Shedding Light on Non-Financial Risks – a European Survey

Shedding Light on Non-Financial Risks – a European Survey — January 2012

2. A General View of the Situation and Challenges

assets (definition of eligible assets and diversification requirements) and on the enforcement of risk management practices” (p. 31), yet that there were various definitions of eligible assets. On the whole the main message is that differing implementation of EU laws and differing supervisory cultures have cause heterogeneity in the European fund management industry. We investigate which of the following causes are judged most important in explaining the rise of non-financial risks: •  Increased sophistication of operations •  Lack of professionalism or poor training of some intermediaries •  Inadequate and/or unclear regulation (particularly related to non-financial risks) •  Reduced capacity of some intermediary to guarantee deposits •  Absence of responsibility ofmanagement companies regarding restitution •  Lack of harmonisation of rules •  Internationalisation of the fund management industry The rise in non-financial risks stems not from a unique cause but from concomitant factors For respondents, it seems that most of the historical causes we put forward were deemed important, so much that a clear hierarchy is not striking. The increased sophistication of operations is however undoubtedly a prominent source of non-financial risks: it was important for 77% (irrelevant: 1%). With the increasing sophistication of fund management techniques and number of asset classes, investment funds invested in derivatives and extended their holdings

depositaries couldholdall assets incustody. With the increasing sophistication of fund management techniques and number of asset classes, investment funds invested in derivatives and extended their holdings of securities to geographies that required local custody.” (p. 26); that “regulatory certifications based on inadequate rules contributed to adverse selection and mis- selling: adverse selection may arise when certification can be obtained by complying with the letter of the law but without truly restricting the fund’s investment strategy or protecting investors. UCITS money market funds, supposedly the most liquid, have been able to invest in illiquid assets, such as sub-prime securities, which only seemed liquid, as trading volumes were very thin relative to the size of the underlying assets. Investment in structured products can provide the same illusion of liquidity. For such funds, the requirement to have bi-weekly calculation does not mean that fund liquidity will be available when needed by investors, and it creates a false sense of security, especially since regulators and supervisors authorised in UCITS funds suspensions and side pockets typical of illiquid hedge fund strategies” (p. 27); that “unclear depositary obligations and liabilities increased risks: the growing sophistication of funds, as well as their greater use of derivatives and of international assets that require external sub-custody”; that the depositary liabilities where left undefined in UCITS; that there was “country competition in implementation guidelines: The UCITS regulation has inherited from country and European retail regulations the objective to protect unit- holders of regulated investment funds. It relies on requirements on eligible

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An EDHEC-Risk Institute Publication