on 12 July 2010 the European Commission (2010) adopted a legislative proposal for a thorough revision of the directive on investor-compensation schemes, a proposal by which clients of all investment services covered under MiFID should be automatically entitled to compensation if, because of the failure of a UCITS depositary or sub-custodian, the assets cannot be returned to the UCITS. The cost of this extension would be borne by depositaries and custodians rather than by investment firms. Maximum proposed compensation is € 50,000 per investor; the aim is to protect small investors (or, as they are known in MiFID, non-professional clients). Insurance, like capital requirements, must be paid for by investment firms. As of October 2010, pre-funding of 0.5% of assets under management was planned. Full pre-funding

is an option that makes it possible to hasten paying compensation to unit-holders, but, other than for money-market funds, it is not necessary for UCITS. Full pre-funding would arguably be a great shock to the industry since the amounts required are several times the operating profits of investment firms, so progressive funding should be preferred. Last, to prevent adverse selection, the pricing of such insurance should be based on the risks involved in the funds; for the moment, however, the pricing proposal made by the EU fails to take these risks into account. Risk-sensitive capital requirements and insurance of non-financial risks must be based on a measure of the non-financial risks involved in funds, which we call ratings of non-financial risks. Ratings of non-financial risks are necessary to shed more light the risks arising from sub-custodianship and other practices that often hide risks from the end-investor. A rating of the non-financial risk of a fund should, together with its financial risk, represent the riskiness for investors, a concept different from the riskiness of investment firms or securities firms for their investors: UBS’s good rating did not keep investors in Luxalpha from getting taken to the cleaners as a result of sub-custody risk UBS failed to shield investors from. Rating the non-financial risk of a fund is different from assigning a fund, investment firm, or depositary a general rating. It requires access to information about sub-custody risk. In general, depositaries have the best information about some non-financial risks: they are usually the best informed of sub-custody risk, they are The use of ratings of non-financial risks in insurance schemes

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An EDHEC-Risk Institute Publication