To the ramparts

Asset managers are fighting an EC plan to hike capital charges. They may have to learn to live with them.

Asset managers are fighting an EC plan to hike capital charges. They may have to learn to live with them.

By Andrew Capon
September 2001
Institutional Investor Magazine

“Investment firms will be subject to the new risk-based capital charge for operational risk under the same terms and conditions as credit institutions.”

There it was, a matter-of-fact statement buried at the bottom of page 36 of a bone-dry 66-page European Commission report issued in January. So simple and unassuming that a reader might easily have passed over it while stifling a yawn. In fact, the brief directive, which was intended to apply new capital rules from an updated Basel Capital Accord, known as Basel 2, for banks to all EU institutions, has prompted an unlikely call to arms among normally reserved money managers.

Why? Easy. The report, authored by the European Commission’s Internal Market Directorate General, calls for the imposition of new and potentially expensive capital requirements on European fund managers. If adopted, these requirements would slice into their profits, making them less competitive with U.S.-based rivals as well as potentially undermining start-up firms.

What has money managers most upset is that they believe their business to be significantly different from that of banks and thus not subject to the generic regulations spelled out in the commission’s so-called Capital Adequacy Directive, or CAD3. Basel 2, like its predecessor accords worked out over the years by the Group of Ten central banks and regulators, is aimed at keeping large international banks out of trouble; CAD3 regulates European financial services firms of all sizes and types. But asset managers - even big ones like Capital International Research - which invest their clients’ money, don’t run the same risks as huge global banks like Citigroup, which have their own - not their clients’ - capital on the line in multinational loan portfolios and sprawling capital markets groups. The money that asset managers invest is segregated for its beneficial owners, be they large pension funds or individual holders of mutual fund shares. Subjecting a boutique money manager in Brussels to the same type of capital charges as Citigroup is even more outrageous, say the fund executives.

“It’s like applying fishing quotas to the dairy industry,” insists Julie Patterson, director of regulation and taxation at the U.K.-based Association of Unit Trusts and Investment Funds.

“These rules are designed for banks, and it is not sensible to treat fund management companies the same,” adds Robert Parker, vice chairman of Credit Suisse Asset Management, which oversees $300 billion. “This is a real threat. We should be making a lot more noise. We are not being vocal enough.”

The threat and the costs are real. Currently, U.S. money managers are not subject to any capital charges by the Securities and Exchange Commission. In Europe the current CAD regime means that fund managers keep minimal amounts of capital, in most cases amounting to hundreds of thousands of euros. Under the new regime, which extends the capital charges to cover operational risk, these charges could grow to millions.

“We are talking about far larger capital requirements. Large capital charges will change the cost structure of the asset management business,” says Michael Haag, secretary general of the European Asset Management Association, a trade group vigorously opposing the commission’s directive. Depending on the formula used, Haag estimates that capital costs could rise anywhere from three- to 15-fold from current low levels.

For their part, the European Commission and its IMDG unit, headed by the Netherlands’ Frederik Bolkestein, are simply following one of the EU’s basic tenets: applying even-handed regulation to all financial services firms. As Bolkestein (who declines to discuss the matter with Institutional Investor) and his group stated in their controversial draft: “There are two distinguishing features of the capital regime in the EU: First, it is a legislative framework, and second, it applies to the entire banking industry and investment firms irrespective of their size.” By incorporating the new Basel Committee guidelines in their own revised rules, Bolkestein and his IMDG colleagues are ensuring that every financial services firm is treated equally.

Fund managers have not been sitting still, of course. They’ve commissioned their own, more favorable, capital adequacy study, flooded the commission with protest letters and launched an energetic lobbying campaign. These initial efforts have met with some success. In early July the Basel Committee on Banking Supervision pushed back the timetable from its original 2004 implementation date to 2005 and extended its consultation period beyond its initial October 2001 deadline, into 2002. The EC also asked the committee, which operates under the aegis of the Bank for International Settlements, “to look again at these issues.”

Even so, no one expects the plan to be scrapped. The offending consultation document will still form the basis for new legislation to be drafted by the EU. The legislation will go to the European Parliament in Strasbourg for a vote in 2003-'04, and if, as anticipated, it passes, it will be enacted in member states by the new target date of 2005.

CAD3 would impose capital charges that go well beyond previous Basel initiatives. Most important, the new directive covers for the first time operational risks that include everything from computer failures to accounting errors, fraud and misdealing. Neither Basel 2 nor the European Commission has stated what specific numbers will be applied to cover these operational risks.

Whatever the precise method, the new guidelines could put all European asset managers and U.S. fund management subsidiaries of big banks at a disadvantage. The American banking units do have to comply with Basel 2 and therefore will have to cope with the capital charges in Europe and the rest of the world. European money managers like Axa Investment Managers, Credit Suisse, Robeco Group and Zurich Scudder Investments will be similarly affected all over the globe. However, some large U.S.-based independent outfits like Capital International, Fidelity Investments and Putnam Investments aren’t subject to Basel 2. Though they would have to put aside additional reserves against their European operations to comply, they would not have to pony up against the rest of their global businesses.

One concern is that this difference in regulation will give these large U.S. firms a real cost advantage. “We are living in a highly competitive, fast-moving global market. Our members need capital to grow their businesses. Tying it up to cover risks, which may not be real, because the European Commission mandates it does not make sense. It is business suicide when we are faced with a highly competitive U.S. industry,” says Carlos Pardo, director of economic affairs at Association Franaise de la Gestion Financire, the French asset management trade group.

Many in the industry also worry that high capital charges will stifle competition within Europe, where smaller independent boutiques have begun to chip away at the dominance of fund managers owned by large banks and insurance companies. A sharp hike in costs might be enough to swamp some fledgling asset managers.

“The need to carry large amounts of capital might well have made me think twice before starting this firm,” says Nigel Legge, CEO of Liontrust Asset Management, a five-year-old firm that today has $2.3 billion in assets. “The danger [from higher capital charges] must be that barriers to entry are raised,” says Legge.

Critics claim that the European Commission, in its quest for a level playing field, isn’t paying heed to the basic issues that led to the original Basel Concordats of 1975 and 1983. These rules were designed to limit international banks’ credit and market risk following a series of collapses at institutions such as Germany’s Bankhaus Herstatt and the U.S.'s Franklin National Bank of New York, which sustained huge foreign currency losses. With the world’s markets bigger, more interconnected and more highly leveraged than ever, international banking authorities wanted to ensure the safety of the global financial system.

But fund managers are not exposed to credit or market risk because they don’t invest for their own account. Their clients take these risks.

Even some regulators would prefer the guidelines be more sensitive to an institution’s particular risk profile. In a speech this past spring, Howard Davies, chairman of the U.K.'s Financial Services Authority, said the commission’s ambition to treat all financial services the same “ignores the impact dimension. If we set the same capital requirements for low-impact and high-impact firms, we either undercharge the high impact or overcharge the low impact. That is neither efficient nor consistent with competitive equality.”

What do the fund managers suggest? Trade group EAMA commissioned a report from Oxford Economic Research Associates to provide an answer. The authors, professors Julian Franks and Colin Mayer, had in 1989 written an evaluation of asset management regulation that became the cornerstone of the U.K. regulatory regime. Not surprisingly, their study concludes that wide-ranging capital set-asides aren’t needed. Not only do money managers segregate client money from their own capital, say the authors, but they also provide insurance against many forms of operational risk. Contracts with custodians, for example, guarantee that a manager is paid the proceeds of a trade even if it has not settled and that dividend payments are made on time even if the income has not been received.

Misdealing and fraud are legitimate operational risks, say Franks and Mayer. But how does one protect against these risks? “What the Oxera study shows in spades is that once you get beyond a tiny capital requirement, you get into an extraordinary conundrum. Either losses are so big that no amount of capital can cope with them without completely destroying the costs of the business, or they are so trivial that carrying extra capital is an absurd and meaningless burden,” says Donald Brydon, chief executive of Axa Investment Managers and president of EAMA.

There is some room for compromise over the size and method of the capital charge. On that score the experience of the European mutual fund business offers guidance. An amendment to the EC’s undertakings for collective investments in transferable securities directive, which governs the cross-border sale of mutual funds in Europe, is scheduled to be passed later this year by national governments after a lot of debate. It, too, will impose capital charges on fund managers. But the charge of 2 basis points of assets under management ($2 million for a $10 billion firm) is much smaller than originally estimated. If something similar emerges from CAD3, most fund managers say they can live with it.

Lobbying for a lesser fee may prove a wiser course than betting on - and very possibly losing - a philosophical argument about government regulation. Besides, there has already been an unintended benefit: The backlash against CAD3 has united senior executives like Credit Suisse’s Parker and Axa’s Brydon in a cause. Now, says Brydon, the industry should push for its own investment management directive. “Hopefully, that would prevent the idiocy of Basel and CAD regulating fund management companies as if they were banks.”

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