Proposals for Better Management of Non-Financial Risks within the European Fund Management Industry

Proposals for Better Management of Non-Financial Risks within the European Fund Management Industry - December 2012

Executive Summary

safety net for non-financial risks, but rather an encouragement which ultimately aims to ensure that the reduction of capital linked to improved risk management is greater than the increased cost of implementing additional requirements relative to the standard formula. EDHEC-Risk Institute considers this so-called "risk based capital" approach, which using the internal model should not lead to a strong increase in the economic capital of depositaries and asset managers, to be more virtuous than the costly contribution to an investors’ guarantee fund, which the Commission is proposing to extend to UCITS. The approach being proposed by the Commission would effectively create a pooling and transfer of risk which would not reduce it in the slightest, but on the contrary encourage the phenomena of adverse selection and moral hazard. Indeed, fund managers and investors would have no interest to reduce non-financial risks, but instead would have incentives to minimise their management costs or to maximise the profits they can generate from financial risk taking. The third and final series of recommendations is probably the most important because we feel that not only does it address the challenge of marketing UCITS funds to inexperienced individual clientele, but it also helps clarify and strengthen the global image of the UCITS label, which was affected following the emergence of NewCITS and also altered due to a number of issues and scandals that have come to light since 2007.

financial risk – on one hand we have the extreme correlation between the real estate mortgage and equity markets and, more broadly, on the other hand the extreme price sensitivity of all assets to counterparty and liquidity risks of the financial system with respect to off-balance-sheet operations such as securitisation. Despite being quite pronounced in 2007-2008, the first type of risk was regarded, after the fact, as a logical consequence of increasingly globalised markets and probably of the theoretical character, from the perspectives of both investors and the regulator, of the very idea of distinct asset classes or categories and the reduction of this risk through its dissemination. The second type of risks led regulators to absolutely want to reduce counterparty and liquidity risks by strongly stressing the need to increase regulatory pressure with regard to proper management of these risks by actors in the financial world. Within the fund management industry, this focus paradoxically led the regulator not to question the extent of operations and assets eligible for regulated funds (and on a European level particularly the flagship investment vehicles that are UCITS), but rather focus on non-financial risks within funds and call for a trusted third party – the depositary – to act as a guarantor for the risks taken by all parties.

We believe this approach is wholly ineffective and dangerous to say the least.

In fact, the recent financial crisis shed light on a number of new sources of

Ineffective because, in the end, the goal of fully protecting an investor’s assets

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An EDHEC-Risk Institute Publication