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

The role of the depositary While our proposal entrusts the depositary with a fiduciary duty vis-à-vis the fund’s investors and subjects it to a strict liability of unconditional restitution, it does not require the depositary to carry the burden of non-financial risks on its own. Not only must the depositary adopt best practices for the mitigation of non-financial risks, it must also design contracts with the other links in the chain – notably the fund manager and its sub-custodians – to align interests towards the prevention of non-financial risks and support the latter with adequate processes. The depositary’s negotiating power naturally depends on the competitive environment. From an adverse selection and moral hazard viewpoint, it would be unhealthy for depositaries to compete on the unconditional restitution obligation; this is precisely why we limit it to the restricted UCITS category. In this respect, 45% of the respondents in our survey considered that the concept of a secured subset of UCITS would be the best way to clarify responsibilities between parties in the fund industry (12% disagreed). Alignment of interests can feed on contractual distribution of responsibility for non-financial risks amongst entities that are suitably capitalised to share in the losses arising from the materialisation of these risks, and/or sufficiently incentivised (by way of a risk-based capital framework) to diligently identify, measure and mitigate the non-financial risks that stem from their decisions. Alignment of interests can also be supported by differential pricing of services that would be sensitive to the adoption of processes

that contribute to mitigating non-financial risks; this can be performed in the absence or as a reinforcement of a risk-based capital framework. Achieving a high level of security is relatively easy if opportunity costs are disregarded: restrict the asset class menu and the geographies to those offering the highest passive protections; shun operations and investments entailing non-financial risks, etc. For the concept to be attractive, it is necessary that stakeholders actively engage in building an architecture and processes that improves the prevention and management of non-financial risks to bring these down to a level where it can be insured (internally or externally) at a reasonable cost – it may well be that in the process, certain assets, geographies and arrangements, while permitted within the legal framework of restricted UCITS, will prove too costly to secure or insure relative to the benefits that they may offer and that they will be left out as a result. We regard this as both necessary to achieve the objective of restricted UCITS and as a valuable signal that could prompt stakeholders to make the investments and/ or the changes required to establishing an environment conductive to sustainable investments. The scope of restricted UCITS For the depositary to be in a position to guarantee unconditional restitution, it must reduce risk to a very low level. Given the extreme nature of the non-financial risks of key relevance and the practical difficulty associated with their assessment, a conservative approach is preferable.

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An EDHEC-Risk Institute Publication