January 30, 2003

Mr. Jean-Claude Thébault
Director
European Commission
Directorate General for the Internal Market
Directorate F (Financial Institutions)
Rue de la Loi, 200
B-1049
Brussels

Dear Director Thébault:

The Investment Company Institute appreciates the opportunity to comment on the Commission's Working Document on Capital Requirements for Credit Institutions and Investment Firms. The Institute is the national association of the US investment company industry.¹ Many of our members manage European mutual funds and pension funds through their European-based affiliates.

The Commission's Working Document is intended to provide the basis for a dialogue on how best to reflect the new Basel Accord, which is expected to be adopted in the fall of 2003, into a revised EU capital adequacy framework.

Bank-Styled Capital Requirements Are Not Appropriate for the Asset Management Industry
The possible application of the new Basel Accord to the asset management industry is a matter of concern to the Institute and its members. In May 2001, we first shared our concerns with the Commission in a letter to Commissioner Frederik Bolkestein. Since that time, the Institute published a paper (a copy of which is enclosed) authored by two prominent academics on the regulation of operational risk in asset management companies. The paper concludes that the justification for bank-style capital requirements does not apply to the asset management industry, that there are better ways than capital requirements to protect asset management clients-including insurance and process regulation-and that high capital requirements in asset management have anti-competitive effects.

We continue to believe that it would be unwise to introduce into the Capital Adequacy Directive bank-style capital requirements for asset management firms. As we mentioned in our May 2001 letter, the businesses of banking and asset management are fundamentally different and any capital requirement imposed on institutions that engage in these diverse activities must take into consideration the separate risks involved in these businesses. We believe that the academic paper the Institute published makes a persuasive case why it is unnecessary and inappropriate to impose capital requirements in addressing operational risk in asset management. Therefore, we hope that, as the Commission proceeds with its ongoing work for the application of the new framework on operational risk for investment firms, the Commission will remain cognizant of these differences between banking and asset management.

The Commission Should Apply Lower Calibration and Permit the Use of Insurance for the Asset Management Industry
If the Commission, despite our views, determines to impose bank-style capital requirements on asset management firms, we believe that the Commission should (1) apply a lower calibration for imposing capital charges for operational risk on asset management than for banks and (2) permit firms to offset capital with insurance.

First, the Commission should, as it has considered in its Working Document, permit member states to apply a lower calibration of the operational risk charge for certain business lines, including asset management. As the Commission states in the Working Document, a lower charge would be appropriate in recognition of the fact that these services are regulated by other prudential and risk management standards, such as those included in the Investment Services Directive.² We believe certain aspects of mutual fund regulation-including provisions that address operations of mutual funds (such as segregation of client assets), impose oversight responsibilities of a fiduciary nature on depositaries and directors, provide for an annual audit by independent accountants, and require bonding or establish alternative investor compensation schemes to protect against fraud by employees of mutual funds-help mitigate against operational risk and therefore should reduce the amount of capital that must be held by managers of these funds.

Second, we strongly support the Commission's willingness to recognize insurance as a mitigation technique for the reduction of capital charges. We are pleased that the Commission contemplates permitting member states to incorporate insurance not only for the Advanced Measurement Approach (as proposed by the Basel Committee) but also for the Basic Indicator and Standard approaches.³

Developing a specific proposal or formula for permitting insurance to alleviate capital charges is a complex undertaking. As you may know, the US asset management industry has experience in using insurance to cover certain operational risks. We currently are gathering the relevant data from that experience to assist the Commission in recognizing insurance under the Basic Indicator and Standardized approaches. We understand that the Commission will be closing its dialogue on the Working Paper at the end of this month and is expected to issue a final consultation paper in the middle of this year. We hope to provide you with this data shortly.

Commission's Proposal for Imposing Capital Charges on Asset Management Firms
In addition to our broad conceptual comments that address the Commission's fundamental approach to capital adequacy in the European Union, the Institute would like to make two additional comments on the Commission's proposal.

1. Commission Should Retain the Alternative for Consolidated Capital
The Commission proposes to amend the existing waiver from consolidated capital requirements for investment firm groups. Under the proposal, the Commission is considering revising the specific conditions under which member states may grant waivers to investment firm groups from the requirements to consolidated capital.

We agree with the Commission that under certain circumstances, the objectives of prudential supervision can be achieved effectively without imposing consolidation. We believe, however, that some of the specific conditions under which the alternative for consolidated capital would be permissible are unduly restrictive, and we urge the Commission to reconsider those conditions. In particular, we are concerned about the condition that would require all the investment firms within a group to be authorized and supervised by the same member state to be eligible for the waiver. This proposed condition would prevent member states from granting waivers to groups whose holding company structure does not pose particular risks.

As mentioned above, our members manage European mutual funds and pension funds through their European-based affiliates. As a result, our members support the efforts in the European Union to facilitate a truly pan-European market for financial services. This particular condition, which would limit the alternative approach to only national investment firm groups, appears to be contrary to those purposes. We strongly urge the Commission to revise this condition and permit groups with affiliates authorized in more than one member state to be eligible for this alternative.

2. Asset Management of UCITS Funds Should Not Be Considered in Assessing Capital Charges for the Standardized Approach
In Annex H-3, the Commission describes the capital requirements for operational risk under the Standardized Approach, which is the sum of the capital requirements calculated for each of the business lines. In specifying the asset management business lines, the Commission delineates asset management under ISD, asset management under UCITS, and other asset management. We have two comments with respect to including asset management under UCITS as a business line in these requirements.

First, we understand that for managers that will manage both UCITS and pension funds pursuant to the authorization under the new UCITS Directive, capital requirements under the Capital Adequacy Directive would only apply to asset management services other than the management of UCITS funds. Therefore, if this is the correct interpretation of the new UCITS amendments in Section III, Title A, Article 5 (4), managers of both UCITS and other assets will not include the management of UCITS funds within the business lines for purposes of calculating capital requirements under the Standardized Approach. We request that the Commission clarify this point.

Second, we recommend that the Commission take this same approach-of excluding UCITS fund activities for purposes of calculating capital under the Capital Adequacy Directive-for banks and bank holding companies whose affiliates also manage UCITS funds. With the new UCITS Directive, firms managing UCITS funds already would be subject to UCITS-specific capital requirements, and it would seem unnecessary to impose additional capital charges on these companies for such activities.

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If we can provide any other information or if you would like to discuss further any issues, please call me at (202) 326-5826 or Jennifer Choi at (202) 326-5810.

Sincerely,

Mary S. Podesta
Senior Counsel

Enclosure

1 The Institute's membership includes 8,938 open-end investment companies ("mutual funds"), 535 closed end investment companies, and six sponsors of unit investment trusts. Its mutual fund members have assets of about $6.539 trillion, accounting for approximately 95 percent of total industry assets, and 90.2 million individual shareholders.

2 We respectfully request that the Commission revise the language in Article 113 to make clear that the lower calibration would be permitted under both the Standardized Approach and the Basic Indicator Approach. While we believe this was the Commission's intent, the current language is not entirely clear.

3 In further developing the proposals for incorporating insurance for the calculation of capital requirements, we respectfully urge that the Commission require the competent authorities of the member states to permit firms to use insurance to alleviate the operational risk capital charges for both the Basic Indicator and Standardized approaches. The Commission has proposed to do so under the Advanced Measurement Approach, and we do not understand the rationale for providing member states with the discretion to prohibit capital alleviation in the more basic approaches.