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

with the letter of the law but without truly restricting the fund’s investment strategy or protecting investors; this is particularly worrying in the retail landscape as non-professional investors often lack the resources to exert due diligence and make informed decisions (Amenc and Sender, 2010). A case in point is the French dynamic MMF segment as we underlined in previous work (Amenc, 2007; Amenc and Sender, 2010), whereby the regulator certified as highly liquid funds that were invested in potentially illiquid assets. Moral hazard may arise as investors or the fund management industry, on the basis of certification, become more risk-taking with the expectation of being bailed out by the regulator and its parent should risk materialise. Inadequate prescriptions and misleading certifications also contribute to mis-selling (i.e. incorrect representation of product characteristics leading to unsuitable or inappropriate investments) and poor risk management (when regulators’ assurances are taken at face value and risks are neglected). In the case of dynamic MMFs, regulatory certification based on inadequate rules contributed to the rise of adverse selection and mis-selling and to an increase in non-financial (as well as financial) risks. Other incidents demonstrated issues with the assessment of liquidity of eligible assets and with the liquidity management practices of funds certified as UCITS; suspension of redemption obligations and extraordinary measures allowing for isolation of illiquid assets in side pockets reflected poorly on UCITS as open-ended vehicles.

A majority of respondents to our survey agree that inadequate regulation and supervision played an instrumental role in the rise of non-financial risks in the industry: 58% of respondents consider that the lack of harmonisation of rules was an important or very important factor (and only 14% that it was irrelevant), and 57% blame inadequate and/or unclear regulation (11% judge it irrelevant). Not only has the regulation in place proven to be ill-suited to prevent or manage the non-financial risks arising from the changes in the investment fund industry, but it has also facilitated the growth of these risks by creating opportunities for jurisdictional arbitrage and reinforcing moral hazard through the promotion of certification over transparency. Regulatory initiatives follow crises with a lag and are crippled by backward-looking biases that make them poor instruments in terms of preventing future calamities. It is necessary to make the management of non-financial risks an integral part of risk management as a piecemeal approach to prudential regulation is bound to fail – specific predictions are bound to fail and blind spots are unavoidable. In the wake of the global financial crisis, the role of the regulator has grown to titanic or heroic proportions since its ambitions are nothing short of protecting humanity against risk. We consider this a manifestation of hubris and recognise in the constant recurrence of crisis the fates of Prometheus and Sisyphus. 25 We trust a more modest approach to regulation is warranted, which will focus on incentives to proper risk management and transparency In this approach, the central role of regulation

25 - For championing the cause of humanity and stealing fire from the gods, Prometheus, a Titan, was condemned by Zeus to eternal torment: bound to a rock with unbreakable chains, the defeated Titan went through the daily ordeal of having his liver eaten by a giant eagle–the organ would grow back overnight. For repeatedly tricking the gods (and causing a temporary interruption of human deaths by the chaining of god of death Thanatos, who had to be freed by god of war Ares who was annoyed by the lack of casualties), King Sisyphus brought upon himself an eternity of useless efforts and unending frustration. He was condemned to roll a huge boulder up a steep hill but Zeus ensured that the boulder would roll away from Sisyphus and back down the hill, forcing him to begin again and repeat the action forever.

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An EDHEC-Risk Institute Publication