22 April 2003

FEFSI: Limited justification for Capital Requirements in Investment Fund Management

Contributing to the debate and future work of the Basel Committee on Banking Supervision and the European Commission, the University of Toulouse published a study on operational risk and capital requirements in the European investment fund industry. The study concludes among others that only limited justification for Capital Requirements in Investment Fund Management do exist.

The study was undertaken to Professor Biais from the University of Toulouse and commissioned by the Fédération Européenne des Fonds et Sociétés d'Investissement (FEFSI) for an independent analysis of the merits of capital regulation to control operational risk in investment fund management.

Conclusions:
First, the study confirms the importance of the three pillars of the proposed new Basel Capital Accord, i.e. minimum capital requirements (Pillar 1), supervisory review process (Pillar 2) and market discipline (Pillar 3). It underlines in particular the beneficial prudential effects of market forces and supervisory oversight. It also confirms the view that the existing investor protection requirements enforced by the UCITS Directive play an important role in reducing the frequency and severity of operational losses in investment fund management and thereby reduce the need for capital requirements.

Secondly, the study underscores the importance of keeping track of loss data to arrive at a comprehensive assessment of the types and frequency of operational risks faced by investment fund management companies. In this regard, FEFSI supports the view that reporting requirements are useful to help regulators evaluate the quality of companies’ internal control mechanisms and allow for a lower capital requirement for operational risk.

Main findings
The study confirms the view that neither systemic risk nor the incentive problem can be used as a justification for capital regulation of the investment fund industry. Indeed, investment fund management companies pose no significant systemic threat, and there is no government safety net that could create incentives for investment fund managers to take excessive risks. It follows that only investor protection is relevant to the regulation of operational risk in investment fund management companies.

The main empirical findings on limited operational losses in Investment Fund Management of the study can be summarized as follows:

On average, total operational losses per firm over one year amounted to € 0.93 million.

For the majority of firms, the ratio of actual capital to asset under management was 25 bp, whereas the mean of this ratio amounted to 75 bp. 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.

The largest operating single loss event reported by the sample of firms was € 0.95 million. This loss amounted to 14.2% of the capital held by that company and to 0.14 bp of its asset under management. The largest total yearly loss amounted to 17.31 bp of the assets managed by the company concerned.

One of the key contributions of the study is to highlight that the prudential regulation of operational risk should rely primarily on market discipline, disclosure rules and insurance, essentially because those tools tend to create incentives for investment fund management companies to implement sound monitoring systems for operational risk.

The importance of market discipline as a risk mitigation factor is demonstrated in the theoretical analysis of the study. The study also argues that under certain circumstances, regulatory intervention can be beneficial. The study concludes that “while regulation could involve some capital requirements, it could and should also rely on other tools”. The study emphasizes in particular the importance the tools of depositaries, disclosure and transparency requirements, and insurance.

FEFSI position
The study reinforces FEFSI’s position on the regulation of operational risk. The main points of this position can be summarized as follows:

Risks in asset and investment fund management are very different from those in banking and other financial activities.

Regulatory requirements applicable to investment funds play an important role in reducing operational risk in investment fund management.

The most direct approach to limit operational risk is to implement carefully monitored risk management systems.

The use of insurance cover as risk mitigation tool should encourage institutions to implement sound operational risk monitoring systems and therefore justifies lower capital charges.

The capital requirements to meet operational risk should not have any anti-competition effects.

In commenting this study, Steffen Matthias, Secretary General of FEFSI, remarked:
“This study confirms the view that investment fund management posed low operational risk and should therefore benefit from low operational risk capital charges. It also supports FEFSI’s position that 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.”

Toulouse study

© FEFSI