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

3. Proposal towards Better Management of Non-Financial Risks

to one quarter of their preceding year's fixed overheads (Article 21 of 2006/49/ EC). UCITS management companies are also required to have an initial capital of at least EUR125,000 plus two basis points of the assets under management above EUR250,000 (excluding assets it is managing under delegation), up to a cap of EUR10,000,000 of capital (Article 7(1) (a) of UCITS IV Directive, 2009/65/EC). The Alternative Investment Fund Managers Directive (AIFMD) has imposed the same capital requirements on managers of non-UCITS funds. 63 The own funds of an company managing collective investment funds are thus the maximum of the sums provided for by the CAD on the one hand and the UCITS Directive or the AIFMD on the other; they are thus particularly modest. Still the CAD explains that own funds” can serve to absorb losses which are not matched by a sufficient volume of profits, to ensure the continuity of institutions and to protect investors.” The UCITS framework requires asset management companies to employ a risk management process (Article 51 of Directive 2009/65/EC) and to maintain a permanent risk management function (reporting to the board of directors and in charge of implementing the risk management policy and procedures; ensuring compliance with the UCITS risk limits; advising the board of directors as regards the identification of the risk profile of each UCITS; providing regular reports to the board of directors, the supervisory function and management; reviewing and supporting the arrangements and procedures for the valuation of OTC derivatives (Article 12 of implementing Directive 2010/43/EU).

The risk management policy requires the management company to measure and manage all risks its UCITS are or might be exposed to (Article 40(1)(a)); these risks are market risk, liquidity risk, counterparty risk, and all other risks, including operational risks, which may be material for each UCITS (Article 38). 64 CESR has repeatedly underlined 65 that the computation of the UCITS global exposure 66 (as per Articles 41 and 42) represents only one element of the overall risk management process. Requiring, via ESMA guidelines and recommendations 67 , that management companies prepare, for each UCITS that they manage, a report on non-financial risks and their management, as we have suggested above, would greatly contribute to promoting transparency on these risks. This would also provide a welcome clarification of the related responsibilities of management companies and of the other links in the fund management chain, thus facilitating claims by investors when duties have been breached. While the threat of European class actions would promote adherence to high standards of risk management, these will remain lengthy, difficult and uncertain procedures. We consider it to be a stronger incentive to link the capital requirements of management companies to the importance of non-financial risks that their risk and investment management choices create for investors. This is not about creating a buffer for losses triggered by non-financial risks but about fostering realignment of interests between asset management companies and investors and reducing unmitigated risk. The need for risk-based prudential regulation

63 - It has also required that fund managers cover the professional liability risks either by additional own funds or by an appropriate professional indemnity insurance. Additional own funds can be as low as 0.01% of assets managed (Article 14 of the implementing delegated regulation) while adequate insurance requires coverage of 0.7% and 0.9% of assets managed for an individual claim and on aggregate per year, respectively (Article 15). 64 - Specific requirements are identified for liquidity risk so that the UCITS be able to comply with Article 84(1) of the UCITS IV Directive and respect its redemption policy (Article 40(3) and (4)); for counterparty and collateral risks (Article 43). Management companies also need to adopt arrangements and procedures to ensure appropriate, transparent and fair valuation of UCITS exposures to OTC derivatives (Article 44). 65 - e.g. in its guidelines 66 - Global exposure is a “measure designed to limit either the incremental exposure and leverage generated by a UCITS through the use of financial derivative instruments (including embedded derivatives) or the market risk of the UCITS portfolio” (CESR/10-788). 67 - While ESMA received expanded powers relative to CESR, its guidelines and recommendations remain non legally binding; however, competent authorities must now comply or explain and financial market participants can be required to publicly report on compliance. on risk measurement and counterparty risk (CESR/10-788).

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An EDHEC-Risk Institute Publication