March 2011

UP IN THE AIR: don't only do the math

Cover_story_picRisk systems and regulations have centred on the quantitative and not the qualitative. Nicholas Pratt looks at the juggling required in the world of non-financial risk and asks whether more systematic rigour can be applied

Risk management has become increasingly dominated by complex mathematical modelling and scenarios and simulations based on market statistics. When trying to anticipate market movements, such an approach would seem wise – even though the financial crisis demonstrated that too much reliance on models can lead managers to think that the “what-if” scenario they have just witnessed is a reflection of the market rather than a computergenerated simulation.

Regulation has also become a highly quantitative discipline concerned mostly with financial risks, such as market and credit and expressed through capital charges. Even the newest areas to fall within the regulators’ radar, such as liquidity risk, are financial in nature.

Less has been made of so-called non-financial risk. Admittedly, the term can often be vaguely defined and used to describe anything that is not financial risk, but its vagueness and wide definition should not detract from its importance. And nor should the fact that regulation does not explicitly address these risks mean that asset managers or investors should neglect them.

Regulatory requirements
A recent study by Edhec-Risk Institute and Caceis Investor Services, entitled The European Fund Management Industry Needs A Better Grasp of Non-Financial Risks, traces the management of non-financial risks such as counterparty risk, compliance and misinformation. As its title suggests, the report concludes that the fund management industry has paid insufficient attention to this area – not necessarily in the management of non-financial risk but in the level of transparency of such risks and how they are expressed to investors.

Regulation is partly to blame because it has failed to keep up with the non-financial risks that have resulted from continued financial innovation and this has led to a lack of disclosure of non-financial risks. The lack of information in this area means that many investors are unable to see if an asset manager is good or bad at managing the non-financial risk within a fund.

“Retail investors and even some institutional investors will look at a regulated fund such as a Ucits fund and assume that it is fully secure and largely risk-free, but the Madoff scandal showed us that that is not always the case – regulation does not always capture all non-financial risks,” says Samuel Sender, applied research manager at Edhec-Risk Institute.

To improve the regulatory requirements for managing non-financial risk would also mean addressing many of the systemic problems with EU regulation. For example, the depositories lie at the forefront of non-financial risk and the liabilities involved, but the laws governing these depositories operate at national level – furthermore, they differ from one country to another within Europe, says Sender. “We are seeing the geographical boundaries of fund distribution and promotion continually expand, but the regulation of these funds has not managed to keep up and ensure that the assets within a fund can be returned in the case of a catastrophic non-financial risk event. The result is that once you go beyond the vague guidelines of Ucits, there is very little regulation at all concerning non-financial risk.”

Rating funds
Sender is hopeful that there will be some developments in this area next year, either through the development of insurance policies that cover non-financial risks and also a system for rating funds that focuses on qualitative issues such as operational risk and not just the quantifiable risks that make up the probability of default. “A number of institutional investors are taking this approach to the selection of hedge fund managers and it would be good to see this extended to mainstream funds,” says Sender.

He envisages something similar to the Key Investor Information Document (Kiid) that is to be introduced through Ucits IV but which also makes a declaration about the non-financial risks within a fund in a format that a retail investor can easily understand. “This needs to be done because if investors think there is not a transparent process around these risks and they are unable to see a report, they will gravitate towards those funds that are immune to many of the non-financial risks, such as simple bonds and equities. The question is how much investors will be willing to pay for more transparency and more reporting or for insurance. This is something we will investigate this year.”

Sender also hopes that regulation around this area will become more comprehensive and more homogenous between different countries, particularly given the popularity of emerging market funds among European investors. “At the end of the day, when you expand the investment universe, you also expand the risk and this has to be taken into account.” According to Jean-Marc Eyssautier, group chief risk and compliance officer for Caceis, reforming the whole question of liability is the first issue that needs to be addressed when looking at non-financial risk within a fund. “We are all in an intermediary business – from the depository to the distributor to the manager to the investor – and over the years the feeling has been that if these non-financial risks occurred, it was not up to us to take action. And, typically, the end-investor who ultimately has the exposure to these risks was the least informed about the management of these risks.”

The financial crisis showed how uncoordinated the laws around liability are when it comes to the failure of a fund as a France-based custodian such as Caceis soon discovered. “Under French law, the depository is the one that is liable and the management of risk falls on those thought to have the deepest pockets. We do not think that is a satisfactory position,” says Eyssautier. Such an approach puts the depository in the role of an insurer of sorts and makes custodians unfairly liable for the investment decisions of others.

“Custodians do not have enough capital to act as insurers. If something goes wrong, it is important that we accept our responsibility and protect our investors. But if our investors choose to invest in an emerging market fund where there is a high proportion of non-financial risk, that has to be made clear in the investor’s view of the fund and there should be a premium attached to that financial product. The investors benefitting from higher returns should be aware of the risks involved and the responsibilities and liabilities of each investment product should be clear.”

The report conducted with Edhec proposes some ways in which the various players involved can assume greater responsibility for managing non-financial risk. In addition to a more consistent and standardised definition of the role and responsibilities of depositories, there should also be an onus on fund distributors to provide more detailed information to investors, including information on non-financial risks; and there should be an inclusion of nonfinancial risk ratings in the Kiid which would favour those funds that adopt best practice and guarantee that management companies and depositories act in the best interests of investors.

Better balance
For management companies, capital requirements should be strengthened to include counterparty as well as operational risk; insurance should be considered for nonfinancial risks that exceed equity; improved governance should address the lack of transparency and absence of best practice in dealing with conflicts of interest; the encouragement of the creation of closed funds containing illiquid assets dedicated to institutional investors for long-term investments; and clear regulations that lay down the responsibilities towards final investors and ensure a better balance between the remuneration of asset management companies and that of investors.

Eyssautier hopes that the asset management industry will address these issues en masse and a more consistent investment industry will result. “It will make no difference if Caceis does this alone. We all say and think that we want a common market but if there remains such a huge difference between different national regulations and in the responsibility for managing risks within a fund, there will never be a level playing field. We hope our concerns will be understood and the rules for Ucits IV [and other regulations] will reflect these but, so far, there has been little said.”

Just as insurance only addresses part of the issues, so it is the same with regulation and, ultimately, the long-term solution lies in better due diligence, corporate governance and risk management for everyone involved.

“There has been more focus on these issues since the financial crisis but I’m not sure the asset management community is ready to go the whole way because there is a cost attached to better risk management,” says Eyssautier. “But one of the reasons we wanted to work with Edhec on this study is to see what approaches and methodologies could be appropriate for managing non-financial risk and whether the application of the models and metrics, such as value at risk that we see in financial risk, could be sufficient in non-financial risk.”

The challenge of applying the systematic and mathematical rigour seen in financial risk to non-financial risk has long been a feature of the sustainable and responsible investment (SRI) sector where investment decisions are based on the assessment of environmental, social and governance (ESG) risks.

“The information used to assess these types of risk is very qualitative and not quantitative and that creates a big challenge,” says Mathilde Moulin, SRI equity analyst at Allianz Global Investors France. “So we try to use diverse sources of information – we don’t rely just on the material provided by the companies but also the employees and trade unions. We look at sector-specific reports, the formal company commitments, implementation into corporate practices and we examine all controversies.”

Business behaviour
Given the highly qualitative nature of the information available, is it possible to formulate any quantitative analysis? “We try to produce quantitative information where possible. It is easier to do on the environmental side because you can look at figures for energy consumption or CO² emissions. It is more difficult for the business behaviour and social issues but we look at as much quantitative information as possible. For example, we assess employee satisfaction by looking at employee turnover, health and safety records and the number of fines for bribery or anti-competitive practices,” adds Moulin.

There can be a tendency for ESG risks to be viewed as reputational risks rather than financial, even if there is some impact on profits as a result of breaches of reputation. So how do SRI analysts address this issue? “Some criteria have very direct financial impacts – for example, a pollution case will lead to fines, restoration costs and legal fees. Other risks are more reputational – such as accusations of exploiting child labour – but this can cause a dent in the sales through consumer boycotts.”

Even though investment trends occur at an ever-increasing rate, SRI is still a relatively new area but as it matures and the management of the risk factors involved becomes more rigorous and systematic, can we expect to see it become an area of investment that is pursued mainly for its promise of returns rather than its worthiness? “There are two main objectives to SRI,” says Moulin. “The first concerns performance. We are convinced that a company that takes care of its stakeholders and manages its nonfinancial liabilities will create more benefit to shareholders in the long run. The second is to participate in the sustainable  development of society by investing in more responsible issuers and by accompanying companies in improving their ESG performance.”

Qualitative analysis
Bearing in mind the qualitative nature of the data around non-financial risk, is it possible to instil the same mathematical models and systematic approach we see with market risk? For example, are the various SRI indices and SRI ratings, as well as the non-financial risk data produced by companies in their audits and annual statements of any practical use to non-financial risk managers and SRI analysts at fund managers?

“The SRI indices and the data coming from ESG ratings agencies are not the sole basis of our work but they do often form the first part of our analysis,” says Moulin. “We integrate them into our databases and then we have to add qualitative analysis by interviews with the companies, NGOs and external experts. The indices are mostly reliant on companies’ disclosure and, therefore, any numbers that are produced have to be backed up with qualitative information so that we can verify them and put them in context. We have to ensure that the information is not just produced by the companies for their own marketing purposes.”

©2011 funds europe