A Better Grasp of Non-financial Risks

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

Appendices

Appendix 1: Synthesis of main losses

Figure 4: Large non-financial losses in the fund management industry (selection) This figure summarises the losses detailed in section 1.5

Name

Loss

Illustrates

Consequences

Lehman Invest- ment Bank & AIG, 2008

Losses on derivatives and high replacement cost

Counterparty risk management with derivatives

Extension of central counterparties for OTC derivatives (CCPs)

Lehman Prime Broker, 2008

Failure to return assets held by Lehman; losses for French depositaries responsible for return of assets

Counterparty risk with prime brokers; exorbitant responsibility of French depositaries; lack of homogeneity in European regulations of depositaries. Certification of Luxalpha shows diverging supervisory practices; lack of transparency on non-financial risks; insufficient supervision; reliance on reputation of large groups, not on regulations to protect unit-holders; diverging enforcement practices Lack of control of managers of hedge funds in the US; securities firms as risky custodians. Misleading certification of illiquid funds as liquid funds; absence of liquidity risk management by investment firms; lack of a clear definition of (eligible) liquid assets; unsuitability of the UCITS wrapper for illiquid strategies. Relying solely on ratings to assess (extreme) financial risks is an inadequate risk-management practice. Underlines possible inadequate processes and conflicts of interest with rating agencies. Underscores the difficulty of supervision of a fund with derivatives or structured products and the risk of reliance on the capital reserves of parents rather than on regulations. Importance of strict segregation of funds (ring-fencing) and of consumer protection by regulations, not only by governance and fiduciary duties. Underscores the absence of checks and balances in the fund industry (the depositary monitors the compliance of a fund, but no independent party such as the board of directors monitors the suitability of the decisions of an investment fund, contrary to what usually happens in a corporation). Underscores the importance of segregation and ring-fencing.

Awareness of non-financial risks and of regulatory divergences in the European fund industry; EU political agenda towards clarification, homogenisation and strengthening of depositaries’ obligations and liabilities.

Luxalpha, 2008

Delegation of management of a UCITS; total sub-custody of assets without due diligence and monitoring by the depositary; sponsor, depositary, and asset managers not able to assess the security of assets.

Madoff Securities, 2008

Madoff, not registered with the SEC, acted as an investment advisor, while Madoff securities took custody of assets. A Ponzi scheme was created. In France, cash+ funds certified as money- market funds were partly invested in mortgage-backed securities. They became illiquid and shareholders of the investment firm provided liquidity to the funds and bore some of the losses. Some US mutual funds, including money- market funds with usually constant $1 net asset value, “broke the buck” after holdings of AA-rated structured products collapsed. Reserve Primary Fund wrote off $785 million of debt issued by bankrupt Lehman Brothers Holdings Inc. Albion was forced to wind up because it did not have the means to make up the shortfall of about £1m in missing client assets. The manager used opaque structured bonds for increasingly concentrated investments in high-risk holdings, and breached the regulatory restriction of 10% holdings in unapproved securities. R. Maxwell juggled assets around his business empire, using company pension scheme assets as collateral for bank loans partly used for personal benefits. Hundreds of millions of pounds went missing. An option-type fund invested in Japanese options whose value fell considerably. The investor sued the depositary bank for failing to ensure that the fund was geographically diversified. The charge was dismissed on the basis that a depositary is responsible only for checking the legality (not the suitability) of the investment decisions of the management firm.

Obama package: Financial advisors must register with the SEC; greater oversight planned.

French cash+ funds, 2007 (and other property funds in Europe)

That the sponsors had to pay for losses which they were not informed of the possibility is is a failure of regulations. New regulations/criteria for money- market funds have been adopted.

Reserve Primary Money Fund and

Dodd-Frank Wall Street Reform and Consumer Protection Act;

other money- market funds.

SEC issues new regulations for money- market funds (2009).

SEC to set up a special office to watch over rating agencies and improve their workings. At the time, these events did not attract much regulatory attention.

Albion, 2002.

MGAM, 1996

Maxwell fraud, 1992.

Stricter segregation in financial regulations (Pension Act and Financial Services Market Act 2000)

A German invest- ment fund, 2001.

(probably has no direct regulatory consequence)

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An EDHEC-Risk Institute Publication