September 2012

EDHEC RESEARCH: Depositories not always responsible for losses

Forest-FireSamuel Sender analyses opinion about the impact of regulation in the third and final article about non-financial risks. Neither regulations nor the fund management industry have been able to adequately anticipate the rise of non-financial risks and ensure these are controlled, managed and adequately communicated, respondents to Edhec’s Shedding Light on Non-Financial Risks survey said. The industry is well aware of the limitations of regulations and, on the whole, there is a certain consensus on the idea that there are some non-financial risks inherent to investing which, even when not rewarded, must be taken. Indeed, 87% of respondents agree that the role of regulation is to limit non-financial risks and ensure that they are controlled and managed, not to suppress them. A very strong associated statement is that 56% agree that insuring risks will lead to a loss of accountability among investors. In addition, when it comes to a much-discussed practical detail regarding the way to protect investors, increasing the depository liability regarding restitution, 62% agree that a depository cannot guarantee the restitution of assets that are not under its custody and control. Restitution
Respondents are also afraid that enforcing restitution duties will be costly (49% think that regulations cannot guarantee the restitution of assets at a reasonable cost and 29% are unsure, so only 22% think this is possible). Yet respondents are split on the importance of supervision and regulation itself. Respondents in asset servicing, who may be more concerned with these questions, are more worried than others that it cannot be done at a reasonable cost. After all, they think that they will bear a large chunk of the costs associated with more extensive regulations. Similar percentages (42% agree, 31% unsure) are given to the assertion that the fund management industry cannot guarantee the restitution of assets at a reasonable cost. This last item sees a lot of divergence between countries. While France believes more than average that it is possible, the UK, Germany, Austria and the Netherlands are significantly more sceptical than average. In terms of categories of respondent, we also see an interesting group of pension funds, insurers and resellers being more optimistic on that option than assets managers and asset management servicing. Whether this reflects a more informed position or a different prior is up for debate. A minority of respondents, usually more from the British regulatory and political culture, are pessimistic about regulations because they think that regulators have absolutely no hindsight and, just like the industry, are following market trends and acting after risks have materialised, but will always fall short of preventing them. This view confirms that regulations are partly politically driven, that they are inadequate, costly, induce high frictional costs that end up penalising clients, and they generate inappropriate innovation from the industry aimed at removing the inconveniences of regulation rather than at providing better solutions to their clients. Faith
Respondents from continental Europe, such as the French, who have inherited a stronger administrative and regulatory culture, have more favourable perceptions of regulatory initiatives in their open answers. Luxembourg and Ireland, which have both relied on European regulation and the notion that it facilitates the distribution of funds to expand, are naturally inclined to have faith in European regulations. They disagree significantly more than average that the role of regulations is to limit non-financial risks and ensure that they are controlled and managed, and not to suppress them. They are also attached to the Ucits brand. Almost 59% of respondents agree that, on the whole, the existing complexity and internationalisation of Ucits funds may make it impossible to guarantee the restitution of assets at a reasonable cost. In this light, one could envisage creating a subset of secure Ucits for which the depository is — contractually or legally — unconditionally responsible for returning all assets that can be returned (financial derivatives cannot be). More than 67% of respondents agree that this would be worth investigating. However, if securities are limited to European financial securities admitted to central securities depositaries, a significant but lower 57%
think that this secure subset is worth investigating. For regulators, the main lesson is that even though rule-based regulations are necessary, the principles of responsibility and transparency must not be forgotten. Homogeneity is needed, and regulation will contribute to it largely, as well as to giving adequate incentives. Principle-based regulations are required to ensure that fiduciary duties are taken seriously everywhere, including in countries that have historically had a more administrative approach to regulation. Rule-based regulations are also needed for European regulations to be applicable in civil law countries as well as to ensure a uniform implementation in common law countries and to avoid vagueness in contracts and responsibilities. A regulatory approach limited to box-ticking would be severely counterproductive. As it happens, in the themes of interest in our study, the major ones that emerge are those that have largely been overlooked by regulators in recent work. First, in the respondents’ eyes, transparency should be the primary regulatory requirement for non-financial risks, which suggests that non-financial risks should be communicated with similar indicators to financial risks. Second, since non-financial risks primarily arise from the fund manager’s decisions, they must be the primary responsible party too. The answers to the survey largely support this view, making the role of the asset manager at least as important as that of the depositary. Blind eye
In these matters, practical challenges remain. For transparency, adequate measurement processes remain to be found. For manager’s responsibility, since capital requirements are costly, fiduciary duties should be taken at face value in regulations. In this field, regulations should, rather than limit manager compensation, focus more on optimal compensation contracts. In any instance, regulators cannot afford to turn a blind eye to non-financial risks. Again, transparency is a major concern that can be significantly improved at moderate costs.
Clarification is needed on various aspects, notably the split of responsibility between depositories and asset managers. So far, too much of the emphasis has been put on depositories; the pendulum should swing back towards asset managers who, after all, are in the best position to manage those risks. Samuel Sender is applied research manager at Edhec-Risk Institute ©2012 funds europe

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