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

to expect they will have little incentive to perform their own due diligence and will expect to be rescued by large financial groups attempting to preserve their good names. The demise of American International Group and Lehman Brothers: counterparty and collateral risks While concerns about counterparty risk were brought to the fore by the near-default of Bear Stearns in March 2008, they soared with the September 2008 demise of Lehman Brothers (Lehman), a trusted investment bank which was a major counterparty to over-the-counter derivatives transactions. 12 The day after Lehman filed for bankruptcy, the United States authorities initiated the rescue of American International Group (AIG), then the largest insurance company in the world. The Financial Products Group of AIG had become a key counterparty in the credit derivatives business with gross exposure in the trillions; the failure of AIG would have further increased financial instability and systemic risk. 13 Pension funds that hedged their long-term interest rate risk with swaps to which Lehman was counterparty suddenly found themselves with a huge interest rate risk on their balance sheet, just as the crisis was provoking a flight to quality and sharply falling interest rates. Investors who had relied on AIG or Lehman for protection from credit risk found that they were virtually facing comparable woes. For those affected, the main tools used to hedge financial risk, financial derivatives, had become useless exactly when they had been most needed because of the

materialisation of non-financial risk whose concentration had been overlooked.

12 - When OTC derivatives are cleared and settled bilaterally between the investment bank and its client, the client remains exposed to the bank counterparty risk throughout the (long) life of the instrument; counterparty risk can be reduced by collateralisation and, where relevant, bilateral netting. However, there are legal and operational concerns regarding the ability to access and liquidate collateral in case of counterparty default. With exchange-traded instruments, clearing and settlement takes place through central clearing houses counterparties with the support of central securities depositories (CSDs). The central clearinghouse typically plays the role of central counterparty (CCP) i.e. it becomes the buyer to every seller of a contract and the seller to every buyer. Clearing houses are typically highly regulated and require all counterparties to over-collateralise. The use of a central counterparty simplifies the management of counterparty risk and collateral management, allows for multilateral netting of exposures and payments, and increases transparency. When a central counterparty is used in an OTC market, trading continues to take place on a bilateral basis, but each bilateral agreement is novated to the CCP i.e. it is replaced by two new contracts linking the CCP and each party. 13 - The Lehman collapse nevertheless led to panics on the money market mutual funds and commercial paper markets; impairment of access to short-term funding and upped collateral requirement caused major trouble at investment banks and other institutions crucially relying on the short-term debt markets for funding. 14 - Yet another issue was that some clients were unaware of the loss of protection linked to their entering into title transfer and right of use arrangements (vs. security financial collateral arrangements) with Lehman, which had made them unsecured creditors of the company. As a result of Lehman’s default, these investors lost access to and possibly part of the assets for which they were beneficial owners for the duration of bankruptcy proceedings. 15 - The British system treats rehypothecated assets as assets of the insolvency estate, but even assets that had not been re-hypothecated were tied up in the administration process (Belmont, 2012). 16 - MiFID refers to Directive 2004/39/ EC, implementing Directive 2006/73/ EC and implementing Commission Regulation (EC) No 1287/2006. 17 - The topic had been the subject of discussions for several years.

Another issue that arose in relation to the Lehman case was that of the access to the collateral held by Lehman’s prime brokerage unit on behalf of its clients, some of which had not been segregated. While some clients of Lehman Brothers International Europe (LBIE) saw their assets returned promptly, others experienced delays and losses. 14 One of the reasons for this discrepancy of treatment was a different legal approach to collateral held across jurisdictions. As an illustration, the French regulator required that collateral, minus the debt of the client to Lehman, be returned by depositaries immediately to the investment fund; whereas the UK liquidator blocked the restitution of assets held as collateral. 15 As a consequence, many investment funds could not complete any transaction, and the French regulator ordered depositaries to return the securities placed in sub-custody with LBIE to the funds concerned. The effectiveness of the client money protections rules of the Markets in Financial Instruments Directive (MiFID) 16 may be limited in practice since these rules do not change Member State insolvency and bankruptcy laws; in the case of LBIE, the protection were afforded through an English statutory trust, whose exact scope was contested leading to uncertainties and delays until the matter was settled by a controversial Supreme Court decision. The systemic risk implications of the financial distress experienced by Lehman Brothers and AIG triggered a swift response from regulators which made it a priority 17

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An EDHEC-Risk Institute Publication