March 2010

RISK MANAGEMENT: the risk reducers

Regulatory and client demands for more risk management created an increased role for specialist risk officers. Nicholas Pratt talks to risk managers from three distinct investment management firms...   tightrope.jpgIt is a good time to be a risk manager and it is an even better time to be a chief risk officer (CRO). In comparison to the rest of the C-suite, the CRO role is relatively new, only appearing in the largest investment banks in the last ten years before cropping up in the fund management industry. This prominence is indicative of the growing focus on all things risk related.

Some years ago the main responsibility for a fund manager’s risk manager was looking at investment risk. There were risk frameworks in place but it was not clear that they were the right frameworks or that they were being applied in an enterprise-wide context, as is the fashion in today’s market.

Now fund managers are looking to respond to types of risk that they might not have looked at before, such as counterparty risk, as shown by the industry inquiry into stock-lending in the last two years. After years of fear-free stock lending, fund managers are now questioning the ability of their counterparties to meet their obligations and querying the quality of the collateral on offer.

There is also the issue of ‘tail’ risk – improbable but potentially franchise-threatening risks – which covers everything from straightforward investment fraud in the style of Bernard Madoff, to unknown but catastrophic exposure to failed structured products, as was the case with any fund manager caught up in the Lehman Brothers’ default.

A lot of these changes have been charted in a series of industry surveys. For example, one carried out by risk systems provider MSCI Barra canvassed over 30 CROs at asset managers in Europe and the US to ascertain just how much had changed in the last year. The biggest surprise to the participants was the sudden and violent appearance of liquidity and counterparty risk and the need to better understand their impact on investments across all assets.

But the overriding theme of the survey was that all CROs anticipate further overhaul and significant investment in the risk management function over the next twelve months, suggesting that the risk manager of the future needs to be able to gain seniority, offer investment advice to fund managers rather than just beat them over the head with a compliance stick, and make significant investment in their risk management ‘toolboxes’. 

Similar conclusions are made in other industry studies. “Most major asset managers will say they have a risk management department but how many of them are fit for purpose?” says Pars Purewal, who heads up PwC’s asset management business in the UK. PwC has addressed many of these changes in a report that talks of the awareness of new risks as well as the need to address risk on an enterprise-wide basis. The report also refers to the increasing appointment of CROs. In part, says Purewal, this is being driven by regulators. In the UK the FSA has been looking at fund managers’ risk management functions to see if there is a dedicated executive for risk management and, if not, whether there should be one.

“It is not so much about having someone with the CRO title but about having a senior person in charge of risk,” says Purewal. “Right now, most CROs report to the CFO but in the future they might be a board member in their own right.” Not only would this give greater profile to the role of risk management, it forces boards to give more attention to the risk appetite and tolerance of the company, the presence of systems and processes to escalate risk management and the cultivation of a risk culture throughout the firm.

Purewal also says that the role need not be limited to the biggest firms in the market. “It is more about complexity of the business than its size.” The main challenge facing asset managers, says Purewal, is that there is a shortage of suitable candidates for the CRO role.

“Good managers are in high demand because there are not too many of them. This shortage is not unique to the asset management industry – both the banking and insurance industries are also looking for good risk managers. But it is still early days and it will take time for there to be a surplus of good-quality candidates.”

Investit, the UK-based management consultancy, is currently producing a report for its investment manager clients on risk management that looks at issues such as system selection and business processes. According to the report’s author and investment principal consultant Alistair Byrne, a key issue for risk managers is finding the balance between the compliance function and the investment process in order to meet any regulatory or mandate requirements and to help with portfolio construction.

“The compliance function needs to understand the context of the risk numbers. For risk managers to play a role in portfolio construction, their approach has to be consistent with the investment process. They have to get the buy-in of the fund managers otherwise the fund managers will simply start using their own spreadsheets, leaving the risk managers very detached. Firms need to think about how engaged the risk team are with the investment teams. Is it just about compliance or are they actually collaborating? They need to create a culture where the risk teams know that their role is to support the investment teams.”

What follows is a series of interviews with those responsible for overseeing the risk management function at a range of firms, including hedge funds and private equity. While there are differences in the specific approach taken by each risk manager, it is clear that there are some similarities – not least the point made by Byrne that risk managers must gain the respect and, ultimately, the cooperation, of their portfolio manager or trader colleagues if they are to succeed in establishing an effective risk management structure.
  ©2010 funds europe

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