A Better Grasp of Non-financial Risks

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

5. Conclusion

UCITS directives rely partly on country regulations, so European regulations should be reworked to close loopholes in the definition of depositary duties and liabilities and to ensure that non-financial risks are taken into account; the ESMA should be given extremely clear direct authority over country supervisors. The Madoff fraud and the demise of Lehman Brothers have put the definition of depositary rules on the regulatory agenda, but new EU regulations involve the risk of exorbitant liabilities for EU depositaries and that of implicit reliance on the reputation of large financial groups, precisely what new systemic regulations and oversight are trying to prevent. Convergence, drawing on the best of common-law regulatory culture, which relies on the adequate information of agents, and of civil-law regulatory culture, which relies on a clear definition of the duties of parties such as depositaries, is now possible. There are several means of providing unit holders better protection from non-financial risks, so an examination of the opinions of investment fund professionals would improve our understanding of the necessary development of regulations and risk management practices. With the support of CACEIS, EDHEC will take a survey of fund industry professionals and seek feedback on the options available. The options can be summarised as follows: For risks to be managed, each party should be accountable for the risks it is responsible for, and each could be required to hold adequate capital to compensate unit-holders for any non-financial losses it is responsible for (otherwise, again,

responsibility without regulatory capital means that the ultimate responsibility lies with the most highly capitalised party, usually the depositary). Capital requirements must serve as incentives, not as insurance. After all, investment firms are not sufficiently diversified or capitalised to offer full protection from non-financial risks; not even depositaries, with a ratio of capital to assets under custody on the order of 0.05%, can provide insurance against large losses in the system, because the disappearance of a large sub-custodian would involve losses worth several times their capital base. Insurance is a form of protection typical of civil-law countries. One could either require investment firms or investment funds to seek insurance against the risks that exceed a certain threshold or extend the investor-compensation schemes to the risk of disappearance of assets of UCITS funds. To prevent adverse selection, this insurance should be priced in keeping with a rating of the non-financial risks to which the unit-holders of investment funds are subject. These ratings should make more transparent the non-financial risks of investments in target funds and derivatives, which hide the true nature of risks. These ratings could also be used for risk-sensitive capital requirements. Typical of common-law regulation is transparency, not insurance. As long as non-financial risks are present in investment funds, without transparency, regulation cannot but be a failure. That the sponsors of funds or distributors and shareholders of investment firms had to pay for losses they were not informed of is a failure of regulation, because it means that, ultimately, unit-holders cannot count on regulations to protect them. Ratings of non-financial

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An EDHEC-Risk Institute Publication