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

3.3. Restricted UCITS Applying the onerous restitution liability standards of the draft UCITS V Directive across the entire UCITS universe would, in our opinion, result in significant costs and opportunity costs for investors, in particular for non professional investors, should some classes of investments be discontinued under UCITS or see their expected yields severely reduced by compliance costs. Moreover, communication around the obligation of restitution may mislead non-professional investors into believing that they will always be protected against the non-financial components of investment risk, which will not be the case since the restitution liability concerns only assets that can be held in custody 74 and even within this range there will be circumstances e.g. acts of nature that will discharge the depositary of its restitution duty. As illustrated in the previous two chapters, one should remain wary of promoting a false sense of security by over-communicating around the protection afforded by new laws, best practices or even high ratings. Last but not least, the absence of contractual discharge for the liability of the depositary in UCITS V creates adverse selection and moral hazard issues at the expense of depositaries and the soundness of the industry. Against this backdrop, EDHEC-Risk Institute wishes to put forward a proposal for a major upgrade of the European fund management industry. The proposal is to create a subcategory of UCITS that would be structured to avoid exposure to

operational risk category. Making reserves more sensitive to exposure to and mitigation of non-financial risks would promote a clearer allocation of these risks between institutions, sounder risk management at the level of each firm and risk reduction at the macroeconomic level. The use of internal models instead of standardised approaches would allow to measure economic capital for non-financial risks and better direct investments and risk mitigation measures. Extension of restitution liabilities, whether mandated by law or as per contractual agreements e.g. offering of a guarantee by the depositary to a fund that implies that the depositary will make good on losses caused by the default of a third- party, would unambiguously require additional operational risk capital charges for depositaries. The extent of the charge would depend on the gross exposure and the mitigation measures applied by the depositary, which will have strong incentives to carefully select counterparties and implement best risk management practices. With respect to the definition of best practices and while the potential for further improvement exists, a lot of work has already been done under the impetus of industry bodies as well as international regulators and supervisors. For illustration, the Appendix discusses the mitigation of counterparty and restitution risk in the context of OTC derivatives, EPM techniques, and sub-custody networks. Other areas of interest are the safekeeping of liquidity and the associated credit risk management of cash deposits, due diligence for target funds (see Amenc and Sender, 2010), and operational risks.

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An EDHEC-Risk Institute Publication