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

that marred the European Money Market Funds market.

Differences in efforts applied by supervisory authorities towards uncovering breaches of regulation and variations in sanctioning regimes are likely to lead to unequal levels of compliance, and therefore different levels of market integrity and investor protection. These also open the door to supervisory arbitrage detrimental to the establishment of a level playing field across the European Union. As things stand differences in the resources of supervisors, in their administrative and enforcement powers, in the criteria they use to arrive at a decision, in the pecuniary sanctions they can impose with respect to different categories of breaches, and in their use of sanctions is bewildering. 23 There is also variety with respect to civil and criminal liabilities for wrongdoing. 24 Differing implementation of European Union laws and differing supervisory and sanctioning cultures have created dangerous cross-country heterogeneity and opportunities for jurisdictional arbitrage, which are conducive to the growth of non-financial risks. Regulatory certification reduces the incentives for investors to perform effective due diligence on the actual risks of products and may exacerbate adverse selection and moral hazard phenomena, whose mitigation should be a major and ongoing preoccupation for the regulator (Amenc, Ducoulombier, Goltz, Tang, 2012), thereby increasing risks in the fund management industry. The danger of regulatory certifications based on inadequate rules

Likewise, under the current UCITS framework 22 , the meaning of safe-keeping is not defined, there is no list of assets that are expected to be held in custody, the duties of a depositary with respect to the selection and oversight of sub-custodians are unclear, and liability in case of loss of assets under custody is expressly left for each Member State to define. This combines to create considerable legal uncertainties about the extent to which a depositary is liable for asset losses and allows for widely differing levels of investor protection. As we highlighted in previous work, these unclear liabilities also mean that is difficult for depositaries to ascertain the extent to which they need to perform due diligence and exercise oversight and to charge fund managers for additional verifications not clearly expressed in regulations. The investment scope extensions described above were not preceded by studies of their impact on back-office or middle- office functions, and in some instances, e.g. investment in structured vehicles or funds of funds, it has become impossible for depositaries to discharge their monitoring duties (Amenc and Sender, 2010). Perhaps unsurprisingly, non-binding recommendations have proven a weak tool for convergence. In previous work, we underlined the possibility of considerable cross-country variations in leverage limits for sophisticated funds owing to different measurement options taken by Member State regulators when they adopted the non-binding recommendations of CESR (Amenc and Sender, 2010.)

22 - i.e. Directive 2009/65/EC (UCITS IV), Directive 2007/16/ EC (EAD); Directive 2010/43/ EU, Regulation No 583/2010, Directive 2010/42/EU, and Regulation No 584/2010. 23 - See for example the CESR report on the supervisory powers of Member States under the Market Abuse Directive (CESR/07-334) and the ESMA report on the actual use of sanctioning powers in this matter (ESMA/2012/270). 24 - After the serious deficiencies of the European supervisory and sanctioning powers were underlined by the de Larosière Group report (de Larosière Group, 2009); the European Commission defined a strategy to reinforce sanctioning regimes (COM(2010) 716) and started implementing it.

Adverse selection may arise when certification can be obtained by complying

38

An EDHEC-Risk Institute Publication