Risk management may not be the most glamorous of functions. But as the recent market turmoil, wave of corporate bankruptcies and counterparty defaults, and the Madoff scandal have underlined, it is one of the most important.

Risk management may not be the most glamorous of functions. But as the recent market turmoil, wave of corporate bankruptcies and counterparty defaults, and the Madoff scandal have underlined, it is one of the most important.

In these extraordinary times – where every type of asset class, from developed and emerging stocks and debt to commodities and currencies, have shown extreme volatility – risks have become not only more pronounced, but more diverse too.

Market and credit risk, given the global stock market swings and slew of actual or potential company bankruptcies, are an obvious landmine. Yet increasingly liquidity risk has come to the fore too, as asset managers in recent years have sought out sources of alpha through, for example, exposure to esoteric and illiquid derivative instruments.

Similarly, illiquidity is a concern where firms have exposure to less-actively traded emerging and frontier markets, which bring with them heightened country and political risks too. And cross-border investments in many cases come with currency risks, as the US dollar’s fluctuating fortunes against other major currencies have shown.

Lessons learned

Counterparty risk, ignited by the demise of Bear Stearns and Lehman Brothers, has become another burning topic. For one, those shocking events raised profound fears for investors of all kinds about the efficacy of the enormous credit derivatives market, which had ballooned in the first place as a way to offset the credit risk threat.

In addition, their collapse as prime brokers created untold problems for those hedge funds that had their collateral tied up with the firms and which they were unable to access. The upshot therefore has been a much greater focus by investment managers of all kinds on the need to assess and monitor the balance sheet strength of their counterparties. 

Meanwhile, the Madoff scandal has served to underscore the risk for investors of unwittingly becoming embroiled in fraudulent schemes, or indeed any other type of malicious activity, and the importance of rigorous due diligence procedures.

So much for the various trading-related risks today’s investor faces. No less important for asset managers though is the need to contend with the operational risks that exist in their internal environments.

Operational risk, as defined by the Basel II Accord, is “the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events”, and can be caused by systems failures, employee mistakes, criminal activity or natural disasters. For example, the widespread use of complex trading strategies and instrument types means there is significant potential for errors to creep in wherever manual intervention or unreliable systems are involved.

Legal risk – such as the threat of fines or penalties from supervisory actions – also comes under the banner of operational risk. For independent asset managers in Switzerland, for example, that means complying with the Anti-Money Laundering Act, as supervised by the Anti-Money Laundering Control Authority. But in addition, firms may also opt to adhere to the strictures of self-regulatory organisations, such as the Code of Ethics and Professional Conduct of the Swiss Association of Asset Managers (SAAM).

The compliance burden

Firms’ compliance responsibilities are becoming more onerous and complex all the time, as highlighted by a study released in October 2008 by research firm NOVEO Conseil for BNP Paribas Private Banking, which found that 80 per cent of independent asset managers in Switzerland expect regulatory pressures to increase.

It is imperative then that independent asset managers ensure they have proper control over the various forms of investment and operational risks they encounter. Naturally, the requirements will depend to a certain degree on each firm’s area of activity.

However, some best practice guidelines include an ability to report on client-wide positions across asset classes so as to have an up-to-date view of their total risk position, rather than it being segregated by asset silos; obtaining accurate valuations for illiquid securities and portfolios; monitoring counterparty risk; and getting accurate and timely data from counterparties for reconciliation purposes.

Monitoring exposure

The tasks are significant, and to meet those requires a robust and sophisticated technology framework. Core to that is a portfolio management or accounting platform that supports the full range of financial instruments, and includes cross-asset class risk tracking and reporting, plus the ability to track exposure by name or issuer across asset classes. The platform should also allow for the breakdown of sources of risk in a portfolio by factors such as style, sector, interest rate, country and currency.

In addition, a risk system should allow for accurate monitoring of manager thresholds and fund concentration limits, to guard against overexposure to particular positions, industries, economic sectors or geographies, and so avoid style drift and remain in compliance with any strictures laid down by the firm and its clients. And those limits should be easily configurable, to accommodate any future changes in strategy.

Meanwhile, an automated and integrated front-to-back systems environment will help the firm to minimise its operational risks, by removing manual intervention and the errors that can result from inaccurate data entry, misinterpreted information and the like. Similarly, automated systems with robust security controls can safeguard the firm from internal or external malicious activities.

Nevertheless, while such an IT infrastructure is essential, it must also be supported internally by the implementation of rigorous processes and procedures, and well-trained personnel for your risk management environment to be truly effective.