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Unnecessary imposition

The law of unintended consequences is a rich source of irony. There are perhaps four necessary ingredients: the good intentions of the parties involved, some merit in their thought processes, their failure to take account of one or two critical factors and significant damage to those involved or to the object of their attention. The proposed revision of the Capital Adequacy Directive appears to have all the necessary ingredients.
Good intentions there are aplenty. Protection of the world financial system against systemic risk – what right thinking person, from regulator to man in the street, would not support such a cause? Investor protection – some might mutter ‘caveat emptor’ but most regulators and their political masters will endorse the concept. And is a capital requirement not an effective form of protection? Furthermore, it does not cost the taxpayer. And, if capital is to be required by regulators, who would object to the suggestion that the amount required should be sensitive to the risks involved? Surely a fair, beneficial proposal waiting to be inscribed in the European statute book.
And surely operational risk, however tricky to define, is a major category of risk? If capital requirements are to take account of risk they should take account of operational risk. And how convenient that the Basel Committee, which is not composed exclusively of European, or at all of asset management industry, regulators, should be preparing a blueprint which could be applied by means of a European directive across the board to financial services throughout the EU.
There is much merit in these thought processes as applied to the ‘internationally active’ banks and also as regards some types of investment firm. But, for the purposes of the Capital Adequacy Directive, investment firms includes asset management companies investing assets belonging to pension funds, life funds and other forms of collective investment. And the merits of the above thought process are distinctly limited in respect of asset management companies.
Asset management companies, even the best controlled ones, make operational errors despite tight internal controls. Generally these errors are small in terms of financial liability relative to current capital requirements, which are based on operating expenditure, or to assets under management. Occasionally, usually when fraud is present, the financial liability to customers can be large. It is difficult to see how the occasional occurrence of such large financial liabilities to customers poses a threat to the financial stability of the global or European financial system. The asset management company is not generally trading on its own account but on account of its customers and its customers are diverse, independent entities whose assets are held by independent custodians.
The customer may need protection – but how much and at what cost? Capital provides protection but has a cost which will be reflected in the level of fees charged to the customer. The greater the amount of capital required, the greater the cost. The amount of capital required to meet any potential liability arising could, in extreme cases, equal the amount of assets under management. Clearly this is not economically viable.
What are the factors which the parties involved are failing to take into account? One important factor is that the European Commission’s proposals for a capital requirement for operational risk for EU-based asset management companies will not be applied to non EU-based ones. In the US there is no significant capital requirement on asset management companies nor is the Securities and Exchange Commission likely to impose one. And yet US-based asset managers are competing with managers based in the EU for mandates from clients both in and outside the EU without incurring the cost of a high capital requirement.
How would European asset management companies react if this imposition materialises? Some may withdraw from certain parts of their activities because, as a consequence of the higher capital requirement, the business no longer satisfies the return on equity requirement to which they are subject. Others may transfer their business in varying degrees outside the EU. Significant damage is thus likely to be done to an industry which legislators and regulators are aiming to improve and promote. The damage done to the industry will impact its customers in terms of higher costs and less competition among suppliers. It will encourage them to entrust the management of their portfolios to unregulated offshore asset management companies – surely not the objective.
The perceived or real need for speed perhaps transforms irony into farce. When earlier capital adequacy legislation was enacted to reflect agreement reached at Basel, the European legislative process was unable to move as rapidly as the American legislature. European banks therefore suffered a transitional competitive disadvantage relative to American banks. In their determination to ensure that this does not happen again, those responsible for European legislation are rushing ahead without due regard to the effects on the European asset management industry.
But in the meantime, the European asset management industry has developed into an industry in its own right investing client portfolios in securities. Many of these securities effectively provide finance that would formerly have been provided by banks. Some are actually securitised bank loans. With the growth of equity and securities finance throughout Europe, the European asset management industry is increasingly playing the economic role, formerly played in continental Europe by the banking industry, of transforming savings into investment. It would be ironic if, in their determination to maintain the competitive advantage of the European banking industry, European legislators and regulators were to seriously compromise the competitive position of the European asset management industry.
Michael Haag is secretary general of the European Asset Management Association in London

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