EY efama study light resolution

Societal and economic impacts of the European asset management industry

December 2014

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Societal and economic Impacts of the European asset management industry

Contents

Executive summary 5 1 Introduction 8 1.1 European asset management in the 21st century 8 1.2 Aim of the report 8 1.3 Methodology 8 1.4 Structure of the report 8

2 Context: the rise and shape of European asset management 10 2.1 The rise of European asset management 10 2.2 The shape of European asset management 12

3 Direct impacts of the European asset management industry 15 3.1 Direct and indirect employment 15 3.2 Financing European economies 17 3.2.1 DebtfinancingoftheEuropeaneconomy 18 3.2.2 EquityfinancingoftheEuropeaneconomy 20 3.3 AreEuropeanassetmanagementfirmssystemicallyimportant? 21 3.3.1 Why some banks are systemically important 22 3.3.2 Whyassetmanagementfirmsarenotsystemicallyimportant 23 3.3.3 Second-order risk factors at product level 24 3.4 Added value of the European asset management industry 25

4 Indirect impacts of the European asset management industry 28 4.1 Thecostsandbenefitsoffinancialexpertise 28 4.1.1 Costsoffinancialexpertiseinactiveinvestmentmanagement 29 4.1.2 Benefitsoffinancialexpertiseinactiveinvestmentmanagement 30 4.2 The asset management industry and market quality 30 4.3 Assetmanagementandthecorporategovernanceoffirms 33

5 Conclusions and implications 36 6 Appendices 39

Bibliography 42


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Thank you to Bernard Delbecque, Christian Dargnat, Peter De Proft, Hermin Hologan, David Pillet, Roy Stockell, and Shahin Shojai for helpful discussions on the subject areas analyzed in this study. The views expressed here are those of the author anddonotnecessarilyreflectthoseofEY.

AuthorJens Hagendorff, PhD MA BA Professor of Finance & Investment University of Edinburgh 29 Buccleuch Place, Edinburgh, EH8 9JS, UK [email protected] +44 131 650 2796

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Executive summary

This research report examines the impacts of the European asset management industry on Europe’s economy. The report explores both direct and indirect impacts.

ContextThe European asset management industry is large, with assets under management (AuM) of over 115% of GDP (or nearly EUR €17 trillion). The industry is also growing fast and operates on a pan-European basis with a strong economic foothold in almost every European country. With Europe as the second-largest center for asset management globally, European asset management is an economic success story.

Demand for asset management solutions has grown to cater to older and wealthier societies that can look forward to increased life expectancies and longer retirement periods. None of the factors responsible for the stellar growth of the industry is likely to subside or reverse in the foreseeable future. The European asset management industry is therefore poised for further and fast growth.

The size of the industry indicates that it meets important needs of European societies and, in doing so, has an important impact on European economies and societies.

Direct impacts• The European asset management industry is a large

provider of employment. The report estimates that the industry generates a total of around 530,000 full-time equivalent positions. Most of the employment is indirect and linked to support roles in related services such as marketing, distribution, accounting, auditing, custodianship and research.

• The European asset management industry provides a cruciallinkbetweeninvestorsandthefinancingneedsofthereal economy. Long-term savings and risk management are at the heart of what the industry provides. This makestheindustrysuitabletoprovidelong-termfinancetoEuropean corporations. The report estimates that European asset managers hold 23% of European debt securities outstanding or 32% of the value of European bank lending. Similarly, the value of equity held by European asset managers corresponds to nearly 40% of the free float of European listed firms.

• Thebondfinanceprovidedbyassetmanagersisparticularlyimportant as banks retreat from lending in Europe and externalfinancingchannelsoutsidethebankingsectorbecome increasingly important. Crucially, while the European asset management industry provides debt funding that is substantial compared to bank lending, it does so without the bailout subsidies afforded to the banking sector. Bank subsidies, which follow from the systemic relevance of the banking sector, are substantial and costly to taxpayers. Therefore, the European asset managementsectorfinanceseconomicactivitybutdoes soinamorecost-efficientwaythanthebankingsector.

• It is estimated that the European asset management industry contributes an average of 0.35% per year to European GDP. This estimate is based on the industry’s profits,staffcostsandtaxespaid.Thevalueaddedisparticularly large in the UK, where it is in the region of 1% of GDPperyear.Thefiguresarealsolargeinabsoluteterms.Across Europe, it is estimated that the yearly value added is EUR €50 billion.

Indirect impacts• Thereareanumberofsocietalbenefitslinkedtoasset

management, many of substantial magnitude and indirectly linked to the industry. By acting as an agent on behalf of investors, the asset management industry is an important provider of investment expertise and risk management services to institutional and retail clients. Further, the industry is instrumental in making markets more frictionless placesinwhichtooperate.Theresultingbenefitsincludelower transaction costs, faster execution and price discovery andenhancedmarketefficiencyforallinvestorgroups.

• This report estimates that trading activity by European asset managers generates cost savings of EUR €12 billion per year in the cost of providing and demanding liquidity. These savings result from tightening bid-ask spreads in European equity, which can be linked to the trading activity of European asset managers. Crucially, these savings are shared among all investors in European stock markets.


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• Further, the industry acts as a steward of Europe’s corporate landscape and has brought about improvements in the corporate governance of European corporations through periods of engagement. The report values the total European governance premium generated by European asset managers at EUR €462 billion. In line with the other indirectbenefits,thegovernancepremiumissharedmorewidely with other market participants.

Implications• Oneofthekeybenefitstheindustryprovidesrevolves

aroundfinancingeconomicactivity.Thisislikelytoincreasein the near future as the banking sector gradually retreats from traditional lending activities. This leaves a growing and increasingly important role for European asset managers to fill the gap in providing finance to European economies.

• Against the backdrop of concerns that ever-larger trading volumesinfinancialmarketscarrynobenefitsforsociety,the report shows that the asset management industry has been instrumental in making markets more frictionless places to deal in. This translates into lower trading costs and higher net performance for all investor groups.

• Only a small part of the population currently possesses thefinancialliteracyrequiredtomakefinancialdecisions. The industry’s expertise is therefore not only warranted to createfinancialproducts,itcould also play an important role in promoting financial education and to sensibilize European societies to their financial planning needs.

• European lawmakers need to carefully balance the needs of the European asset management industry, its clients and European economies without undermining some of the key benefits the industry provides to society. As regards European economies, this report provides evidence that the European asset management industry has a strong record of positive impacts on European economies and societies.

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01Introduction


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Introduction11.1 European asset management in the 21st century

Assetmanagementisakeyindustryineveryfinancialeconomy. The industry channels the savings of millions of firmsandhouseholdstocompaniesandgovernmentsinneedoffunds.Indoingso,theindustryfinancesasizableshareofeconomic activity while offering its investment expertise to savers. As banks gradually withdraw from lending activities and aging societies look for ways to fund healthier and longer retirements, asset management is poised to play an even more important role in future years.

Asset management is a European success story. Europe is the second-largest center for asset management globally, and the industry is growing fast. The industry operates on a pan-European basis: in almost every single European country, asset management is both a substantial and a growing industry. The growth and scale of the industry suggest that European asset management addresses a number of important needs for a substantial client base.

However,theaftermathoftherecentfinancialcrisishasbroughtaflurryofnewregulationsaimedattheindustryandcreated a sense of wariness regarding the overall contribution of the industry to the economy. There are concerns that the industry may have grown too large and poses similar fragilities to the economy as the banking sector. Equally, there areconcernsthatsomeassetmanagementfirmstradetoofrequently and foster a culture of corporate short-termism, perhapsevenjeopardizingthequalityandintegrityoffinancialmarkets.

It is therefore important to understand the net effects that the European asset management industry has on the economy and, more broadly, what impacts the industry has on society at large.

1.2 Aim of the report

The aim of this report is to explore and quantify the various impacts the European asset management industry has on Europe’s economies and societies.

Thisreportlooksatdirectandindirectimpactsandbenefitsthat the European asset management industry has on European economies. For the purposes of this study, direct impacts include those aspects that are relatively tangible and therefore more easily measurable and attributable to the industry,namelyemployment,thefinancingofrealeconomic

activity and the overall economic value-add of the European asset management industry (including tax revenues and wages).

Further, the study aims to quantify less obvious, but by no means less important, indirect impacts in the form of the benefitsandcostsoffinancialexpertise,thequalityandfunctioningoffinancialmarketsandthemanagementofcorporations.

1.3 Methodology

This report is based on original research to address the aims set out above. The research involved reviews of academic and policy literature pertaining to the core aims outlined above andalsodetailedexaminationofdataobtainedfromofficialstatistical sources, including the European Central Bank (ECB), International Monetary Fund (IMF) and Organisation for Economic Co-operation and Development (OECD), as well as commercial data providers.

For the purposes of this report, asset management is definedbroadlytoincludeallprofessionalmanagementoffinancialsecuritiesandotherassets(suchascommoditiesand real estate). Further, Europe is the geographic focus of this report. Where available, the report uses data on the European Economic Area (EEA). Some sections in this report rely on the availability of detailed and harmonized statistics across countries. In those sections, the analysis will focus on anarrowerdefinitionofEurope,suchastheEUortheeuroarea.ThereportprovidesdetailsonhowEuropeisdefinedineach section.

1.4 Structure of the report

The remainder of this report is structured as follows.

Section 2 provides the context of the analysis by describing recent developments, as well as the rise and shape of European asset management. Section 3 analyzes the direct benefitslinkedtotheindustry.Theseincludeemployment,financetofirmsandgovernmentandanattempttocomputethe value-add of the industry. Section 4 attempts to quantify theindirectbenefitslinkedtotheindustry.Thissectionanalyzesthecostsandbenefitsofthetypeoffinancialexpertise underlying the products the industry creates, the effects the industry has on European stock markets and the corporategovernanceofEuropeanfirms.Section5concludesand seeks to explore some of the implications of the reported benefitsoftheEuropeanassetmanagementindustry.

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02

Context: The rise and shape of European asset management


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Context: the rise and shape of European asset management2

This section provides an overview of the asset management industry in Europe. The discussion focuses on those aspects of the industry that are important for the analysis oftheindustry’snetbenefitstosociety.

2.1 The rise of European asset management

The European asset management industry is very large. In 2013, assets under management (AuM) of the European asset management industry, the key measure of the industry’s size, stood at nearly EUR €17 trillion, slightly higher than European GDP. Figure 2.1 demonstrates how large the European asset management industry is and how relatively stable the size of theindustryhasbeen,bothduringandafterthefinancialcrisis.

However, the size of the industry across Europe, as shown in Figure 2.1, could mask important differences in the size of the industry among individual European countries. For instance, a small number of countries could account for the bulk of the industry’s AuM. Table 2.1 shows that this is not the case. That is, although there are some differences with respect to the scale of the assets the industry manages across European countries, the industry is sizable in almost every European country. In 2012, AuM accounted for nearly 300% of GDP in the UK, 150% of GDP in France and about 50% of GDP in Germany, Italy, Belgium and the Netherlands. Apart from Greece, where AuM accounted for 4% of GDP, asset management is a sizable industry in every European country, making it a true pan-European industry.

Further, Europe is home to some large asset management firms.AsTable2.2demonstrates,thelargestinstitutionalassetmanagementfirmsoperatinginEurope,suchasBlackRock and BNY Mellon Investment Management, manage assets worth hundreds of billions of euros. Section 3.3 discusses whether this implies systemic relevance, in the sense that large European banks are deemed systemically relevant, and argues that size does not imply systemic relevance in assetmanagement.Table2.2alsoconfirmsthatEurope’slargest asset managers can be found in a number of European countries,whichconfirmsthepan-Europeannatureoftheindustry.

Source: European Fund and Asset Management Association (EFAMA, 2014). EFAMA members include current EU member states, excluding Estonia, Latvia and Lithuania, as well as Liechtenstein, Malta, Norway, Switzerland and Turkey.

What makes the present size of the European asset management industry particularly noteworthy is the speed at which the industry has grown over recent decades. OECD data for the UK show that AuM accounted for around 50% of GDP in1980.ComparingthisfigurewiththefiguresdisplayedinTable 2.1 shows that the industry has grown nearly sixfold in little more than 30 years. This remarkable growth trajectory paints the picture of an industry that responds to and meets important needs of its clients. Further, these client needs must be rather substantive for the industry to have been able to grow to its current size over recent decades.

The drivers of this growth, and consequently the needs of the industry’s end investors, are well understood. Populations in Europe and elsewhere have become larger, older and wealthier, thus increasing the industry’s potential client base. Over the last 60 years, life expectancy has increased by 50%, the population has tripled and world GDP has increased by almost 40%. In Europe, the ratio of wealth to income has doubled to 400% to 600% of GDP (Piketty, 2014), partly due to consecutive waves of capital market liberalization over this time. Jointly, these factors have increased the demand for asset management solutions to cater to older and wealthier societies that can look forward to increased life expectancies and longer retirement periods.

0%

20%

40%

60%

80%

100%

120%

140%

Eur €0 t

Eur €4 t

Eur €2 t

Eur €6 t

Eur €8 t

Eur €12 t

Eur €10 t

Eur €14 t

Eur €16 t

Eur €18 t

2007 2008 2009 2010 2011 2012 2013

AuM/GDP AuM (EUR €trillion)

Figure 2.1 Size of the industry across Europe

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2008 2009 2010 2011 2012

AuM AuM/GDP AuM AuM/GDP AuM AuM/GDP AuM AuM/GDP AuM AuM/GDP

UK 3,181 209% 3,783 241% 4,599 270% 4,977 270% 5,449 282%

France 2,554 131% 2,816 148% 2,904 150% 2,756 139% 2,977 146%

Germany 1,327 53% 1,460 61% 1,496 60% 1,438 56% 1,618 61%

Italy 562 36% 6,584 43% 670 43% 611 39% 841 54%

Belgium 468 136% 393 116% 227 64% 217 58% 225 60%

Netherlands 438 73% 474 83% 492 64% 474 78% 469 78%

Austria 79 28% 82 30% 85 30% 75 25% 84 27%

Portugal 74 44% 82 49% 81 47% 70 41% 66 40%

Greece 14 22% 14 6% 10 10% 7 3% 8 4%

Hungary 23 59% 29 31% 34 35% 19 19% 21 22%

Others 2,047 80% 2,554 79% 3,416 85% 3,127 77% 3,662 97%

Company 2013 AuM (EUR €m)

1 BlackRock 625,065

2 BNY Mellon Investment Management 434,653

3 Legal & General Investment Management 381,975

4 APG 343,000

5 State Street Global Advisors 260,121

6 Amundi 255,098

7 PIMCO 202,759

8 Natixis Global Asset Management 165,400

9 PGGM 154,898

10 Deutsche Asset & Wealth Management 152,047

11 Aberdeen Asset Management 138,402

12 BNP Paribas Investment Partners 137,192

13 Goldman Sachs Asset Management International 134,580

14 UBS Global Asset Management 122,080

15 Union Investment 108,203

16 MN 92,238

17 Helaba Invest 89,594

18 Schroders 88,740

19 F&C Management 77,161

20 Robeco Group 74,655

Table 2.1 Assets under management (AuM) across Europe

Table 2.2 Europe’stop20institutionalassetmanagementfirms

2 Context: the rise and shape of European asset management

Data source: EFAMA, 2014

Source: IPE, 2014


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Figure 2.2 Wealth-to-income ratios in selected European countries

Figure 2.3 Client base of European asset managers

It is important to emphasize that none of the driving forces behind the recent growth of the European asset management industry is likely to subside or reverse in the foreseeable future. Life expectancy is due to increase further, and while the wealth-to-income ratios have increased in recent years (see Figure 2.2), the ratios remain below their historical highs. Therefore, the drivers of growth in the asset management industry will remain intact for the foreseeable future. PwC research from 2014 estimates that the European asset management industry’s AuM will increase by 4.4% per year and a total of 42% by 2020.

2.2 The shape of European asset management

It is interesting to point out that while the size of the industry has increased markedly over recent decades, its core client base has remained constant. Figure 2.3 shows the make-up of the client base of the industry as at the end of 2012.

2 Context: the rise and shape of European asset management

Key

Key

Mar

ket v

alue

of p

rivat

e ca

pita

l (%

natio

nal i

ncom

e)

800%

700%

600%

500%

400%

300%

200%

100%

1870 1890 1910 1930 1950 1970 1990 2010

Germany

France

UK

32%

42%

3%

23%

InstitutionalRetail24% 76%

InsurancePension funds

BanksOther Institutions

Source: EFAMA, 2014

Source: Piketty, 2014

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2 Context: The rise and shape of European asset management

Asset management is an agency activity performed on behalf of end investors. It is therefore not surprising that institutional investors constitute the majority of the client base. Across Europe, institutional investors account for three-quarters of the industry’s client base, with retail investors accounting for the remaining quarter.

Among the institutional clients, three-quarters are insurance companiesorpensionfunds.Whilethefigurespresentedreferto 2012, the relative importance of individual client groups has not changed markedly over the past decade.

There are differences across European countries with respect totherolethateitherpensionfundsorinsurancefirmsplayin the provision of asset management services for long-term savings products. For instance, pension funds form a larger share of the client bases in the UK and the Netherlands because occupational pension schemes are more widespread in these markets.

Figure 2.4 Investment portfolio of European asset managers

Bycontrast,insurancefirmsaccountforalargershareofthemarket in Italy and Germany, owing to the importance that insurancefirmsintheprovisionoflong-termsavingsandtypically retirement-oriented products outside occupational pension schemes. Research by EFAMA (2014) shows that in eachEuropeancountry,pensionfundsandinsurancefirmsjointly account for the lion’s share of the asset management client base.

Given that the structure of the liabilities of both pension funds and insurance companies are rather long-term in nature, the fund management industry is particularly suitable to act as asourceoflong-termfinancetocorporations.Equityandbonds are most likely to meet client preferences as regards investment horizons, liquidity and risk levels. It therefore comes as no surprise that the asset allocation of the European fund management industry is heavily geared toward equity and bond investments. Figure 2.4 demonstrates that bonds and equity make up 46% and 29%, respectively, of the asset allocation of European asset managers.

Naturally, some differences remain across European markets regarding the exact allocation of assets. These differences reflectvaryingclientpreferencesorcontinueddifferencesinthewaythatcorporationsraiseexternalfinanceacrossindividual European markets. Therefore, European countries with widespread use of occupational pension schemes (such as the UK) hold more equity, whereas countries where debt markets are much larger than equity markets (Germany, Austria, France) hold more bonds.

Figure 2.4 also shows that alternative asset classes, including hedge funds, private equity or infrastructure funds, jointly account for 15% of the assets managed by the European asset management industry. The relatively low holdings of these asset classes is noteworthy because so much of the publicdebatefollowingtherecentfinancialcrisisoverbroaderregulation and improved transparency requirements have been targeted at these types of assets.

While these alternative asset classes may have important effects, in particular on asset markets or local markets, investments in these asset classes by the European asset management industry remain small compared with the overall investment universe of the European asset management industry. That is, the asset management industry invests predominantly in conventional bond and equity asset classes to meet the risk preferences of a largely institutional client base that offers savings and retirement-based products to many of its end clients. Thus, the industry is predominantly focused on managing long-term and often retirement-oriented savings. This is an important point to emphasize when analyzing the overall impact of the European asset management industry.

Bonds

Equity

Money market instrument

Other

46%

29%

10%

15%

Source: EFAMA, 2014


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03

Direct impacts of the European asset management industry

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Direct impacts of the European asset management industry3

This section provides an overview of the directimpactsandbenefitsthattheEuropeanasset management industry has on European economies. Later sections of this study will examine impacts of a more indirect nature. For the purposes of this study, direct impacts include those aspects that are relatively tangible and therefore more easily measurable and attributable to the industry.

While the distinction between direct and indirect impacts is not always clear-cut, this study will examine the direct effects in relation toemployment,thefinancingofrealeconomicactivity, the lack of sizable public subsidies and the overall value-add of the European asset management industry (including tax revenue and wages).

3.1 Direct and indirect employment

The European asset management industry is a large-scale provider of employment across Europe. EFAMA (2014) research estimates about 95,000 individuals are directly employed by the asset management industry (on a full-time equivalent basis). Perhaps predictably, the UK accounts for a large share but by no means accounts for a dominant share of the European employmentfigures.AsFigure3.1shows,GermanyandFrancehave sizable numbers of employees directly employed by the asset management industry, highlighting that it is a pan-European industry in terms of employment.

It is worthwhile pointing out that employment in this sector is highly skilled and somewhat less geographically concentrated thaninotherfinancialindustries.Forinstance,intheUKabout one-quarter of direct UK employment in the asset management industry is located in Scotland (IMA, 2013). The same is true for a number of other European asset management centers, such as Ireland and Luxembourg, which arealsolocatedoutsidethemainEuropeanfinancialcenters.Therefore, the numbers in Figure 3.1 are likely to understate the true impact of the asset management industry on local labor markets. This is especially true where the industry employs people in areas that are structurally weaker than Europe’smainfinancialcenters.

Figure 3.1 Direct employment in the European asset management industry

France

UK

Germany

Rest of Europe16,000

33,000

30,800

15,000

Source: EFAMA, 2014


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The numbers presented in Figure 3.1 also understate the overall impact of the industry on Europe’s labor market because they do not include indirect employment in related services, such as accounting, auditing, custodianship, marketing, research and distribution; for instance, IMA (2013) reportsthat79%ofUKassetmanagementfirmsoutsourcesome parts of their business. Notably, this proportion has increased from 74% in 2008. Thus, the overall employment figureslinkedtotheEuropeanassetmanagementindustryaremuchlargerthanthedirectemploymentfigures.

Precisely how many individuals work along the value chain of the asset management industry is not straightforward to estimate. However, estimates of indirect employment have recently been provided by the French Asset Management Association (2011). This report estimates the overall employment for various types of indirect employment in the asset management industry using data from the French Asset Management Association.

The survey data from the French Asset Management Association (2011) indicate that for every individual directly employed in the asset management industry in France, 4.55 full-time equivalent positions are created for individuals indirectly employed in the industry. This number includes positions in marketing and distribution (which account for about three full-time equivalent positions), as well as positions in accounting, auditing, and custodianship.

This report applies that multiplier to the list of countries in Figure 3.1. That is, across Europe, for every person directly employed by the asset management industry, 4.55 people are indirectly employed by the European asset management industry. Applying the multiplier to the number of those directly employed by the asset management industry (as published by EFAMA, 2014) yields a total of just under 530,000 full-time equivalent positions that are generated by Europe’s asset management industry. The substantial employment numbers generated by the industry are graphically depicted in Figure 3.2.

Figure 3.2 Total employment in the asset management industry

200,000

400,000

600,000

02006 2008 2010 2012

Source: EFAMA, 2014; French Asset Management Association, 2011

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3 Direct impacts of the European asset management industry

3.2 Financing European economies

Section2outlinesthatoneofthedefiningfeaturesoftheasset management industry is the long-term nature of its liabilities. This liability structure allows the industry to act as animportantsourceoflong-termfinancetotheeconomy,mainly by investing in equity and debt securities issued by companies and governments across Europe.

The asset management industry provides a crucial link inthefinancialsystem.Figure3.3illustratesthattheasset management industry collects funds from savers to transfer to borrowers, including businesses, households and governments. This channeling of savings is made possible becausetheassetmanagementindustryinvestsinfinancialassetsonbehalfofsavers.Theseassetsincludecertificatesof deposit, commercial paper, corporate bonds, government securities and stocks. When asset managers invest on behalf offirms,householdsorgovernments,itisknownasindirectfinance.Thetermstemsfromthefactthatassetmanagersdonot directly own the marketable securities but purchase these securities in an intermediary capacity.

The role of channeling savings is not unique to the asset managementindustry.Variousotherfinancialinstitutions—mostprominentlybanks,butalsoinsurancefirmsandpensionfunds—canperformtheroleofchannelingsurplusfundsfromdeficitunitstosurplusunits.Invirtuallyalleconomies,banksarethedominantfinancialintermediaryandbankloansthesinglemostimportantwayinwhichtheexternalfinancingneedsoffirmsaremet.

Europe has a particularly large banking sector that provides financetofirmsandhouseholds.In2013,theconsolidatedbalance sheets of euro-area banks amounted to around 290% of GDP. By comparison, the equivalent ratio in the United Statesis70%,thushighlightingthatEuropeanfirmsareparticularlyreliantonbanksfortheirexternalfinancingneeds.

However, the share of bank lending across Europe is decreasing. The size of bank balance sheets (relative to GDP) has declined by 15 percentage points since 2010 (see Figure 3.4).Further,loan-to-depositratiosfellfrom142%inthefirstquarter of 2008 to 117% at the end of last year. The ECB (2014) expects these ratios will fall further in the near future. Consequently, as structural changes in the banking industry continue, there is great need and demand for non-banking-basedfinance.

Indirect finance

Direct finance

Financial intermediaries

Borrower — Spender 1. Businessfirms2. Government

3. Household 4. Foreigners

Lender — Savers1. Household 2. Businessfirms3. Government 4. Foreigners

Financial markets

Funds Funds

Funds

Funds Funds

Figure 3.3



While some of the reasons for the gradual decline in bank financearecyclical—thatis,drivenbyalowersupplyofeconomically viable projects and shrinking bank–asset values inthedifficulteconomictimesfollowingtherecentfinancialcrisis—theregulationofbankactivitiesalsohasaroletoplay in explaining why the balance sheets of banks shrink (IMF, 2011a). Successive capital adequacy rules such as the various versions of the Basel Accords have made lending a more capital-intensive and thus less attractive business line for banks compared with capital-markets-based activities (Basel Committee, 2010).

Therefore,thereisanimportantneedfornon-bankfinancein Europe, and the asset management industry already acts asalinkbetweensaversandthefinancingneedsoftherealeconomy. Financing takes the following two key forms:

• Debtfinancing

• Equityfinancing

Figure 3.4 EU-18 bank assets as % of GDP

The study estimates the contribution that the European assetmanagementindustrymakestowardthefinancingofcorporations using both debt and equity. The approach follows and further develops a methodology introduced by EFAMA to calculate the contribution of European asset managers to the financingoftheEuropeaneconomyasexplainedinEFAMA(2014) and Delbecque (2012).

3.2.1 DebtfinancingoftheEuropeaneconomy

To estimate the importance of the asset management industry tofinancingeconomicactivity,wereliedondetailedandcomparable data on the holdings of the asset management sector and the amount of debt securities outstanding.

Weobtainedharmonizedstatisticsondebtsecuritiesfinancingand bank lending from the ECB Monetary and Financial Statistics. The ECB data were then used to demonstrate the importanceofassetmanagersfordebtfinancingEuropeaneconomies along two dimensions:

• Debt securities holdings of the European asset management industry as a share of all outstanding debt securities issued by euro area residents. The purpose of thisfigureistodemonstratetheimportanceoftheassetmanagement industry in terms of all debt-based (bond) finance.Figuresonoutstandingdebtsecuritiesissuedbyeuro–area residents are from the ECB and are at year end. Thefiguresincludelong-andshort-termsecuritiesandallpotential holders.

• Debt securities holdings of the European asset management industry as a share of bank lending. The purposeofthisfigureistodemonstratehowimportantthe European asset management industry is relative to the bankingsectorintermsoffinancingtherealeconomy.Banklending data¹ are the outstanding amounts of loans at the end of the fourth quarter of a given year based on consolidated amounts from the balance sheets of all Monetary Financial Institution (MFI) residents in the euro–area.

1Specifically,thisstudyusesMFIloanstotheprivatesectorandgovernmentintheconsolidatedECBstatistics.MFIsincludecentralbanks,residentcreditinstitutionsasdefinedinEUlaw,otherresidentfinancialinstitutionswhosebusinessistoreceivedepositsand/orclosesubstitutesfordepositsfromentitiesotherthanMFIsand,for their own account (at least in economic terms), to grant credits and/or make investments in securities.

295%

290%

305%

300%

315%

310%

285%

280%

275%

270%2008 2009 2010 2011 2012 2013

Source: ECB

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Debt securities issued by euro–area residents and held in

EUR €b % euro–area debt securities financing

% euro–area bank lending

% euro–area bank lending (excl. mortgages)

Euro area

2009 3,761 24.73% 31.91% 42.69%

2010 3,704 23.46% 30.24% 40.48%

2011 3,539 21.53% 28.71% 38.55%

2012 3,875 23.35% 31.77% 42.84%

Germany

2009 595 17.81% 13.85% 17.26%

2010 522 15.52% 11.90% 14.77%

2011 449 13.25% 10.19% 12.67%

2012 450 13.64% 10.17% 12.67%

UK

2009 884 25.73% 64.36% 68.35%

2010 996 27.56% 73.41% 78.10%

2011 1,054 26.30% 80.61% 86.29%

2012 1,100 25.54% 82.30% 87.49%

France

2009 809 28.01% 26.23% 32.20%

2010 768 24.82% 23.47% 28.81%

2011 768 22.77% 22.67% 27.96%

2012 812 23.72% 23.51% 29.00%

Data on debt securities financing and bank lending are from the ECB. Data on debt issued in Europe and managed by asset managers in Germany, UK and France are estimated using data reported in EFAMA, 2014

Table 3.1 Debt issued by euro–area residents

Table 3.1 shows that the European asset management industryplaysaveryimportantroleinthefinancingofeconomic activity. In 2012, the asset management industry held debt securities issued by euro–area residents worth nearly EUR 4 trillion. This amounted to 23% of all debt securities outstanding at the time.

Even more striking, the debt securities managed by the European asset management industry are of a value that corresponds to 32% of the value of euro–area bank lending. The ratio increases to 43% if mortgage lending is excluded

fromthebank–lendingfigures.Thus,financingoftherealeconomy performed by the asset management industry is substantial both in absolute and relative terms.

We also estimate the debt securities issued by euro–area residents and held by German, UK and French asset managers. To do so, we computed the market share of bond holdings by asset managers in a particular country relative to all bonds under management in Europe (irrespective of the geographic origin of the issuer) and applied this market share to the amount of debt securities issued by euro–area residents.²



2For instance German data for 2012, EFAMA (2014) show that bonds make up 46% (or EUR €7,099.64b) of European AuM. Equally, 51% of German AuM (EUR €825.17b) are allocated to bonds. Therefore, the market share of bond holdings by German asset managers in terms of all bonds managed in Europe is 11.62% (825.17/7,099.64). We apply this market share to the amount of bonds issued by euro– area residents to estimate that EUR €450b (0.1162*3875) of debt securities issued by euro–area residents are held by German asset managers in 2012.

3The formula used to determine the free float is: free-floating market capitalization = (STOXX free-float/STOXX total)* Total market value of European listed companies. Data provided by STOXX Limited. As an illustration, the free float was around 77% of total market value of European firms in 2010.

Table 3.1 shows that the importance of asset management financevariesslightlyacrosscountries.Thefiguresarelowerin Germany, where capital markets are less developed, in contrast to a very impressive 87% in the UK. In all countries for which data are presented in Table 3.1, the data show that theassetmanagementindustryisimportantforfinancingeconomic activity in Europe.

Overall,thereportedfiguresareaconservativeestimateofthecontributionoftheindustrytothefinancingofeconomicactivitybecausetheyincludeMFIlendingtothefinancialsector. Further, holdings of debt securities by asset managers in Germany and France may be even higher than those estimated due to a home bias in the industry’s asset holdings.

3.2.2 EquityfinancingoftheEuropeaneconomy

Next to debt markets, equity markets are also important providersoffinancetoEuropeaneconomies.Toestimatetheimportance of the asset management industry in providing equityfinancetoEuropeaneconomies,thisstudyobtainsdata on the market value of equity issued by euro–area residents and managed by European asset managers from EFAMA (2014). Data on the equity holdings of European fund managers are then separately divided by two monetary aggregates to indicate the importance of asset management firmsinprovidingequityfinance:

1. The total market value of quoted shares issued by euro– area residents as published by the ECB. Thefiguresindicate the outstanding amount of all quoted shares issued by every economic sector and at the end of a given year.

2. The free float of quoted shares issued by euro–area residents. Thefreefloatexcludesnon-tradableequity,suchasequityownedbygovernments,companyofficersorinvestorswithacontrollinginterest.Thefreefloatistherefore more representative of the tradable universe of equity.Thefree-floatmarketcapitalizationiscalculatedbymultiplyingthepercentageofthefree-floatmarketcapitalization of the STOXX Total Market Index (TMI) and the total market value of quoted shares.³

Table 3.2 shows that European asset managers managed equity valued at EUR 1,374 billion in 2012. This is a substantial share of the value of European equity. The value of equity held by European asset managers corresponds to 31% ofthemarketvalueofeuro–arealistedfirmsandnearly40%ofthefreefloatofEuropeanlistedfirms.

21



Equity issued by euro area residents and managed in

EUR €b % European quoted shares

% European free float

Euro area

2009 1,371 31.09% 43.79%

2010 1,418 30.95% 40.19%

2011 1,212 31.23% 40.29%

2012 1,374 30.51% 39.37%

Germany

2009 93 10.01% 13.85%

2010 88 8.06% 10.46%

2011 65 7.07% 9.42%

2012 89 7.77% 10.36%

UK

2009 582 32.34% 44.74%

2010 691 33.24% 43.11%

2011 633 33.54% 44.73%

2012 703 32.18% 42.91%

France

2009 207 16.11% 22.28%

2010 171 12.95% 16.80%

2011 150 13.64% 18.19%

2012 164 12.98% 17.30%

Data on equity securities financing are from the ECB. Data on equity issued in Europe and managed by European asset managers are from EFAMA, 2014

Table 3.2 Equity securities issued by euro–area residents The extent to which European asset managers hold equity variesacrossEuropeanmarketsbutremainssignificantinevery market examined.4Thesefiguresconfirmthecentralrolethattheindustryplaysinprovidingequityfinancetoeuro–area corporations.

AnumberofEuropeanassetmanagementfirmshavegrownrapidly over the last decade and now manage AuM in the hundreds of billions of euros. With increases in the scale of the industry come concerns that, similar to banking, someEuropeanassetmanagementfirmsmayhavebecomesystemically important.

Ifassetmanagementfirms—orotherfinancialinstitutions—become systemically important, this creates costs to society, mainly in the form of expected bailout costs and higher risk-takingbyfinancialinstitutions.Cruciallyforthisreport,ifthe European asset management industry is not systemically important and is therefore able to perform its valuable services to an economy without subsidies, this further increasesthebenefitsoftheassetmanagementindustryrelativetofinancialinstitutionsthatreceivesubsidiesbasedontheir systemic relevance.

This section argues that the European asset management industry is not systemically important. Operating on an agency basis,theindustrydoesnotmanagesignificantamountsof credit and liquidity risk. In European asset management, potentialfragilitiestofinancialstabilitystemfromtheproductlevelratherthanfromEuropeanassetmanagementfirms.

"Unlike in banking, history is not littered with examples of failing funds wreaking havoc in financial markets. The historical examples we have tend to be confined to small and isolated corners of the financial system."

Andrew Haldane (2014) Chief Economist at the Bank of England

4We use the same technique as in the previous section to estimate the amount of equity issued by euro–area residents and held by German, UK and French asset managers. For instance, German asset managers held 6.51% of all European equity under management in 2012, and we applied this percentage to the amount of equity issued by euro–area residents (0.0651*1374) to reach our estimate of EUR €89b.

3.3 AreEuropeanassetmanagementfirmssystemically important?



5In order of magnitude, the 10 systemically most important banks (in terms of bank assets to GDP) in our sample during 2007 are (whether they were bailed out during the crisis is indicated in parentheses): UBS (yes), Ageas (yes), Credit Suisse Group (no), Danske Bank (yes), Dexia (yes), Arab Bank (no), Royal Bank of Scotland Group (yes), Nordea Bank (no), Depfa Bank (yes; via parent company), Bank of Ireland (yes).

However, as will be argued below, these fragilities are of second order compared with the negative externalities created by the failure of systemically relevant banks.

This section proceeds by demonstrating why banks are systemicallyimportantandbyvaluingthesafety–netbenefitsafforded to European banks. It then goes on to argue why the European asset management industry is not systemically important.

3.3.1 Why some banks are systemically important

Systemic importance creates expectations among creditor groups that an institution is too large or otherwise too important to be allowed to fail in periods of distress. These expectations are based on concerns that the failure of such an institution would create considerable negative externalities, oftenbeyondacountry’sfinancialsystemanditsrealeconomy.

Inthebankingindustry,bailoutexpectationsallowfinancialinstitutionstoraiseexternalfinancemorecheaplythantheyotherwise could and cause institutions to engage in a more risky set of activities than external creditors would otherwise tolerate. Since governments (and ultimately the taxpayer) will becalledupontofinanceabailoutresultingfromunduerisk-taking,bailoutexpectationsareakintoasubsidythatbenefitsthe industry and is billed to the taxpayer.

For the banking industry, there is plenty of evidence in support of a size-related subsidy. By means of illustration, 7 of 10 systemically largest banks were subject to a taxpayer-funded bailout during the crisis.5 Demirgüç-Kunt and Huizinga (2011) showthatsystemicallylargebanksbenefitfromtakingonmorerisk.Theauthorsfindthatwhensystemicallylargebanks increase their share price volatility, this increases their market valuations and decreases their credit default swap spreads relative to systemically smaller banks. The size of this subsidy can be substantial. There is persistent evidence of lower funding costs for large banks and more leverage on the balance sheets of large banks. It is not uncommon for large international banks to hold equity cushions of less than 3% of total assets.

Thisreportestimatesthesafety–netbenefitsgrantedtoEuropean banks. The costs of bank bailout guarantees are calculated based on a contingent claims approach that values the safety net as a put option. Details of how this is worked out

are included in Exhibit 3.1. Based on this approach, the report estimates that the average subsidy to banks, and therefore the costs to European taxpayers, was 0.04% of bank assets per year between 2007 and 2013. Since average total assets of EU-28 banks were EUR €43.89 trillion over this time period, this values the costs of bank bailout guarantees as more than EUR €175 billion per year. It should be noted that the European asset management industry does not attract a bailout guarantee as outlined in the next subsection. By offering financingservicestotheeconomywithoutthepresenceofcostly bailout guarantees, the European asset management industryoffersfinancingservicesinamorecost-efficientwaythan banks and thereby generates a large saving for society.

The value of bailout guarantees can be calculated using a method developed by Ronn and Verma (1986). This method assumes that bank liabilities will be bailed out and that government therefore advances a put option to bank liability holders. Thus, the value of the government’s financialsafetynettoshareholdersisthevalueofaputoption underwritten by taxpayers.

By guaranteeing bank debt, taxpayers write a put option whose value can be expressed as a percentage of a bank’s debt as:

Valueofbankbailoutguarantees=N(y+σA,t√T)-((1-δ)n(VA/Bt) N(y)) * Bt

y=(ln[B/VA,t(1-δ)n]-σA,t2T/2)/(σA,t√T),

whereBtisthebookvalueofliabilities,δisthefractionof dividend to assets, n is the number of dividend payments per year, N(•) is the cumulative standard normal distribution, and T is equal to one, based on the assumption that bank deposits mature in the next year when a bank examination or audit occurs. Values of the bailout guarantees rely on calculating values for the market value ofbankassets(VA,t)andtheriskofbankassets(σA,t),details of which are listed in Appendix A.

On an intuitive level, the value of the put option to bank shareholders, and therefore, the value of bailout guarantees, increases the leverage of banks and risk of bank assets.

Exhibit 3.1 What are the taxpayer costs of bank bailout guarantees?

23



3.3.2 Whyassetmanagementfirmsarenotsystemicallyimportant

Given the substantial costs to European taxpayers linked tothesafety–netbenefitsaffordedtobanks,animportantquestion is whether European asset management industry receivessimilarsafety–netbenefits.Toanswerthisquestion,it is worthwhile considering three reasons that banks are vulnerable and to contrast these with asset management firms:

1. Banks provide extensive maturity transformation. Banks use short-term funding to make longer-dated investments. This leaves banks vulnerable to sudden withdrawals in short-term funding, for instance, when depositors or other bank creditors “run” and withdraw funding.

2. Banks operate using extremely high leverage. Banking is unusual in terms of the low equity funding relative to other industries. Since the role of equity is to absorb losses, even small losses in the region of a few percentage points in the value of bank assets threaten the solvency of a bank.

Figure 3.5 Value of bank bailout guarantees (in % of bank assets)

3. Banks benefit from explicit and implicit liability insurance. Deposit insurance covers deposits up to EUR €100,000 (or the non-euro equivalent) in all EU Member States.6 In addition to explicit deposit insurance, banks alsobenefitfromimplicitguaranteeswhengovernmentsbail out institutions to prevent the type of large negative externalities for the economy frequently associated with bank failures. The end result is that most bank creditors are de facto protected from losses and are therefore not interested in monitoring bank risk-taking.

However, asset management differs in important aspects from banking, and although some asset managers may be large, the industry is not as inherently fragile as the banking sector. Since the industry operates on an agency basis, asset managers do not bear credit, market and liquidity risk on their portfolios. Losses (and gains) are borne by end investors, and falls in asset values do not threaten the solvency of an asset manager in the way they threaten the solvency of a bank. Theriskoffailureofanassetmanagementfirmisremote.

6Art. 7 (1a) of Directive 94/19/EC.

0.30%

0.10%

0.20%

0.00%Greece UK Germany Italy France Portugal Spain

0.10%

0.05%

0.08%

0.00%

0.03%

2009 2011 20132007

Data from SNL Financial. The chart at right indicates average value.



3.3.3 Second-order risk factors at product level

However, while the asset management industry on the whole is not systemically important, there are still reasons to be vigilant as a number of second-order risk sources are linked tospecificinvestmentproducts(OfficeofFinancialResearch,2013;FSB2014)ratherthanassetmanagementfirms. These second-order risk factors include the following:

Counterparty risk. Direct connections between asset managers,banks,insurersandotherfinancialservicesproviders have steadily grown over the past few years. Funds actascounterpartiestofinancialservicesfirms,forinstance,as clients of broker-dealer services, custody services and formsofcredittofundsandfirms.Banksandinsurancecompanies also serve as counterparties for various types of derivatives contracts and portfolio investments. Therefore, distress at a fund could potentially be transmitted directly from an investment fund to the counterparties of a fund.

Herding. Asset managers may herd into certain widely employed strategies. This could contribute to the build-up of bubbles and magnify market instability generally (Dasgupta et al., 2011).

Redemption risk. Some investment vehicles offer unrestricted redemption rights to investors. In distressed markets, this offersafirst-moveradvantagetoinvestorstosellearlyaslong as they believe that delays in selling will cause further deterioration in the net asset value of a fund’s portfolio. Asset sales that follow accelerating redemptions could then spread across different portfolio types and markets (Manconi et al., 2012). There is a risk that accelerated redemptions could increase market risk generally if they were to create the impression with some investors that the asset management firmcouldbeunderdistress.

Leverage. Leverage subjects borrowers to liquidity constraints, particularly through the prospect of margin calls. Leverage for asset managers can be achieved using variousmeans:borrowingbyfirmsassetmanagersinvestin, borrowing by funds or borrowing at portfolio level, for instance, using derivative products. Derivative products allow funds to obtain exposure to market risk over and above the fund’s investment in a derivative.

7The various UCITS directives have their origins in the UCITS I Directive (85/611/EEC in 1985), which was amended and adjusted over time. The key amendments were as follows: the Management Directive (2001/107/EC in 2002) and the Product Directive (2001/108/EC in 2002). The UCITS brand continues to evolve, notablywiththeintroductionofDirective2009/65/EC(knownasUCITSIV),whichintroducedsomemodificationsforenhancedliquiditymanagementbyfunds.

While many regulated funds are subject to leverage restrictions, others are not. The less–regulated asset management sector, such as hedge funds, often relies on complex trading strategies in which leverage is often an integral component to boost returns. Risks related to leverage arepoorlyunderstoodowingtoinsufficientdataavailabletounderstand the extent of leverage of the industry, particularly in the non-regulated sector.

Europe has an established and robust regulatory framework that is designed to mitigate many of the above-mentioned product-level risk factors. The so-called Undertakings for Collective Investment in Transferable Securities (UCITS) directives form the basis of national regulatory requirements for European fund products that are marketable throughout EU Member States.7 UCITS already mitigate some of the above-mentioned risks by, for instance, subjecting funds to high levels of liquidity requirements and redemption settlement periods, as well as by regulating credit quality, asset concentrations and other risks. Equally, non-UCITS funds can manage redemption risk by imposing lock-in periods or restricting redemptions in ways that other forms of financialservices,mostnotablybanks,cannot.

However, another risk factor rests on reputational and operational risk. As the industry is largely agency-based, its reputation as a trustworthy custodian is crucial. Events that shake this belief can therefore cause large-scale redemptions fromaparticularassetmanager,assetmanagementfirmoreven the whole sector. Recent examples include fraud charges brought against AXA Rosenberg (see Exhibit 3.2), which causedsubstantialoutflows.

There were also concerns at the time that alleged fraud at one firmcouldsparkoutflowsintheentireindustrytoanextentthatwouldhaveaneffectonfinancialmarketsalongthelinesdiscussed above.

25



Three AXA Rosenberg entities were charged with securities fraud in February 2011 by the US Securities and Exchange Commission(SEC).TheSECchargedthefirmsfor“concealingasignificanterrorinthecomputercodeofthequantitative investment model that they use to manage client assets.... The SEC’s order instituting administrative proceedingsagainstthefirmsfoundthatseniormanagement… learned in June 2009 of a material error in the model’s code that disabled one of the key components formanagingrisk.Insteadofdisclosingandfixingtheerrorimmediately,asenior…officialdirectedotherstokeepquietabouttheerroranddeclinedtofixtheerroratthattime.”

AXA Rosenberg Group, AXA Rosenberg Investment Management and Barr Rosenberg Research Centre agreed to settle the SEC’s charges by paying US$217 million to harmed clients and a US$25 million penalty.

Thedamageforthefirmsfarexceededtheallegedinvestorlossesandfines.Inthefollowingquarter,AXARosenbergexperiencedverysubstantialoutflowsofaroundtwo-thirdsof its AuM in 2011–12.

Exhibit 3.2 Reputation as a risk factor: the case of AXA Rosenberg

Figure 3.6 Value-add of European asset management

In sum, the asset management industry is large and forecast to grow further in the future. While individual European asset managementfirmsarelarge,sizeisnotasufficientfactorto classify the European asset management industry as systemically important.

Theriskoffailureofanassetmanagementfirmisremote.Since the industry operates on an agency basis, it does not managesignificantamountsofcreditandliquidityrisk.TheEuropean asset management industry therefore operates without the bailout subsidies afforded to the banking sector. Thus, European asset managers fund economic activity to a similar extent as banks but do so without the costly subsidies afforded to banks.

In European asset management, potential fragilities to financialstabilitystemfromtheproductlevelratherthanfromEuropeanassetmanagementfirms.Fragilitiesexistaround counterparty risk, redemption and leverage inherent in products. However, these risks are already mitigated to a great extent by existing UCITS regulations. Non-UCITS products have means of managing and mitigating product-related risks to a much larger extent than banks. This is feasible because the nature of the risk management performed by the European asset management industry is fundamentally different from the type of risk management services performed by banks.

However, there are reasons to remain vigilant about the role of the asset management industry, especially as the industry is vulnerable to reputational and operational risks that have thepotentialtodestabilizefunds,firmsortheentireassetmanagement industry.

3.4 Value-add of the European asset management industry

This section estimates the economic value-added that the industry creates overall. Value-added is estimated using a revenue-basedmeasurethatincludestheindustry’snetprofitsplus staff costs plus taxes paid.

Not all of the three components of the value-added measure are published at an aggregate level in each country, and therefore the data are not directly observable for the purpose of this report. Consequently, this report uses the following estimation technique for the value-added of the industry in 2012.

Annualreportsfromlistedassetmanagementfirmswerecollected from Thomson Reuters Datastream. This yielded dataonnetprofits,taxesandstaffcostsforasampleofEuropeanassetmanagementfirms.Dataonstaffexpensesincluded indirect employment if published by the asset managementfirm.Foreachfirm,wescaledthevalue-addedbyfirmrevenue.

Net profit

Staff costs Tax

Source: www.sec.gov/news/press/2011/2011-37



Figure 3.7 Value-added of the European asset management industry

Annual value-added as % of GDP Annual value-added in €EUR

Forinstance,theratioofvalue-addedtofirmrevenueis75%for Aberdeen Asset Management and 84% for Amundi.

Next, data on the industry’s revenues in each country were used to estimate the value-added relative to industry revenues. In markets where data on industry revenues were unavailable, the ratio of revenues to AuM is set at the UK ratio of 0.43%.8 Assuming that revenues are proportionate to AuM, the value-added was then calculated and presented as a percentage of GDP.

The calculations in this report show that the European asset management industry contributes an average of 0.35% per year to GDP. The value-added is particularly large in the UK, where it is just under 1% per year. This estimate appears accurate. As a point of reference, TheCityUK (2013) reports that UK asset management generated about 1% of GDP in 2012.Thevalue-addedfiguresarealsolargeinabsoluteterms. Across Europe, the report estimates that yearly value-added of the industry is EUR €50 billion.

8The ratio of revenue to AuM is derived as follows. TheCityUK (2013) estimate that the total revenues of the UK asset management industry were €18.8b in 2012 (or EUR €23.2b if converted at end of 2012 exchange rates). Table 2.1 shows that UK AuM are EUR €5,449 b in 2012. Therefore, 23.2/5449=0.43%.

France FranceGermany GermanyEurope EuropeUK UK

0.97%

EUR €19 b

0.50%

EUR €10 b0.21%EUR €6 b

EUR €50 b

0.35%

27


04

Indirect impacts of the European asset management industry


28

Indirect impacts of the European asset management industry4

Thebenefitsestimatedanddiscussedinthissection are of an indirect nature because, unlikethetypeofdirectbenefitsdiscussedin the previous sections, they do not relate tomonetaryflowseitherintheformofimmediatefinancingneedsofcorporations,households or governments or the ability of asset management to provide employment. Asset management activities also generate anumberofpotentialindirectbenefits;forexample, the substantial holdings of debt and equitysecuritiesnotonlyfinanceEuropeanfirms(asdiscussedinSection3.2),butalsoaffectthequalityandfunctioningoffinancialmarkets and the management of corporations.

4.1 Thecostsandbenefitsoffinancialexpertise

By acting as an agent on behalf of investors, the asset management industry is an important provider of investment expertise and risk management services to institutional and retail clients. Asset managers are in a position to offer services through the investment products they produce and improve therisk-adjustedreturnsininvestorportfolios.Specifically,theindustryoffersimportantexpertiseintermsofdiversificationacross economic sectors, asset classes and geographies in waysthatwouldbedifficultandtime-consumingorimpossiblefor individual investors to achieve.

Givenagingpopulationsandthedemiseofdefinedbenefitpension schemes across Europe, expertise on constructing high-performing portfolios is timely and getting more households to make better use of the existing investment anddiversificationopportunitiesisimportant.Theissuethissectiondealswithishowthecostsandbenefitsoffinancialexpertise measure up. As the next section demonstrates that the bulk of AuM continues to be actively managed, this section focusesonthecostsandbenefitsoffinancialexpertiseinactive investment management.

Figure 4.1 Global AuM by product type

Key

Passives and ETFsOther

Traditional active core assetsActive specialistAlternatives

2008 201320035%

21%

63%

8%

9%

22%

56%

10%

10%

25%

45%

15%

Source: Boston Consulting Group, 2014

29


4 Indirect impacts of the European asset management industry

4.1.1 Costsoffinancialexpertiseinactiveinvestmentmanagement

Contrastingthebenefitsandcostsofthetypeoffinancialexpertisetheassetmanagementindustryprovidesisdifficult.Data on costs across institutional and private mandates are difficulttocompare,notleastbecausemanyofthecoststoend investors are created further down the investment chain. Distributors of asset management products contribute greatly to the costs of the end investor’s products.

The bulk of the investment products are actively managed and involve debt and equity positions in highly liquid markets. This is shown in Figure 4.1 which demonstrates that 45% of globalAuMareclassifiedastraditional(i.e.,large-capequityand government bonds). While investments in large-cap equity and government bonds have fallen (from 63% to 45% between 2003 and 2013), active asset management continues to make up the largest share of AuM. However, actively managed asset managementproductsandthefinancialexpertiseunderlyingthese products are relatively expensive. Active asset management includes stock picking, tactical asset allocations and market timing to generate value for clients. Crucially, active asset management involves substantially higher costs for end clients than passive asset management strategies that seek broad exposure to benchmarks and do not rely on cost-intensive company analysis and stock picking.

Theefficientmarkethypothesisisthecornerstoneoffinancialeconomics.FormulatedbyNobelLaureateEugeneFama,thetheoryholdsthatmarketpricesreflectinformation available at the time. In its basic form, the theory is widely accepted. In its applications to asset pricing models, however, the theory is seen as more controversial.

For instance, the capital asset pricing model (CAPM) relies onthenotionofperfectlyefficientmarkets(inthesensethat all information, public or otherwise, is impounded into prices) and various other assumptions, such as rationality, by investors.

InitsapplicationtotheCAPM,anefficientmarketmeansthat if no investor has an informational edge, stock picking will not lead to outperformance. Instead, the return on an asset is determined by its exposure to certain risk factors. The key risk factor is market risk, i.e., the relationship between an asset’s returns and a market benchmark (or “beta”). Later research has discovered additional risk factors, such as the state of the economy or the relative valuation of an asset.

ThemainimplicationofthevariousmodificationsoftheCAPM is deceptively simple. Outperformance (“alpha”) is not possible, and returns above the benchmark are down to one of two explanations: the asset manager has increased exposure to certain risk factors in her portfolio to a degree thatitnolongerreflectsthebenchmark(inotherwords,she has assembled a portfolio that is riskier than the benchmark) or, alternatively, the asset manager got lucky.

Initsstrongestform,marketefficiencysuggeststhatstockpicking will not lead to outperformance. Therefore, actively managed portfolios will not deliver outperformance, and investors should opt for passively managed products that provide more cost-effective exposure to risk exposures, the ultimate drivers of returns. In practical terms, this means that investors should opt for passive investment strategies that replicate returns on an existing benchmark index.

Thebasicimplicationofanefficientmarket—thatrisk-adjusted outperformance over a benchmark is not feasible onaverage—isnotwithoutcontroversy.Manyeconomistshave analyzed in great detail how and why investors are not always rational in their decision-making and thereby questionthefoundationoftheefficientmarkethypothesis.

Exhibit 4.1 Insight: does active investing constitute valueforinvestors?



Further, the industry’s expertise in active asset management is expensive for clients, given that studies have repeatedly shown that active management in heavily-traded markets rarely creates value for clients after taking the higher costs of active asset management into account "see Fama and French, 2010 or for recent European evidence, Blake et al., 2014". Exhibit 4.1 illustrates why the active asset management industry rarely constitutes value for investors. For the mutual fundindustry,itisawell-documentedfindingthatthevastmajority of actively managed funds underperform compared with passive funds once costs are taken into account.

While the near impossibility of active asset managers creating value for clients relative to passive fund management is well documented,thisdoesnotmeanthatthecostsoffinancialexpertise are a deadweight loss to the economy, as explained in the next section.

4.1.2 Benefitsoffinancialexpertiseinactiveinvestment management

A number of factors have to be taken into account to illustratethebenefitsofthefinancialexpertisethattheassetmanagement industry offers to clients:

1. Evidence of the poor value of active asset management for investors refers to the most heavily traded financial assets. In other and less liquid markets, asset valuations may deviate from their fundamental values for extended time periods. In these markets, it may therefore be possible for active asset managers to generate risk-adjusted returns above those of passive asset managers once fees have been taken into account.

2. The empirical literature has long documented that retail investors in particular suffer from a number of cognitive biases which cause them to forgo returns. Thesebiasesinclude:under-diversification(whenretailinvestors hold too few different asset classes and also suffer from a home bias in their investment choices); loss aversion (most investors avoid realizing losses but not gains); and herding behavior (investors seek exposure to identical or similar risk factors at the same time). While asset managers are not immune to cognitive biases, portfolio analyzes have shown professional portfolio managers to be less likely to succumb to these and other biases than retail investors.

3. Third, even if active asset management does not constitute poor value for investors, active investing is not a deadweight loss to society. There are a number of societalbenefits,someofwhicharesubstantial,directlylinked to active fund management. For instance, active fund management affects the market quality by ensuring thatmarketpricesareinformationallyefficientandpricediscovery more instantaneous (and cheaper), as well as improving the quality of corporate governance. These benefitsarelinkedtoactiveassetmanagementandtheyare shared among all investor groups.

Thebenefitslinkedtoactiveassetmanagementonmarketquality and the quality of corporate governance will be discussed in the following two subsections.

4.2 The asset management industry and market quality

Technologychangeshaverevolutionizedfinancialmarketsandthetradingoffinancialsecurities.Recentyearshaveseenincreasing automation in the trading process, and large trades whose execution once relied on the services of broker-dealers to identify and transact with suitable counterparties can now be executed by purely electronic means. One particularly noteworthy innovation in the trading process has been the introduction of computer-driven algorithms.

Algorithms are employed by some investors to route orders to a particular trading venue as well as to determine the size and timing of trades in order to minimize trading costs. Designated funds use algorithms to process information contained in orderflowstotradeonpatternsathighfrequency.High-frequency traders are able to react to market updates within milliseconds. By most accounts, high-frequency trading is nowresponsibleformostofthetradingvolumesinfinancialmarkets worldwide (Boehmer et al., 2014). The result has been nothing short of a revolution. Trading volumes have increased substantially, with trades executed faster, at higher frequency and in smaller batches than in the recent past.

31



Source: Boehmer et al, 2014. Includes all intraday messages that present trades or changes in price or size of the best quotes for each stock. *Quote messages computed based only on price changes because quote sizes were not available for the whole period. ** Data begins in 2005.

Table 4.1 Trading activity in selected European markets

Median number of messages per stock in 2001

Median number of messages per stock in 2012

% change over 2001–12

Euronext Amsterdam 41 2,762 6,637%

Athens 179 25 -86%

Brussels 11 156 1,318%

Copenhagen 7 21 200%

Dt Boerse Xetra 54 745 1,280%

Helsinki 23 94 309%

Istanbul 147 957 551%

London* 21 122 481%

Euronext Lisbon** 59 586 893%

Madrid 156 904 479%

Milan 108 529 390%

Oslo 18 53 194%

Euronext Paris 27 83 207%

Swiss Exchange 20 113 465%

Stockholm 59 55 -7%

Wiener Boerse 14 276 1,871%

Warsaw 11 31 182%

Median 27 122 352%

Crucially, rocketing trading volumes have caused a reduction in the costs of trading. A key component of the costs incurred bythosetradinginfinancialmarketsisthespreadbetweenbidand ask quotes. Spreads mark the difference in price between the highest price that a buyer is willing to pay for an asset and the lowest price at which a seller is willing to sell it. In recent years, as trading volumes have increased, spreads have declined sharply. This phenomenon is widely documented in the United States (Chordia et al., 2011), as well as in European and other international equity markets (Boehmer et al., 2014).

Since bid-ask spreads are essentially an indicator of the costs ofdemandingandsupplyingliquidityinfinancialmarkets,narrowingspreadssignificantlylowerthecostsoftradingfinancialassetsforallmarketparticipants.

Figure 4.2 shows bid-ask spreads for European stocks. The figureisbasedonstockmarketdataonabout2,000ofthemost frequently traded European stocks listed on Thomson Reuters Datastream. We calculate bid-ask spreads based on year-end quotes at close of market provided by Datastream.9

9Data include all European stocks listed in the Datastream Total Market Europe (TOTMKER) Index after excluding the 25% least– traded stocks in that index. Thisyields1,862stockslistedonallEuropeanstockexchanges.Wedefinebid-askspreadsas:(ask-bid)/ask.



Figure 4.2 shows a marked fall in the bid-ask spreads of European stocks. Liquidity premiums fell the most between 2002 and 2007, and though they increased slightly between 2007 and 2011, they have since fallen back to their historic lows. Between 2002 and 2013, bid-ask spreads have fallen by 0.712 cents.

Given the high volumes of trading activity on European equity markets, this is a substantial reduction in the cost of liquidity. To estimate the average yearly savings this reduction in bid-ask spreads generates, this report multiplies changes in bid-ask spreads between 2002 and 2013, the average ask price and the average yearly trading volume of European investment managers over the same period. It is estimated that the trading volume of European investment is 81.3% of total European trading volume.10 Therefore, this report estimates that trading activity by European asset managers has generated cost savings of EUR €12 billion in the costs of liquidity. 11

These cost savings recur yearly and are shared among all traders in European stock markets.

Thisisasignificantsavingthatbenefitsallmarketparticipants.It is worth noting that this report does not quantify to what extent professional investors trading on their own account, other than investment managers acting in an agency function, have contributed to the lowering in spreads. However, EUR €12 billion is a conservative estimate of the cost savings for two reasons:

1. The estimate does not include commission or delay costs, which, owing to higher trading volumes, have also been reduced in recent years. Bid-ask spreads are a substantial, but not the only, component of the total costs of trading. There is evidence that most components of the trading costs, including commissions and delay costs (owing to the increased speed of price discovery), have decreasedsignificantlyinrecentyearsandtheestimatedoes not account for that.

2. The estimate focuses on European equity exchanges only. Bond and derivatives exchanges have also experienced reductions in trading costs that are not accounted for in this estimate.

A key point behind the reduction in trading costs is that these benefitsaresharedamongallinvestorsdealinginfinancialmarkets. Granted, the bulk of trading activity is performed by some specialist funds that focus on high-frequency trading, and it is those investor groups that account for the largest amount of trading and will disproportionately reap the benefitsoflowertradingcosts.However,thebenefitsoflowerspreadsandspeedierpricediscoveryalsobenefittheassetmanagement industry more widely.

The new execution tools are widely used in the industry and not just by high-frequency traders (BlackRock, 2014). After all, achieving best execution and reduced costs is of importance to all asset managers, given that transaction costs directly affect their ability to deliver outperformance (alpha) and/or track a benchmark. Finally, tighter spreads not only benefitassetmanagersbutalsobenefitretailinvestorstradingon their own account. Savings in the costs of demanding and supplying liquidity increase net portfolio performance of all investor groups and help investors achieve their investment goals, for instance, retirement-based savings.

10We estimate the percentage of trading activity in Europe that is due to non-European asset managers as follows. First, we obtained data from the ECB on the equity holdings in the euro area by asset managers located in the rest of the world (ROW). Second, we assumed that 25% of the equity holdings by ROW asset managers involveeuro–areaequities.(Thefigureof25%isbasedonasampleofROWassetmanagerswhoseannualreportsindicatethattheyassignonaverage25%oftheirequity to the euro–area). Third, we divided the ROW asset manager holdings of euro–area equity by the equity holdings of euro–area asset managers (the latter as reportedinTable3.2).Theresultingfigureis18.7%.Finally,assumingthattradingactivityisproportionatetoequityholdings,weestimatethatEuropeanassetmanagers account for 81.3% of trading activity (=100% - 18.7%) in Europe.

11The calculations to yield investor savings are as follows: Bid-Ask Spread 2002-2013 * Yearly Ask Price* Average Yearly Trading Volume * European Asset Managers’ Share in Trading activity = 0.007118 * 72.87 * 28,874,954,000 * 0.813 = EUR €12.176 billion.

Figure 4.2 Bid-ask spreads (in euros) for European stocks0.012

0.006

0.009

0.0032004 2006 2008 2010 20122002

Source: Thomson Reuters Datastream

33



In sum, the asset management industry has been instrumental in making markets more frictionless places in which to operate. Thus, the industry plays an important part in making markets moreinformationallyefficientandcost-efficientplacesto invest in. This translates into lower trading costs for all investor groups.

4.3 Asset management and the corporate governance offirms

Inmostlistedfirms,stockholdersdelegatemanagementofthefirmstheyinvestintoprofessionalmanagers.Thisseparationofownership and control gives rise to agency problems where the interests of corporate management diverge from shareholders inwaysthat,ifnotaddressed,harmthevalueofthefirm.

For instance, managers may engage in pet projects or otherwiseextractbenefitsoutofthefirm,suchasinflatedremuneration. The asset management industry is particularly suited to tackling these and related agency problems because

Table 4.2 Corporate governance in Europe

Netherlands Belgium France Germany Italy Spain UK

Widely held 30% 0% 30% 35% 15% 15% 90%

Family 20% 50% 20% 10% 20% 25% 5%

State 5% 5% 20% 30% 50% 45% 0%

Widely held financial 0% 35% 20% 25% 0% 15% 5%

Widely held corporation 10% 0% 10% 0% 0% 0% 0%

Miscellaneous 35% 10% 0% 0% 15% 0% 0%

Civil law √ √ √ √ √ √

Common law √

Bank-based √ √ √ √ √

Market-based √ √

Board structure

One-tier √ √ √ √ √ √

Two-tier √ √ √ √ √

Say on pay

Advisory √ √ √ √ √ √

Binding √ √ √

thescaleatwhichitinvestsgivestheindustryasufficientlylargefinancialinteresttoengagewithfirmsovercorporategovernance issues.

Onereasonwhyagencyconflictscanbesoeconomicallyharmful is that, in the presence of many small shareholders, there is no incentive for any one shareholder to monitor corporate management. After all, the individual shareholder would bear the entire monitoring costs while all shareholders enjoythebenefitsofimprovedmonitoring.BecausetheEuropean asset management industry is a substantial investor in European equity and bond markets (see Section 3.2), the European asset management industry plays a vital role in improvingthecorporategovernanceofthefirmsitinvestsin.

Table 4.2 shows ongoing differences in the governance system, ranging from the ownership of corporations (held widely by many shareholders or held by families as concentrated ownership)andthenatureoffinancialsystems(bank-ormarket-based) to the structure of boards (one-tier or two-tier).

It is widely recognized that the asset management industry has played a pivotal role in bringing about improvements in the corporategovernanceoffirmsworldwide(seeMorckandSteier,2005).Theindustryhaslongcriticizedgovernancefailuresand sought to put pressure on company boards and lawmakers to increase managerial accountability and corporate disclosure policies. Recent examples of activism against AstraZeneca, Barclays and HSBC on executive remuneration demonstrate that the industrycontinuestoplayanimportantroleinthegovernanceoffirms.

Whiletheroleoftheassetmanagementindustrybehindcorporategovernanceimprovementsisundisputed,itismoredifficult toestablishhowtomeasure“good”governanceandthebenefitsassociatedwithit.

Source: Towers Watson, 2012



Figure 4.3 Governance scores by country

A seminal investigation into the performance effects of corporate governance was conducted by Gompers et al. (2003). Using 24 governance indicators and a large sample ofUSfirms,theauthorsconstructagovernanceindex.Theauthorsestimateagovernancepremiumof8.5%definedas the difference in abnormal (that is, above-index) returns betweenaportfolioofthebestgovernancefirmsandtheweakestgovernancefirms.ThisestimationhasrecentlybeenconfirmedbyBebchuketal.(2013).

However, Bebchuk et al. (2013) also demonstrate that the governance premium cannot be detected after the year 2000. Thissuggeststhatthereturnsofgoodgovernancearefiniteand stop accumulating once a certain level of governance has been reached.

A governance premium of 8.5% is consistent with a World Bank (2011) survey of international asset managers in which half the respondents put the premium at 10% based on the responses, albeit for markets that included developing countries. Using much earlier data, a McKinsey (2002) surveyfindsthatEuropeanassetmanagersarewillingtopaya premium of between 18% and 23% for high governance standards in a range of European economies.

European economies have slightly lower levels of governance qualitycomparedtoUSfirms.Figure4.3showsthepercentageoflistedfirmsthatmeetalistof44governanceattributes that are deemed to satisfy minimally acceptable governance standards. The data are based on a survey by Institutional Shareholder Services (ISS).12 Given the slightly lower levels of governance quality in Europe, it is reasonable to assume that the governance returns in Europe will have been at least as high as in the United States. Therefore, an 8.5% value premium linked to governance improvements, as estimatedandconfirmedbyUSevidence,isaconservativeestimate of the value effect linked to good governance.

Based on this governance premium, the estimate of governance premium is 8.5% of equity issued by euro–area residents plus UK residents as published by the ECB in 2012. Non-Europeanassetmanagementfirmsarealsolikelytohaveimproved governance. In Section 4.2, it is estimated that 81.3% of European stocks held by asset managers are held by European asset managers. Based on these calculations, this report values the European governance premium caused by European asset managers to be EUR €462 billion.13

Therefore, nearly EUR €500 billion of the value of European equity is due to improvements in the corporate governance of Europeanfirms.Improvementsinthecorporategovernanceresult from periods of engagement with the asset management industry.Justlikeotherindirectbenefitscausedbytheassetmanagement industry, the value is shared with other market participants,andtherefore,thebenefitscausedbytheEuropean asset management industry are shared more widely.

12The attributes fall into four broad subcategories: (1) Board (25 attributes), (2) Audit (three attributes), (3) Anti-takeover (six attributes), and (4) Compensation and Ownership (10 attributes). Appendix 2 includes a full list of the governance standards used in this survey.

13ThecalculationstoyieldthevaluationpremiumlinkedtoEuropeanassetmanagersareasfollows(allin2012figures):valueofeuro-area-resident-issuedandUK-resident-issued equity (EUR €6,686 billion)* 0.085 (governance premium) * 0.813 (share of European asset managers in stocks held by asset managers).

80%

20%

40%

60%

0%

Gree

ce

Port

ugal

Belg

ium

Nor

way

Italy

Denm

ark

Aus

tria

Swed

en

Fran

ce

Spai

n

Germ

any

Net

herla

nds

Irela

nd

Finl

and

Switz

erla

nd UK

USA

Source: Aggarwal et al., 2010 based on Institutional Shareholder Services data

35


05Conclusions and implications


36

Conclusions and implications5The European asset management industry is large and growing across Europe. Demand for asset management solutions has grown to cater to older and wealthier societies that can look forward to increased life expectancies and longer retirement periods. None of these driving forces is likely to subside or reverse in the foreseeable future. The reasons for the stellar growth of the industry are therefore going to continue.

Size and growth of the industry indicate that it meets important needs of European societies and, in doing so, will have an important impact on European societies. This report exploresanumberofidentifiedbenefitsthathaveimplicationsfor ongoing policy discussions.

Financing economic activity

Oneofthekeybenefitstheindustryprovidesrevolvesaroundfinancingeconomicactivity.Theindustryisabletoperformthiscrucialfinancingrolebecausethebulkofitsliabilitiesis invested on behalf of a largely institutional client base in need of long-term savings and risk management services. Thefinancingroleoftheindustryislikelytoincreaseinthenear future as the banking sector continues its retreat from traditional lending activities. The retreat from lending, through a process known as disintermediation, can be observed in a number of European markets and is set to continue in many of Europe’s economies. This leaves a growing and increasingly importantroleforEuropeanassetmanagerstofillthegapleftbybanksinprovidingfinancetoEuropeaneconomies.Giventhe current underperformance of most European economies and the ongoing credit crunch in parts of Europe, the role of asset managers in providing a source of lending must surely be welcomed.

Systemic relevance of the industry

Recent discussions over the supposed systemic relevance ofassetmanagementfirmsraisethespecterofadditionalsupervision and costs to the industry. While individual Europeanassetmanagementfirmslookafterever-largeramountsofAuM,sizeisnotasufficientcriteriontoclassifythe European asset management industry as systemically important.Theriskoffailureofanassetmanagementfirmisremote. As the industry operates on an agency basis, it does notmanagesignificantamountsofcreditandliquidityrisk.

In European asset management, potential fragilities to financialstabilitystemfromtheproductlevelratherthanfromEuropeanassetmanagementfirms.Fragilitiesexistaround counterparty risk, redemption and leverage inherent in some asset management products. However, in Europe, these risks are already mitigated to a great extent by existing and well-established UCITS regulations. UCITS mitigate risks, for instance, by subjecting funds to high levels of liquidity requirements and redemption settlement periods, as well as by regulating credit quality, asset concentrations and other risks. Further, non-UCITS products are able to manage and mitigate product-related risks to a much larger extent than banks. This is feasible because the nature of the risk management performed by the European asset management industry is fundamentally different from the type of risk management services performed by banks.

It is therefore important that European lawmakers balance the needsoftheindustrywithfinancialsafetyconcernsanddonotunderminesomeofthekeybenefitstheindustryprovidesto society. There are certainly reasons to remain vigilant regarding the role of the asset management industry and financialstability.Asamainlyagencybusiness,theindustryis vulnerable to reputational and operational risks that have thepotentialtodestabilizefunds,firmsortheentireassetmanagement industry.

37


5 Conclusions and implications

Financial expertise

TheEuropeanassetmanagementindustryoffersfinancialexpertisetoitsclientsviathefinancialproductsitcreatesand markets. However, questions remain over whether these roles can be delivered in a more cost-effective way for the end investor. Most of the AuM continue to be managed on an active basis and in heavily traded markets where it has proventobedifficulttobeatindexreturnsaftertherelativelyhigh fees of active asset management have been taken into account. This does not mean that active management is superfluous—indeed,someofitisessentialforfunctioningmarkets—butthatitcanbedeliveredinamorecost-efficientway. Also, it is important to bear in mind that large parts of the costs of asset management for end investors are caused by third parties and issues further down the asset management value chain.

Further, it is widely accepted that only a small part of the populationcurrentlypossessesthefinancialliteracyrequiredtomakefinancialdecisions.Theindustry’sexpertiseisthereforenotonlyrequiredtocreatefinancialproducts,itcouldalsoplayanimportantroleinpromotingfinancialeducation. In particular, the industry can play an important roleinenhancingthequalityoffinancialtrainingofstaffandfinancialintermediariestohelpthemenablepotentialinvestors to make better-informed investment decisions and tosensibilizeEuropeansocietiestotheirfinancialplanningneeds.

Trading activity

Theanalysisshowstangibleandsubstantialbenefitslinkedtotheexistenceofassetmanagementfirmsinfinancialmarkets.This comes against the backdrop of concerns that ever-larger tradingvolumesinfinancialmarketscarrynobenefitsforsociety. For instance, the recent Kay Review (2012) in the UK advocates a model of long-term “buy-and-hold” investing. However,asthisreportshows,therearetangiblebenefitsthathighertradingvolumesbring.Thesebenefitsincludelower transaction costs, faster execution and price discovery andenhancedmarketefficiency.Perhapsmostimportantly,withrespecttothisreview,thebenefitsofhighertradingareenjoyedbyandsharedamongallparticipantsinfinancialmarkets. Therefore, the asset management industry has been instrumental in making markets more frictionless places in which to deal. This translates into lower trading costs for all investor groups.

This report comes against the background of ongoing discussionsoverafinancialtransactiontax(FTT)leviedontransactionsinvolvingspecificassetclassessuchasstocksand bonds. The FTT, as discussed across Europe and already implemented in some markets, will have detrimental effects on market quality. For instance, the IMF (2011b) argues that an FTT reduces trading volumes and lowers liquidity. An FTT would therefore reverse some of the cost reductions linked to higher trading volumes that are described in this report. As outlined in this report, the European asset management industry predominantly acts as a long-term investor and provider of long-term risk management services to clients. Therefore, increasing the costs of trading is almost certainly going to have detrimental effects on the ability of the industry toofferitsservicestosocietyinacostefficientway.

Finally, the industry faces increasing competition on a global scale (EY, 2014). Parts of China and Southeast Asia are fast developing into global centers for asset management services. The nature of the challenge is twofold: asset managers’ clients can increasingly be found in Asia and investment opportunities can also be found in these markets. In the medium term, these factors challenge Europe’s position as the world’s second– largest center for asset management.

It is therefore important that European lawmakers carefully balance the needs of the European asset management industry, its clients and European economies.


38

06Appendices

39


Appendix6Appendix 1: Calculation of market value of assets (VA) andportfoliorisk(σA)

We calculate the market value of assets and market sensitivity toportfoliorisk(σA)basedonMerton’soptionpricingframework. According to Ron and Verman (1986), equity holdersoccupyaresidualclaimonthevalueoffirmassets,and their claim structure resembles the value of a call option.

VE,t = VA,t N(d1,t) - Xt e-rT N (d2,t)

σE=VAN(d1)σA/VE

where

d1,t=(ln(VA,t/X)+(r+(σ2A,t/2))T)/σA,tT

d2,t=d1,t-σAT0.5

where VE,t is the market value of equity, VA,t is the market valueofassets,Xisthebookvalueofbankliabilities,σA,tisa measure of asset volatility calculated using the standard deviation of asset values, T is equal to 1, and r is the risk-free rate on 1-year T-bill. Since the equation involves two unknowns, we adopt Newton’s search algorithm. This algorithm involves simultaneously solving the above equations and the following optimal hedge equation:

σE,t=VA,tN(d1)σA,t/VE,t

Forcalculatingdefaultprobability,wecalculateVA,tandσA,tand calculate default probability using the following equation:

Defaultprobability=N((ln(VA,t/Lt)+(r-0.5σA,t)2T)⁄(σA,tT)

For the insurance price premium (IPP), the procedure forcalculatingVA,tandσA,tissimilartotheabove.Theonly difference is that the book value of liabilities B is now multipliedbyanadditionalparameter,ρ,whichtakesintoaccount regulatory forbearance wherein the regulator mightnotliquidatethebankimmediately.ρissetat0.97,which means that the regulator is assumed to proceed with liquidation if the market value of assets falls below 97% of the bank’s liabilities. The estimates are not sensitive to the chosen valueforρ.

Appendix 2: Corporate governance indicators

List of 44 governance standards underlying the Aggarwal et al. (2010) study.

Board

1. All directors attended 75% of board meetings or had a valid excuse

2. CEO serves on the boards of no more than two public companies

3. Board is controlled by more than 50% independent outside directors

4. Board size is greater than 5 but fewer than 16

5. CEO is not listed as having a related-party transaction

6. No former CEO on the board

7. Compensation committee composed solely of independent outsiders

8. Chairman and CEO are separated or there is a lead director

9. Nominating committee composed solely of independent outsiders

10. Governance committee exists and met in the past year

11. Shareholdersvoteondirectorsselectedtofillvacancies

12. Governance guidelines are publicly disclosed

13. Annually elected board (no staggered board)

14. Policy exists on outside directorships (four or fewer boards is the limit)


40

15. Shareholders have cumulative voting rights

16. Shareholder approval is required to increase/decrease board size

17. Majority vote requirement to amend charter/by-laws (not supermajority)

18. Board has the express authority to hire its own advisors

19. Performance of the board is reviewed regularly

20. Board-approved succession plan in place for the CEO

21. Outside directors meet without CEO and disclose number of times met

22. Directors are required to submit resignation upon a change in job

23. Board cannot amend by-laws without shareholder approval or can do so only under limited circumstances

24. Does not ignore shareholder proposal

25. Qualifiesforproxycontestdefensecombinationpoints

Audit and anti-takeover

26. Consulting fees paid to auditors are less than audit fees paid to auditors

27. Audit committee composed solely of independent outsiders

28. Auditorsratifiedatmostrecentannualmeeting

29. Single class, common

30. Majority vote requirement to approve mergers (not supermajority)

31. Shareholders may call special meetings

32. Shareholder may act by written consent

33. Company either has no poison pill or a pill that was shareholder—approved

34. Companyisnotauthorizedtoissueblank—checkpreferred

Compensation and ownership

35. Directors are subject to stock ownership requirements

36. Executives are subject to stock ownership guidelines

37. No interlocks among compensation committee members

38. Directors receive all or a portion of their fees in stock

39. All stock-incentive plans adopted with shareholder approval

40. Options grants align with company performance and reasonable burn rate

41. Company expenses stock options

42. All directors with more than one year of service own stock

43. Officers’anddirectors’stockownershipisatleast1%butnot over 30% of total shares outstanding

44. Repricing is prohibited

41


Bibliography


42

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44

Contacts

Belgium: Frank de Jonghe E: [email protected] T: +32 2 774 9956

Channel Islands:Mike Bane E: [email protected] T: +44 1481 717435

EMEIA: Roy Stockell E: [email protected] T: +44 20 7951 5147

France: Hermin Hologan E: [email protected] T: +33 1 46 93 86 93

Germany:Oliver Heist E: [email protected] T: +49 6196 996 27505

Ireland:Donal O’Sullivan E: [email protected] T: +353 1 2212 455

Italy: Stefano Cattaneo E: [email protected] T: +39 0272212452

Luxembourg: Michael Ferguson E: [email protected] T: +352 42 124 8714

Netherlands: Jeroen Preijde E: [email protected] T: +31 88 40 71679

Switzerland: Bruno Patusi E: [email protected] T: +41 58 286 4690

UK: Gillian Lofts E: [email protected] T: +44 20 7951 5131

Ifyouwouldliketodiscussanyofthefindingsinthisstudy,pleasedonothesitatetocontactyourlocalEYWealth&AssetManagement Leader.

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