Shedding Light on Non-Financial Risks – a European Survey

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

3. The Need for Change in Regulation and Risk Management Practices

argue that the board of directors is not well equipped to monitor the compliance of funds; Khorana, Tufano, and Wedge (2007, p. 6) note: “The SEC has mandated that boards have 75% independent members, but our results suggest that it is boards composed wholly of independent members that seem to be most vigilant with respect to performance”; they remark that boards have exercised their right to take the management contract away from the original fund sponsor only on very rare occasions. Such participation could possibly be reinforced if investors had better representation. The opinion is more divided on topics pertaining to ratings. Amenc and Sender (2010b) proposed that non-financial ratings should be included in the Key Information Document (KID) of each fund. Some 53% agree that quantification of non-financial risks (e.g. ratings) should appear in the KID (25% disagree). How should this information appear? A natural solution would be to resort to rating agencies. In interviews, respondents are more inclined to say that there should not be automatic reliance on rating agencies. Some commenters have put forward doubts regarding the general ability of rating agencies to perform their existing duties, let alone provide accurate non-financial risks ratings. The failure of rating agencies to perform their due diligence is actually a non-financial risk in itself. Regarding counterparty risk, there has been sustained criticism against the leniency of rating agencies for attributing their prized “AAA” grade to risky investments,

Conflicts of interests of asset managers seem to be a major concern of respondents. One specific measure that seems quite popular would be for regulators to reinforce governance by appropriate code of conduct of fund managers, such as the EFAMA (2011) code for external governance (67% agree, 13% disagree); second comes the view that regulators should enforce better governance through greater fiduciary duties of administrators (64% agree, 16% disagree). Some 61% agree that regulators should enforce better governance through an increased role for independent administrators (14% disagree). And some 57% agree that regulators should enforce better governance through reinforced responsibilities for auditors (19% disagree). So, the notion of reinforced external monitoring has received the least support, which can be understood in light of the old debate on the effectiveness and practical independence of external monitoring. A US view would be that independent administrators could have a greater role and weight in boards and supervisory committees, which would give more substance to the requirement that the “AIFM should act in such a way as to prevent undue costs being charged to the AIF and its investors.” (ESMA, 2011, p. 43). But this view has been questioned (including in the U.S.) as the responsibility of the board has not always resulted in strong monitoring. Technically, the board is elected at the general meeting; however, in practice, the promoter or the investment firm initially hires it, and there is little participation by unit- holders. Morley, Curtis and Olin (2010)

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An EDHEC-Risk Institute Publication