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

bulk of this proposed insurance system, lest the scheme perpetuates a situation whereby the party with the highest control over non-financial risks is not given incentives to take them into account when making investment decisions. Furthermore, focusing the attention on a fixed minimum level is at odds with the overarching principle of linking funding to potential liabilities. To foster good practices and deter adverse selection and moral hazard, such an insurance scheme would need to be risk-based. The evaluation of risk should be fair, accurate, and comprehensive and proceed from the fund’s investment policy and risk profile, the selection of counterparties and sub-custodians made by the management company and depositary, and the risk mitigation systems in place. Given the mutualisation of risk that the system implies, self-evaluation by the investment firm and the depositary could not be the sole source of information and external monitoring, e.g. by rating agencies, would be required. The global financial crisis has starkly illustrated the moral hazard dangers of improperly designed risk transfer mechanisms and the limits of monitoring by rating agencies. Against this backdrop, we consider that the aforementioned prudential approach that aims to reduce non-financial risk should be preferred to a system of risk transfer that may prove counterproductive. Depositaries The proposed UCITS V Directive (COM(2012) 350) authorises both credit institutions and investment firms that provide the ancillary service of safe-keeping and administration of financial instruments to serve as UCITS depositaries (these are subject to MiFID

capital adequacy requirements (Article 20(1) of 2006/49/EC), which cannot be less than the initial capital of 730,000 euros (Article 9)). These institutions are within the scope of CRD and thus have capital requirements that are linked to their market, credit and operational risks. While the non-financial risks reviewed here are characterised by a low frequency and high severity, operational risk measurement and measurement has traditionally paid more attention to high frequency events. This is implicitly acknowledged in the proposed CRD revision: “competent authorities shall ensure that institutions implement policies and processes to evaluate and manage the exposure to operational risk, including to low-frequency high-severity events” (Article 83, COM(2011) 453). However, the calculation method for the capital charge for operational risk assigns a very light weight to safe-keeping and administration activities because these activities are considered mildly risky – which is not inconsistent with loss data 72 – and exposure is proxied by gross income whilst these activities are low charge in relation to the assets serviced. 73 When reviewing loss data, one should keep in mind that the operational risk definition of the Basel committee is narrow and as such does not capture all non-financial risks; for example, reputation risk that triggered the fund rescues described in chapter one is not recognised. Risk-based capital frameworks should be further improved to take better account of non-financial risks, via scope adjustments of and finer grain analysis within the

72 - Studying events of all severities, the quantitative studies by the Basel Committee on Banking Supervision find that the annualised operational losses of banks for agency services and asset management business lines each make up less than 5% of losses across all business lines (see for example Table ILD 5A in BIS BCBS, 2009). 73 - The Standardised Approach of the Basel II/III framework computes capital charges for operational risk for each of a bank’s eight business lines, by multiplying the gross income for the business line by a factor reflecting the frequency and severity of loss experienced for this business line across the industry. The factors are 15% for agency services and 12% for asset management; corporate finance, trading and sale, and payment and settlement services are charged at 18%, retail banking and retail brokerage are charged at 12%.

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An EDHEC-Risk Institute Publication