Top 400: Non-financial risks in the European fund management industry
Samuel Sender discusses non financial risks in asset management and outlines some ways in which their effects can be countered
Recent research carried out by EDHEC-Risk Institute as part of the Risk and Regulation in the European Fund Industry research chair, in partnership with CACEIS, examines the rise of non-financial risks in the fund industry. The research looks at how non-financial risks came under the spotlight, the differences in country regulations, the risks of badly drafted EU laws, and the ways of protecting unit-holders from them. We use the term non-financial risks for risks in addition to the financial risks made clear in a fund's prospectus, risks that arise because of failed processes or failed counterparties and that include the risk of assets not being returned at all.
The recent crisis has led to large losses in the fund industry. The losses that spread through what was seemingly a single market for funds in Europe, however, were shared by depositaries, investment firms and distributors in a very different manner across countries.
These disparities have revealed regulatory loopholes and inconsistencies. Until the Madoff fraud and the demise of Lehman Brothers, the role of the custodian and depositary "was not understood outside the circle of practitioners who are professionally involved with custody and settlement activities" (Oxera, 2002). But the European Commission is now working on a set of rules for depositaries and proposing new regulations for investment funds. The EU proposals and regulations will have a major impact on the fund industry and on the supply of investment funds.
In our research, we examine several aspects of the overall issue of non-financial risks in the fund management industry. First, we illustrate the failure of regulatory authorities, the fund industry and investors to take non-financial risks into consideration until the Madoff fraud and the Lehman bankruptcy thrust these risks into the spotlight.
Secondly, we review the reasons for the rise of non-financial risks in investment funds, from the enlargement of available assets, through misplaced confidence in regulatory certifications to country competition in the application of EU regulations and in supervisory practices.
Thirdly, we focus on country regulations in Europe as they are explained by legal origins, on EU laws that give a central role to depositaries in the protection of unit-holders but contain loopholes; we also comment on the risk of depositaries being forced to take on exorbitant responsibilities in future EU regulations, and on the risk of a concentration of the industry if supervisors are tempted to rely on well-capitalised firms.
Fourthly, we review the means of shielding investors from non-financial risks: higher capital ratios for investment companies, the evaluation of non-financial risks involved in investment funds, insurance against non-financial risks, insurance whose pricing could rely on these ratings, or simply more transparency. Last, improving governance should result in better management of non-financial risks such as counterparty risk, liquidity risk and sub-custody risks.
Failure to take non-financial risks into account
EU regulators and the fund industry have failed to make adequate allowances for the operational consequences of financial innovation and for changes to funds. Progress has been made, to be sure, above all in governance, but, on the whole, provisions for managing non-financial risks, as well as the means of managing them, are still unsatisfactory in the UCITS framework.
Governance was improved and operational risks on transactions made with central counterparties (CCPs) were given more attention. On the whole, however, transactions outside CCPs were neglected. Corporate law has accorded governance greater importance.
The European Commission, however, has failed to guarantee the security of the settlement, custody, and control of operations performed outside the traditional space of securities held by central security depositaries; it is of course outside this space that the main realistic non-financial risks in investment funds arise. This failure is apparent in the European green and white papers (EU 2005, 2006) on enhancing the EU framework for investment funds, since the objective of white papers is to make concrete proposals to be discussed before laws are drafted. The green and white papers dealt mainly with simplifications in procedures; some attention was given to the prevention of risks by a limitation of conflicts of interests (notably by disclosures).
The preparatory green paper (EU 2005) shows that regulators were not unaware of potential risks: "The Commission feels that, with its reliance on formal investment limits, UCITS may struggle in the longer term to keep pace with financial innovation". UCITS (undertakings for collective investment in transferable securities) is the set of European directives that allow retail collective investment schemes to operate freely throughout the EU on the basis of a single authorisation from one member state. UCITS may designate a coordinated retail investment fund subject to the UCITS directive.
This recognition, however, is part of the general statement and not of the sections regarding law improvements, probably because at the time the Commission stated: "From an investor protection perspective, there have not been notable financial scandals involving UCITS. UCITS has provided a solid underpinning for a well-regulated fund industry."
Likewise, the Commission acknowledged that a single market for depositary services would first necessitate "further harmonisation of the status, mission and responsibilities of these actors", but only as part of the long-term challenges of the industry, not of any concrete proposal. In addition, the eligible assets directive (EAD) has no reference to the non-financial risks or post-market difficulties that could be generated by the enlargement in eligible assets; CESR (2007) has issued level three guidelines for the definition of eligible assets but no guidelines for depositaries and post-market operations. In none of these texts is sub-custody mentioned. Without improvements to EU regulations, non-financial risks increased as funds relied more heavily on leverage, on derivatives, and on investment in target funds and in countries that required local sub-custody.
Even though UCITS funds as retail products supposedly involve the highest degree of investor protection, Madoff showed that a massive fraud made possible the disappearance of all assets in a UCITS, and this without supervisory authorities or any of the parties involved in the security of unit-holders (the investment firm, the board of directors, the depositary) guaranteeing the security of the UCITS fund or making good on the losses.
Reasons for the rise of non-financial risks in investment funds
The increase of non-financial risks in investment funds is the result above all of the growing sophistication of the transactions and financial instruments of investment funds, of the pursuit of non-traditional risk premia, as well as of such regulatory actions as the passage of the EAD and the improved possibilities for leverage in sophisticated UCITS.
In addition, inappropriate regulatory certification contributed to the sale of bad products, to misrepresentation of these products, and to increasing risk. Country competition in the implementation of EU regulations and possibly in supervisory practices also had an impact.
Country regulations in Europe explained by legal origins
The vagueness of the EU definition of depositary liabilities and the explicit reliance of UCITS on country regulations mean that in the EU country regulations in the fund industry can be understood by legal origins more than by EU law. French financial civil law takes an administrative approach to depositary protection, an approach in which the depositary is an auxiliary to the regulator, whereas common law culture relies on private contracts.
The civil law approach has influenced European financial regulations such as UCITS, in which depositaries play a central role in the protection of unit-holders. In the current reworking of depositary obligations, the French influence on EU law threatens depositaries with exorbitant liabilities; the temptation to rely on well-capitalised firms may also lead to consolidation in the fund industry.
Means of shielding investors from non-financial risks
To shield investors from non-financial risks, all parties can be required to hold regulatory capital against these risks; insuring non-financial risks can also be considered. The pricing of insurance and of risk-sensitive capital requirements must be based on a measure or ‘rating' of the non-financial risks. These ratings would shed more light on non-financial risks arising from sub-custody risk, from market infrastructures, and from investments in other funds or in derivatives on other assets, risks that are not adequately reported today.
Last, governance can be improved by spelling out the responsibilities of the board and facilitating the intervention of unit-holders with class actions. The necessary improvements to risk management practices can then be driven by either regulatory bodies or industry groups. The failure to improve the regulatory framework should imply a subset of ‘secure UCITS' in which depositaries would be unconditionally responsible for the restitution of assets. The necessary changes having been made, assets would involve, in the main, listed European financial securities admitted to central securities depositories systems.
Samuel Sender is applied research manager, EDHEC-Risk Institute. This article was drawn from research carried out as part of the Risk and Regulation in the European Fund Industry research chair at EDHEC-Risk Institute in partnership with CACEIS.
Amenc, N., S. Sender, ‘The European Fund Management Industry Needs a Better Grasp of Non-financial Risks'. December 2010. EDHEC-Risk Publication produced as part of the ‘Risk and Regulation in the European Fund Industry' research chair in partnership with CACEIS.
CESR, 2007, CESR's guidelines concerning eligible assets for investment by UCITS. Ref: 07-044. March.
European Union, 2004, corrigendum to Commission recommendation 2004/383/EC of 27 April 2004 on the use of financial derivative instruments for undertakings for collective investment in transferable securities (UCITS).
European Union, 2005, green paper on the enhancement of the EU framework for investment funds.
European Union, 2006, white paper on enhancing the single market framework for investment funds.
Oxera, 2002, The role of custody in European asset management.