Magazine Issues » June 2012

EDHEC RESEARCH: A strong message about transparency

Transperancy_180The Edhec-Risk Institute said in 2010 that non-financial risks needed more attention. Samuel Sender, research manager, dissects a recent attempt to find out if the investment community agrees.

To date, no satisfactory measures have been taken either by the national and supranational regulators, or by the industry itself, to put non-financial risks under control. Growing sophistication of operations and investment strategies, together with their progressive internationalisation, have outpaced the capacity to establish proper risk management practices.

In our 2010 study, The European Fund Management Industry Needs a Better Grasp of Non-financial Risks, by Noël Amenc and Samuel Sender, we insisted that transparency and governance were at the forefront when trying to tackle non-financial risk. Those improvements could come from regulators, self-regulation by industry bodies, or both.

It was suggested that a possible way to improve the transparency with respect to non-financial risks would be to include an explicit rating of these risks in the Key Investor Information Document (Kiid) of each fund. This could evaluate risks related to sub-custody, infrastructure, operations, or counterparties for funds in derivatives operations.

To avoid ill-defined chains of delegations that create opaqueness and uncertainty, it seems necessary to spell out each party’s duties, either in law or by explicitly defining them contractually at the inception of the fund. One logical approach would be to define obligations according to who controls which part of the information.

Regulation on restitution and depository liabilities would add to these measures. The responsibility for restitution could be defined in law or by contract between depositories, sub-custodians and asset managers, with conditionality and “reasonable delay”.

When protecting the final investor, distribution plays a major role. Mis-selling is a large source of risk, and re-sellers of funds should provide clients with information that is accurate and not misleading. However, who does what due diligence is a valid question, as one cannot expect the distributor to access the information as processes become more complex.

Judicial powers
A final message we sent from the 2010 study was with regards to the judicial powers of investors. The EU legislation is still lacking a legal framework for settling disputes, and those are still handled at a national level. The result is a case-by-case approach, which does not do away with national disparities. An EU body to ensure that national laws do not conflict could be justified.

Supervisory powers differ in implementation with widely varying maximum fines, and differing cultures. Furthermore, it is difficult for an investor to have recourse to a foreign mediator. Thus, a European Ombudsman could be justified. Last, the definition of class actions in EU financial laws could help investors enforce the fiduciary duties of fund managers.

In our recent Shedding Light on Non-Financial Risks – a European Survey (by Amenc, Sender and François Cocquemas), carried out with the support of Caceis, we asked European fund industry professionals for their views on non-financial risks and the possible regulatory and industry solutions.

Industry opinions
The survey was conducted between 27 June and 18 September, 2011 and is based on replies from 163 high-level professionals from the European fund industry, including asset managers, pension funds, insurers, consultants and regulatory supervisers.

More than a fifth of the participants were from France. Luxembourg and Ireland account for almost 17%, followed by the UK, Germany, Austria and the Netherlands. Other European countries still represent more than a third of responses, which testifies to the geographic diversity within our survey.

All the specific risks come out at a high level of importance, without a clear outlier. Gaining 75% or more of the vote were:
• Bankruptcy risk of an intermediary
• Collateral risk
• Internal or external fraud
• Liquidity risk
• Breaches of investment rules

Mis-selling risk was 70%.

The perceived degree of protection from these risks is uneven, with respondents notably feeling less protected against liquidity risk.

The increased sophistication of operations is, however, undoubtedly a prominent source of non-financial risk as it is important or very important for 77% of respondents.

This is followed by the reduced capacity of an intermediary to guarantee deposits (understood as ensuring the return of assets), which came out at 59%.

Inadequate and/or unclear regulation came out at 57% and the absence of responsibility of management companies regarding restitution at 53%.

Respondents have mixed views on regulatory initiatives. They think the Alternative Investment Fund Managers Directive will marginally contribute to decreasing non-financial risks (27% think risks will decrease, 21% that they will increase).

By contrast, they are slightly worried about the Ucits automatic notification procedure (31% think it will increase risks, 10% that they will decrease).

Strong message
The table shows that when it comes to the relative importance of themes, there is a very strong message that the respondents are sending out to regulators: they believe in transparency. Some 61% of respondents rank transparency, information and governance as their top priority for new regulation, while 40% picked the financial responsibility of the industry as their second choice.

Regulation on restitution and distribution come out similarly, in third and fourth positions. Giving more judicial powers to investors seems to come out lower on respondents’ agenda.

An important priority for regulation would thus be to improve transparency, to the extent that respondents on the whole and institutional investors are ready to pay the price for this improved transparency (more than for other types of measure). An overwhelming majority of respondents (91%) agree that regulators should ensure that the information is indeed fair, clear and not misleading.

Governance comes immediately behind transparency. A very strong majority of respondents (79%) agree that fiduciary duties of asset managers should be reinforced, by stating that they must invest for the sole benefit of their clients. Ratings of non-financial risks in the Kiid, as we proposed, would still be a good way to improve transparency for 53% of respondents.

In a following article, we will turn to the survey responses on the important question of the respective responsibilities of asset managers and depositories within the fund management industry.

Samuel Sender is applied research manager at the Edhec-Risk Institute

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