EUROPE – The European Federation of Investment Funds and Companies, FEFSI, says there is “limited justification” for capital requirements in investment fund management -pointing to the limited risk and limited operational losses involved in the sector.

Following a commissioned study to research the merits of capital regulation to control operational risk in investment fund management, FEFSI concludes that the effectiveness of capital requirements, whereby fund managers must have a certain level of capital in relation to the assets under management, is limited.

FEFSI concludes that while regulatory requirements applicable to investment funds play an important role in reducing operational risk, tools such as the maintenance of appropriate internal control systems to limit operational losses, and insurance cover would be more appropriate than capital requirements.

“More attention needs to be given to proper risk management and insurance requirements to mitigate operational risk and less to capital requirements because of their limited effectiveness as operational risk mitigator and potential anti-competitive effect,” said Steffen Matthias, secretary general of FEFSI.

The study by Professor Bruno Biais of the University of Toulouse took data from 46 European fund management companies, and revealed operational losses in the investment fund management industry to be limited. Total operational losses per firm over one year amounted to 0.93 million euros. Relative to assets under management, the median operational loss amounted to 0.3 basis points while the mean amounted to 0.96 basis points.

For the majority of firms, the ratio of actual capital to asset under management was 25 basis points, whereas the mean of this ration amounted to 75bp. For most countries actual capital far exceeds required capital. For more than 75% of the investment fund management companies surveyed, operational losses were below 10% of capital.

In terms of risk, FEFSI says the study confirms that neither systematic risk nor the incentive problem can be used as a justification for capital regulation of the investment industry. With regards to systematic risk, default by one company could not endanger the stability of the European or global financial system, claims FEFSI, and there is no government safety net that could create incentives for investment fund managers to take excessive risks.

Rather than capital requirements, the prudential regulation of operational risk should rely primarily on market discipline, disclosure rules and insurance, says the association, as these tend to create incentives for investment fund management companies to implement sound monitoring systems for operational risk.

Says the study: “While regulation could involve some capital requirements, it could and should also rely on other tools to reduce operational_risk.” The study emphasises the importance of: “depositaries in monitoring certain obligations faced by the fund managers; disclosure and transparency requirements to aid investors’ understanding of services and activities of fund managers; and insurance companies, which could design the optimal combination of monitoring and contracting clauses.”

The study contributes to ongoing discussions regarding the new Basel Capital Accord, and the emerging draft legislative proposal for a new capital adequacy regime for credit institutions and investment firms in the European Union.
Helen Avery

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