July-August 2012

EDHEC RESEARCH: Shedding light on who’s responsible

LighthouseSamuel Sender, of the Edhec-Risk Institute, looks at where the burden of care for non-financial risks lies within the asset management chain.

Following on from last month’s article, which was based on a survey of European fund industry professionals, we turn to the question of the respective responsibilities of asset managers and depositories within the fund management industry.

According to respondents to our Shedding Light on Non-Financial Risks – a European Survey published in January 2012 (which was carried out within the risk and regulation in the European fund management industry research chair at Edhec-Risk Institute supported by Caceis), the responsibilities of the fund management industry should be put under the limelight and reinforced. Directives must ensure that responsibilities are adequately distributed – and made clear to the client, who must in turn be knowledgeable about risks.

Overall, 67% agree that asset managers should have greater responsibility regarding non-financial risks. Some 65% of respondents agree that greater fiduciary duties should be required of depositories. Most prominently, 75% agree that a clearer responsibility regime should be instated for depositories, with monitoring and obligation of means.

Although 44% agree that risk-based capital requirements (based on ratings of non-financial risks) should be applied to asset managers, qualitative answers show that opinions are mixed about basing them on a notion of rating of financial risk. More precisely, because such measures do not exist, many respondents are unsure about when and how these could apply.

We argue that the establishment of such measures is based on similar information to that of ratings, but that it has a strong qualitative component since many events (such as the immobilisation of assets at a bankrupt sub-custodian) have had little or no occurrence in many countries.

Distribution and restitution
Clarification is much needed in the area of distribution. The majority of respondents (81%) agree that responsibilities should be clarified ex-ante according to who controls each subset of information.

And 69% of respondents agree that distributors should have complete responsibility as the first line of defence for investors, but it could fall back on other parties if they have provided inappropriate or misleading information. So, distributors have a large role to play, not only to be transparent themselves but also to request transparency from their providers.

Due to the Madoff affair, restitution is possibly the non-financial risk to have gained the most visibility in recent years. Depositories are entrusted with the safekeeping of assets, and are usually assumed responsible for the restitution of the assets that they hold under custody. The collapse of Lehman Brothers not only showed the world that a systemically large institution could fail; it also put the question of international co-operation and rule harmonisation centre stage. Restitution may be rendered impossible, at least under reasonable delays, in such extreme cases as the default of an institution — reputable as it might have been.

Respondents are in favour of a clarification of the perimeter of responsibilities, which is in line with recent proposals put forward by the European Securities and Markets Authority (Esma), as well as in the response to Esma’s consultation by the European Trustee and Depositary Forum. A strong majority of respondents (69%) agree that depositories should be responsible for the unconditional restitution of assets under their custody or control.

Likewise, 68% agree that the restitution on assets should be contractually defined between depositories and asset managers at the creation of the fund. And many think that sub-custodians should be included in this contractual definition of the roles. Also, 65% agree that the restitution on assets should be contractually defined between depositories, sub-custodians and asset managers.

Divided opinion
On the last theme – the judicial powers given to investors – opinions are split.

Overall, 70% of respondents agree that investors should be able to launch class action suits to get fair compensation (16% disagree). However, only 37% agree that those class action suits should allow for penalties on top of the fair compensation (36% disagree).

Those class actions would have to be defined within a European framework to be consistent across countries. A significant 52% of respondents agree that because of diverging national laws, class action suits in Europe only make sense if they are brought to a pan-European authority or court (19% disagree).

At 52%, more than half of respondents agree that a European ombudsman/ mediator should be created (20% disagree) to settle cross-border cases. Esma could play this role. Only 38% agree that a European savings protection authority (rather than just a savings regulation authority) should be created (30% disagree) to complement the powers of the Esma. This appears to be more positively seen by the respondents from France, and significantly less by those from the United Kingdom.

Greater protections
An important aspect when discussing protection is the question of its costs, as there is usually a trade off. Respondents are ready to pay for greater transparency more than for any other measure. If fiduciary duties can be enforced without much cost, the more general theme of greater financial responsibility of the investment management industry, which included capital requirements, higher depository protection and insurance as sub-themes, is expected to be a net cost for the investment management industry, probably also because in practice investors are less ready to pay for these types of measures since they are already of the opinion that the fund management industry should be prepared to assume its fiduciary duties.

Greater protection in aggregate would be a net cost or a high net cost to asset managers for 70% of our respondents, to depositories for 69%, and to custodians for 73%. Only a minority think it will be a net benefit. The three categories would mostly share the costs of greater protection regarding the financial responsibility of the industry. It would be a net cost or a high net cost to asset managers for 68% of respondents, to depositories for 60% of respondents, and custodians for 67% of respondents.

Other findings included that costs of greater protection regarding regulation on distribution would mostly be borne by asset managers. On the other hand, the costs of greater protection regarding stricter obligations of restitution would fall mostly on depositories and custodians.

At the same time, there is a clear limit to how much costs can be absorbed by low-fee services such as depository services. For this sector, it is likely that expenses will be largely absorbed by increases in fees, which respondents sometimes seem to ignore.

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

©2012 funds europe