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

1. Regulation and Non-Financial Risks

The last decade has been marked by the materialisation of non-financial risks on an unprecedented scale. The heavy losses inflicted upon the fund industry exposed a lack of attention to the proper management of such risks. The losses spread through what was seemingly a single market for funds in Europe. They were, however, shared by depositaries, investment firms, distributors and end-investors in a very different manner across countries. These disparities have revealed regulatory gaps, loopholes and inconsistencies in the way European Union Member States had transposed European Directives into national laws and were enforcing these laws. Crucially, they exposed the European Undertaking for Collective Investment in Transferable Securities (UCITS) framework – which has supported the growth of a pan-European fund market by facilitating cross-border distribution within Europe and earned strong brand recognition internationally for offering high levels of investor protection and prudential supervision – as a franchise with marked national identities. This prompted the European regulators to act to safeguard the integrity of the UCITS market and brand worldwide. Non-financial risks are risks in investment funds that arise out of failed processes 3 and failed counterparties. In contrast to the negative materialisations of financial risks, which are associated with return shortfalls or negative returns on assets, the negative realisations of non-financial risks can include the outright loss of assets. Non-financial risks and financial risks overlap and interact, and our review of financial risks will include non-financial

counterparty risks and liquidity risks. The former refer to the failure of a counterparty in the context of an operation where no credit risk exposure was sought as such, but where counterparty risk arose due to the structural features of the contracts or instruments used. 4 The latter refer to the failure of liquidity management processes at the vehicle level which causes an open-ended fund to suspend redemptions (or subscriptions) or impose restrictions on redemptions (e.g. establish side pockets for illiquid assets or redeem these in kind). 5 The main non-financial risks to be discussed here are the failure of an intermediary (materialisation of counterparty risk), the inability to manage (subscriptions or) redemptions leading to a freeze (failed liquidity management processes at the vehicle level; e.g. following materialisation of counterparty risk or liquidity risk at the instrument level), internal or external fraud, mispricing/misevaluation or poor accounting, mis-selling, the breach of fund rules or regulation and legal risks. Non-financial risk in investment management has been discounted as an afterthought by too many fund managers on the assumption that it was a marginal and to be managed by a third-party, the depositary. 6 End investors, especially retail investors, were largely kept in the dark about the non-financial risks of their investments. While financial risks normally dwarf non-financial risks, the materialisation of extreme non-financial risks – low frequency, high severity events – can lead to crippling financial losses and major impairments of brand value (reputational risk). For

3 - In all dimensions of operations and not only within the organisation but also in relation to all parties involved in the production and distribution of the fund. 4 - For example, when an equity fund purchases a certificate representing ownership of shares from a bank to gain indirect access to international markets, it is trying to reap the equity premium associated with the underlying company rather than actively seeking the counterparty risk exposure of the issuing bank which it nevertheless has to take on as part of the transaction. This is different from the active assumption of counterparty credit risk by a fund with a view to collecting the default premium that is associated with risky fixed income instruments. 5 - Whether the fund failed to recognise the liquidity risk of the underlying instruments or actively sought to reap a liquidity premium, it was marketed as an open fund and probably treated as a liquid vehicle by its investors. 6 - And internal to the fund manager, the temptation could be for the portfolio manager to consider that non-financial risk is a by-product of investment decisions that will be managed by the middle office or is limited to operations risk dealt by the back office.

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An EDHEC-Risk Institute Publication