Good risk management relies on the subsidiary status principle
by Noël Amenc, Professor of Finance and Director of the EDHEC-Risk InstituteThe European Commission consultation on the UCITS depositary function is necessary and welcome, because it puts an end to a long period of European ignorance of the importance of the depositary function to the construction of a single market for investment funds. The European regulator long focused on the responsibilities and obligations of asset management firms and on adapting the UCITS framework to new asset classes or to changing investment practices, as it mistakenly believed that stewardship would follow, and it thus paid too little attention to operational problems and the management of non-financial risk in the European fund industry. From this perspective, it is logical that maintaining the quality of the UCITS label should lead to in-depth reflection on the role and responsibilities of the depositary. But past inactivity is no reason to act with excessive haste. To think that securing assets would necessarily involve a broad restitution obligation is neither serious nor realistic.
The security of the assets entrusted by the client does not depend on the actions and the means of the depositary alone. The entire set of non-financial risks, whether it is the asset management firm, the auditors, the prime broker and, in some cases, the evaluator or the administrator, should be re-examined. It is for this reason that EDHEC-Risk, with the support of CACEIS, began in-depth research into the regulation and management of non-financial risks in the European asset management industry. In any case, the depositary may be in a position to make good on its restitution obligation only for those assets that are really under its control. And this is not always possible for all assets or for all forms of investment. France cannot demand a broad restitution obligation of Brussels and, at the same time, and with good reason, negotiate the lessening of the contractual liabilities of the depositary for so-called Aria funds. Ultimately, the assumption that investors should be completely protected from non-financial risk can lead to reassuring but inapplicable rules that can make investors overconfident and so increase risk.
Good risk management relies on the subsidiary status principle. Those who are closest to the risks should manage them and limit, if not provide a guarantee against, their negative consequences. It would be inconceivable for an insurance company, through its asset-liability management, to be unable to bear the bulk of the risks it insures. It is only in a residual manner that it resorts to reinsurance or that it counts on its shareholders’ equity. To put the depositary bank in a situation in which it must ensure, without controlling, satisfactory execution of transactions involving assets no longer in its direct or indirect control, assets that may be used as collateral in transactions it is unaware of, would force it to endow itself with great amounts of capital, the cost of which would weigh heavily on the performance of the funds in custody. It is far from sure that investors are willing to pay the price of such security.
The asset management industry is characterised by the low regulatory capital of the service providers. This particular situation has made it possible not only to maintain an enterprising spirit favourable to innovation and to the emergence of new talents in asset management but also to develop a business model founded on economies of scale and volume, in the depositary role, in particular. To require of these service providers, from one day to the next, capital enabling them to deal with the entirety of the non-financial risks they bear will necessarily lead to higher prices for their services. Instead of this absolute guarantee, it is perhaps more reasonable to give investors a choice of options—at different prices, of course—for protection from non-financial risks. This approach, which makes the end-investor partly responsible for the non-financial risk borne by the fund, assumes that the investor is informed of the risks and that protection is put in place. In this respect, it is regrettable that the “key information document” for the planned reform contains no provisions concerning the disclosure of the non-financial risks of funds or of the guarantees that are offered.
