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Thursday, 18th April 2024
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Asset mangers need to embrace risk management to remain competitive Back  
Richard Pike outlines the relevance of risk management in private banking and asset management, and says that implementing a detailed risk management structure will aid in keeping clients and winning new business.
In the past year there has been a large change in the investor community regarding their requirements from fund managers. While fund managers’ brochures are laden with claims for past performance, the clients ask now about risk management and how the managers are going to prevent losing their clients’ money. It is no longer enough to say that you beat the benchmark every year for ten years; clients must be shown how much risk was taken and how you intend to report their risk profile to them.
A recent survey within a large European institutional investment management firm showed that throughout the Requests for Proposal in 2001, the two top requirements were reporting and risk management (performance was number five).
Investment managers across Europe are being asked to move away from their previous reliance on the reward side of the risk/reward ratio and to focus on risk. Within current investment management practices the performance and reward area is well catered for in terms of mathematical models, IT systems and processes, but risk techniques are grossly underdeveloped. Many asset managers simply classify risk as high, medium or low and leave their clients to decide what these terms mean.
So, if investment management is being pushed to embrace risk management, what does it need?

Understanding
Asset managers need to make themselves aware of the types of risk and the methods used to evaluate and manage these risks. Market risk, credit risk and operational risk need to be understood and their general effects on portfolio values grasped. The main issues and models surrounding these risk types need to be reviewed (e.g. Value at risk, loss given default, key performance indicators) and the current market practice considered. Luckily for asset managers, the banking fraternity has done a considerable amount of spadework in this area and conferences and books abound on these subjects.

Frameworks
For each area of business an asset manager will need to understand what risks exist, how can they be reported upon and how are they to be managed. For example if you buy a US Dollar corporate bond you have the following risks:
• Market risk in the forms of interest rate and foreign exchange rate risk
• Credit risk in the form of credit grade (bond spread) and default risk
• Operational risk in terms of the physical settlement of the trade and any future payments and the correct reporting and management of the trade
You will therefore need to decide how these risks are captured, monitored and reported upon. A structure is required to set limits and checkpoints around these risks and a procedure is required to escalate concerns or limit breaches.

Mathematical Models
There are countless mathematical models available for the management of the various types of risk. The most important thing to remember when choosing such a model is that it must incorporate all product types and business cases in use in an organisation.

Systems
Any risk management process will require systems to capture, calculate and report on risk. The banking system vendors have completed a great deal of this work, and a number of IT solutions will provide support for risk measurement, management and reporting. Again, one system must support all the instruments and techniques across the organisation. A decision also needs to be made concerning the introduction of new products within these systems. Before a trade is completed in a new instrument type a review of whether or not the risk systems can cope with it is needed. In the case that they cannot, but where the transaction is required, then a firm plan for their incorporation into the systems is required. Too many problems have occurred where a deal is found on an Excel sheet that was forgotten and not marked-to-market or managed correctly.

Processes & Structures
Surrounding these systems and mathematical models, procedures and structures are required to bring life to the risk management techniques and ensure that they are enforced. These processes need to be created internally and will differ from organisation to organisation; however, in most cases they result in the creation of a risk management unit with specific responsibility for measurement, reporting and management. This unit usually reports separately from trading or back office and operates somewhat similarly to internal audit. Constant tracking of the procedures in this area is required and formal signoff of the important tasks should be a requirement.
A key difficulty in this area is management reporting. Due to the fact that the risk can come in many forms and across the entire organisation it is difficult to provide relevant and concise reports to the correct levels of management. The new Basle II Accord is also targeting this area, in that they will require much more dissemination of risk data to the market and the regulators. A well-defined reporting structure and data-set is crucial in convincing your management, shareholders and regulators that you understand and manage your risk proactively.
Implementing the above means that asset managers will be in a position to offer their clients full risk management services. These may be as simple as risk reports or as complex as online scenario analysis backed up by risk consultancy. The most basic services will be utilised to help win business and maintain customer relationships while the more involved may be charged for on a fee basis and provide extra income for the manager.
The internal staff will be aware of the effect of risk on their performance and will therefore take decisions with a better understanding of their full consequences. What would have previously been seen as back office work (risk measurement and reporting) may now be a customer facing operation with the attendant interest and revenue responsibility.
Customers will be able to choose the level of risk required in their portfolio and they will understand this risk in terms of possible monetary loss (e.g., may lose 10 per cent of portfolio value if USD rates fall more than 1 per cent next year).
Asset managers will have to embrace risk management in order to compete successfully in the next three to five years in Europe. While this is a threat it may also be taken as an opportunity to generate fee based income and a deeper customer relationship.

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