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

As observed by Amenc and Sender (2010), these (modest) capital requirements should be set in such a way as to ensure that the marginal incentive to manage risks is greater than the marginal rise in fees charged to investors as a consequence of the rise in the cost of capital. The capital charge computation would be harmonised by ESMA and controlled by competent Member State authorities. ESMA would define the standard model and its parameters and the principles for the computation of the capital charge under internal models. Cost of capital considerations would encourage the management company to implement best practices in the selection of counterparties and infrastructures and the structuring of arrangements. The spirit would be that of the familiar “three- pillar” framework that combines risk-based capital requirements (Pillar 1); supervisory review of capital adequacy (Pillar 2); and market discipline through enhanced public disclosures (Pillar 3). An ill-structured proposal to extend investor compensation schemes to UCITS To strengthen protection of non-professional investors against restitution risk, the European Commission has put forward a draft update of the Investor Compensation Schemes Directive (ICSD), which had been introduced in the wake of the Investment Service Directive now superseded by MiFID. The Directive in force (97/9/EC) does not use the same investor definition as MiFID; it does not protect investor against default by a third party, such as a custodian used by the investment firm to hold the client’s assets; it does not cover collective investment schemes such as UCITS; it limits

protection to EUR20,000 and Member States can provide for investors to share in losses (up to this limit); its funding is not harmonised; and it requires the eligibility and the amount of the claim to be established before compensation is made, which can result in considerable delays. The proposal (COM(2010) 371) extends coverage to all MiFID investment services and activities and aligns the classification of clients with MiFID. 68 It also extends compensation to investors for claims relating to the failure of a firm to return financial instruments due to the failure of a third party custodian, and to UCITS holders in case of failure of a depositary or sub-custodian 69 . It increases the compensation limit to EUR50,000 and disallows co-insurance of losses as it deems it unrealistic to expect non-professional investors to be able to screen providers for operational risk, and it speeds up compensation. The proposal introduces basic principles for funding of the schemes; these include financing in proportion to potential liabilities, a target ex-ante funding level of no less than 0.5% of assets under management to be met within ten years and the possibility of additional calls for contributions, borrowing from various sources including among schemes as a last resort tool. The proposal minimum level of ex-ante funding is extremely high in respect of the operating profits of investment firms, let alone of those of the very depositaries to which the Commission 70 suggests the costs should be passed on to. 71 Since management companies play a central role in creating exposure to and mitigating non-financial risks, they should be the ones funding the

68 - Member States can still exclude professional investors, but this category is narrower under MiFID than ISD. 69 - It is unclear whether the insurance scheme would cover the type of losses for which the liability of depositaries could be discharged, e.g. acts of nature or states. Ex facie, it would not. 70 - As does, perhaps unsurprisingly, the European Fund and Asset Management Association (EFAMA, 2010). 71 - Besides, this figure is not substantiated and appears highly conservative. If a significant share of the premium were eventually borne by the investor, the scheme might be hard to justify to these from a cost-benefit point of view. Note that since the scheme does not cover all PRIPs, it would also encourage regulatory arbitrage.

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An EDHEC-Risk Institute Publication