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The buy-side ecosystem: the interconnectivity of risk The interconnectivity of risk

Foreword Contents: Relationships between buy-side institutions (including insurers, pension funds, asset managers, hedge funds, wealth managers 2 Foreword and asset servicers) are changing as a result of new regulations 4 Drivers for interconnectivity of risk 4 Regulation is a key driving force that are forcing the buy-side to manage risk to new standards. 5 Market factors Regulators, supervisory bodies and rating agencies set much of 7 Key implications of the interconnectivity of risk the agenda for asset owners, managers and servicers and one 7 Asset owners are more demanding needs to look no further than Solvency II, UCITS, MFID, 9 A change in behavior is required AIFMD and Dodd-Frank to get a good feel of the impact that 11 The risk management function is changing this can have across the whole of the buy-side. Transparency of 14 Conclusion risk is on virtually every regulatory agenda and more so than ever before, there is a heavy dependence between buy-side institutions in order to comply and stay in business, let alone to prosper.

Increasingly, asset owners are demanding new standards of risk management from their asset managers, who will have to play Looking forward, the challenge will be not by asset owners’ rules if they want to win and retain their only enterprise risk management, but business. Asset owners need to report risk numbers to managing risk across the whole value chain regulators and for their own risk oversight – this means they are reliant on external asset managers to expose their risk that makes up the buy-side. positions and asset managers may pass on this responsibility to their asset servicers. The robustness of such practices is now regularly tested in the due diligence process. This “domino effect” has brought a new realization of interconnectedness of buy-side players, particularly in the context of risk. Looking forward, the challenge will be not only enterprise risk management, but managing risk across the whole value chain that makes up the buy-side.

However, this “domino effect” also creates opportunities. Enterprising asset managers, asset servicers and new forms of intermediation are creating competitive advantages by offering services and solutions designed to enable asset owners to

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offload tasks and risks so they can better comply, and even For asset owners, aggregating risk across multiple portfolios, prosper, in the new world. Providing Solvency II compliance handled by multiple external managers is a major challenge in services, supplying liability driven (LDI) vehicles, gaining the required risk oversight – something that is made as well as liability proxying capabilities and the existence of the more difficult when there is no common language of risk. bulk annuity buyout industry are just a few examples of innovations stemming from this increasing interconnectivity. This presents challenges for the major players and a growing recognition of the interconnected nature of relationships Not surprisingly, this interconnectivity on the buy-side goes between buy-side institutions. The purpose of drawing beyond just market risk reporting to span virtually every risk attention to this interconnectivity of risk on the buy-side is, in type. For example, there is now recognition that with part, to help understand dependencies and vulnerabilities but outsourced services, the operational risk of one party is now also to identify opportunities in this new era. the operational risk of another. This is evident in the way that operational risk is included in the calculation of the Standard Technology can be seen as an enabler here. Better technology, Formula under Solvency II. In addition, counterparty risk is for example risk factor attribution, stress testing, optimization now a major concern and greater interest is being shown in and very importantly, consistent firmwide aggregation, leads to improving collateral management as well as liquidity risk. better understanding of risk (e.g. levels, sources, appetite) Effective, risk management requires the identification, which, in turn, increases sophistication and transparency as measurement, management and, if necessary, the transfer of firms adopt a total balance sheet management approach. risk. This challenge is accentuated with the increasing complexity of underlying asset classes on most balance sheets This white paper sets out to gather the views of senior risk that has been driven by the quest for returns and/or executives from across the buy-side and other interested parties diversification in the current low yield environment. on how to deal with this greater interconnectivity of risk.

Furthermore, a movement away from a “silo” approach We would like to thank our clients and other key buy-side towards a more consistent view or risk across the entire balance stakeholders for their contribution to this paper: sheet has made asset liability management a growth area. This has occurred both as a result of the risk-based capital • British Telecom Pension Scheme requirements of regulations like Solvency II and as simply a • Caisse De Dépôt et Placement Quebec more strategic objective of managing the balance sheet, with • Clearly Gottlieb Steen & Hamilton pensions de-risking a good example. A whole new growth area • Deutsche Insurance Asset Management of specialist pensions insurers and the continued rise of • Fitch Group fiduciary management is testament to the growing • Standards Board interconnectivity of risk on the buy-side. Whatever the • HedgeMark mandate and whether the measure is absolute or relative risk, • there needs to be appropriate performance measurement and • JP Morgan Worldwide Securities Services attribution. Indeed, there is even cross over to the sell side with • M&G the buy-side demanding more from investment banks to • Pacific Life Insurance Company develop value added products to provide more capability to • ProBTP shape the balance sheet to be consistent with the desired risk appetite.

2 3 The interconnectivity of risk

Drivers for interconnectivity of risk I would say this is in its initial phases. You can see a similar Two key drivers for the interconnectivity of risk are regulation, interest developing among financial industry regulators and in its various guises from Solvency II to the Dodd-Frank Act, rating agencies. These groups both have expectations that and the impact of market factors, not least the challenges these companies have an enterprise level view of risk, and stand to present for asset owners as they strive to meet their current benefit when these organizations provide the most accurate and future obligations in a more volatile, low yield picture of risk they can.” environment. Some heads of risk nevertheless fear that some organizations, Regulation is a key driving force namely regulators, are demanding too much information in the The interconnectivity of financial institutions is on the rise and name of client safety. For example, the European Commission, stakeholders ranging from politicians in Brussels and via the European Securities Markets Association (ESMA), is Washington, to pension fund fiduciaries, are tackling this issue. currently consulting on how to accumulate information on the positions of alternative investors, notably hedge funds. Regulation is already in the works that will have an impact on virtually all buy-side institutions, not least due to the “domino It is not yet clear, according to Forbes Fenton, Head of M&G effect”. The European Union’s Solvency II directive makes the Risk Analysis, in London, on how boards of insurers directly responsible for their own risk and national financial supervisors and then European Union self-assessment reports. The recent Dodd-Frank Act is so supervisors will collate such data, but he fears the idealistic ambitious in its aim that it sends waves way beyond the desire to make alternative investments less opaque will be territory of American banking. In seeking to protect the difficult in practice (ESMA has been tasked to ask the industry financial stability of the United States from “risks that could to define alternative investments categorically). arise from the material financial distress, failure, or ongoing activities of large, interconnected financial institutions”, Dodd-Frank ends up making demands on virtually all kinds of asset owners globally to better understand and evaluate their “A new macro overview of risk is in agents and counterparties. development and in this system each entity needs a more sophisticated view on risk,” “A new macro overview of risk is in development and in this system each entity needs a more sophisticated view on risk,” -Edward Greene, senior counsel at New York law firm, Cleary Gottlieb says Edward Greene, senior counsel at New York law firm, Steen & Hamilton Cleary Gottlieb Steen & Hamilton.

Mike Earley, an insurance investment strategist at Deutsche Insurance Asset Management describes how “In the accounting “There is a danger that the relative significance of individual world, there is a growing interest to describe financial results positions simply gets lost as data are aggregated and passed up more stochastically, and with statistically-driven approaches. the supervisory chain,” he warns.

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Dr Martin Grottke, head of risk control at asset classes and strategies in order to improve their funding in Frankfurt, shares the fear that an overly prescriptive levels while at the same time passing on unwanted risks regulator does not help asset management. “We are now asked where possible. to calculate every position we hold using value-at-risk but this does not tell the full picture. The regulator does not have The €15bn pension provider for the French construction enough information about our view of the full picture. It would industry, PRO BTP, for example, is currently looking to be much more sensible if they asked for a fuller discussion, like diversify further into capital infrastructure funding, having with our auditors.” already moved down the credit ratings in the search for yield. “Every day we ask ourselves what the true level of risk is. Market factors Expanding the opportunity spectrum is our solution to current Two key market factors are the low yield environment and challenges,” says Gilles Garnier, chief investment officer at increased volatility. These present challenges to asset owners PRO BTP. and “downstream” financial institutions seeking to provide valued added products and services to help them achieve their Looking at credit instead of sovereign and taking greater goals. participation in infrastructure are just a few examples of new but pertinent practices for buy-side organizations. They form Prospering in a low yield environment part of a greater trend to transfer risk via the capital markets The need for greater risk transparency across the buy-side is that has grown exponentially in recent decades. ultimately a consequence of asset owners’ search for more efficient and diversified portfolios, which has led to increasing In Montreal, Marc-Andre Lewis, deputy chief risk officer at allocations away from traditional investments such as stocks and Caisse De Dépôt et Placement Quebec (CDPQ), CA$180bn bonds. One negative consequence, as demonstrated vividly , notes that many investment banks have during the credit crisis, has been increased exposures by asset shrunk their lending activities. But he happily announces that owners to risks, such as to the US commercial real estate CDPQ could sensibly use its redoubtable status (it has a market through credit derivatives, which firms may have been triple-A credit rating) to step in as a financier of deals that ill-equipped to assess. other institutions can no longer manage. “Given the concentration of banking and capital in Canada, CDPQ has to However, the credit crisis and ongoing government crisis seek opportunities beyond its borders,” he says. From Paris, are not the greatest challenges faced by pension funds and Garnier gives a similar message that the future of insurers. It is more accurate to say that these calamitous events diversification will involve more direct involvement in have merely added to the fundamental problem of an ageing financing and less intermediation. That means more work for client base in maturing economies. Most G10 countries have an already-expanded risk department. CDPQ and PRO BTP rising in both the public and private sectors, costly can profit from others’ inability to lend, but only after welfare systems and little prospect of increases in economic sufficient analysis of the probable deals. productivity akin to the decades post World War II. Pension funds and insurers, as the providers of pension and health insurance in the private sector, carry some of this burden and, despite recent misfortunes, are forced to continue seeking new

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Dealing with volatility financial services companies, in agreements with other parties, “For our way of life, risk is essential. Without risk-taking there in gathering and interpreting economic data and, of course, cannot be any economic growth,” says Aymeric Poizot, head of market information itself. Smarter risk management requires fund manager and ratings for Europe Middle East and Africa at greater connectivity within companies and greater systems in Fitch. order to marry streams of information on risk which hitherto may not have been shared – across departments but also across David Remstein, global head of JP Morgan’s Investment national boundaries. Analytics & Consulting, agrees. “The world needs risk-takers but it also needs risk managers as a complementary function. “ (MPT) cannot be expected to Just like good legal counsel, the risk management function address all the risks we now acknowledge,” says Joe Celentano, helps on the downside.” CRO at California-based insurer, Pacific Life. “As investors we have modeled what happens if the drops a per cent Buy-side institutions are addressing greater volatility by or equities lose forty per cent. But it is evident that this kind of smarter and more comprehensive analysis of the risk spectrum. quantitative modeling of portfolio risk has to be superseded by In portfolio management, this means acceptance of the true a wider approach when evaluating uncertainty,” he says. characteristics of diversification. “Risk needs to be looked at under a number of underlying “The conundrum is that diversification is always there for you assumptions, both in normal markets and stressed ones,” except when you need it most,” says Lewis. “When there is a says Dr Andrew Aziz, head of risk analytics for insurance crisis, diversification disappears.” and buy-side institutions for IBM Algorithmics solutions. “Effective methodologies need to incorporate a mix of different approaches to help capture an accurate picture of risk.” “The conundrum is that diversification is always there for you except when you need it “There is no silver bullet when it comes to risk management, most,” unfortunately, too many organizations were seeking a simple solution to a complex problem”, recalls Andrew Lapkin, -Marc-Andre Lewis, deputy chief risk officer at Caisse De Dépôt et Placement Quebec (CDPQ) President of HedgeMark. “Value at Risk came to be viewed as the solution, without a proper understanding of its purpose and its many limitations.”

“And conversely, when markets are shooting the lights out, no “Blaming VaR for not foreseeing the credit crunch is like one cares about risk,” adds Remstein. driving through a turnip field and into a farmer’s barn because your GPS told you to,” adds Aziz. “Like VaR, GPS is a More institutions are looking to develop beyond a myopic faith powerful tool but it was never intended to be the sole means of in the buzz of the markets to a more holistic view of navigation. No matter how fancy your GPS, you would never uncertainty and how to balance it out – in the running of drive without looking out the window.”

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Wyn Francis, head of risk at Europe’s largest company- Key implications of the interconnectivity sponsored retirement plan, the BT Pension Scheme, goes of risk further. He believes the ‘scientific’ dependence on VaR stems As asset owners respond to these pressing macro factors, they from its adoption in the Basel II regulations for banks. are becoming more demanding of their asset managers and other servicers. There are also noticeable changes in behavior “The reason why VaR has been misused, mistaken and that are required as the buy-side responds to this new world, mistreated has been the overreliance by regulators on it as a and as a consequence the risk management function itself is structural tool,” he says. In directing the private sector too changing. rigidly, these regulations have in fact undermined diversification. “Rules or de facto rules have a habit of Asset owners are more demanding reinforcing similar behavior,” explains Francis. “Everyone starts Increased transparency (full “look through”) and more to hold similar assets or take the same line of defence. I see this stringent due diligence is now the order of the day if asset in Collateral Support Annexes today – because the norm is to managers want to prosper in the new interconnected world of hold gilts or Treasuries as collateral, any other paper is risk. They are also paying closer attention to asset perceived as ‘risky’. The models and advisers tell you so until management activity. the day markets flip and everyone finds themselves in trouble.” Transparency to stay in the game After that point, according to Francis, participants and For Grottke, the most precious commodity is transparency. regulators reflect on what has caused the calamitous build-up It enables his team to monitor with confidence the €180bn of risk and seek ways to avoid it. The world is in such a period Union invests, mostly on behalf of Germany’s co-operative right now. “So it is not quite accurate to say that the world movement. When funds of hedge funds gained popularity last keeps getting more and more volatile. The interconnectivity of decade, Union developed a special version for both its own risk waxes and wanes,” says Francis. and client monies. Hedge funds have a reputation for secrecy; many claim greater openness would lose them their He believes a successful institution, however, should at least be competitive advantage. Grottke’s team, however, was privy to cognizant of the danger of groupthink at all times. A herd-like their ultimate exposures, not merely the ’s mentality only increases the interconnectivity of risk because as reports. “We were able to notice style drifts. If an underlying sell-side institutions begin offering the same product, buy-side manager didn’t keep to its strategy, we could notice that. institutions agree to purchase the same product. That is a major issue with other hedge funds: you don’t see what positions they have and then something unexpected Francis acknowledges that for occupational retirement plans at happens. Style drift is a pressure on all managers, especially least, there are some others’ viewpoints which have to be taken when they have been underperforming and want to hit their into consideration. In the case of BTPS, it has a publicly- target numbers,” he says. quoted sponsor and a national pensions regulator to deal with. By definition, the three do not naturally the same perspective on risk, which introduces a whole new dimension to its interconnectedness: the interpretation of regulators.

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Grottke contrasts the transparency enjoyed in Union’s Thomas Deinet, executive director of the Hedge Funds managed account of hedge funds with the opacity of ratings Standards Board (HFSB) an industry initiative, says that hedge on asset-backed securities (ABS). “First, the correlation was funds continue to act as enlightened capitalists who have mispriced in these vehicles but intransparency meant no one generally reduced risk around the world in a number of ways. could see this. When the credit crisis broke, managers were “Hedge funds have added liquidity to the system, which makes left asking the question: “When is AAA-rated not AAA-rated?” prices more reliable and capital markets more complete,” There was no reliable standard. Second, these high ratings led he says. to the appearance of ABS in products like money market funds. When the risks became obvious, it was a surprise to Deinet believes it makes sense for institutional capital to most investors that AAA was not what they believed it channel its way through their inventive minds. would be.” On overseeing the risks of such decisions, Deinet expects Andrew Lapkin agrees with Grottke on the importance of institutional clients themselves to regulate hedge funds. transparency. “There is a real and increasing movement of assets into managed accounts specifically because investors recognize that proper investment decisions cannot be made without the right information. This is especially true at the “They want more frequent updates on their total portfolio level, where the inter-play across different exposure – and a far wider range of managers is ultimately realized. The importance of the total analytical information than in previous portfolio over any single fund in isolation puts even more pressure on obtaining position based transparency.” years. I think it is only a good thing for all parties.” Grottke’s experience is that the level of transparency available determines risk far more than the complexity of the strategy -Andrew Stalker, head of operational risk at Insight Investment per se. As more strands of commerce get securitised, investing undoubtedly becomes more varied, diffuse and challenging. But opacity, not complexity, remains the enemy of risk control. He notes the presence of pension funds and endowments on the Hedge Fund Standards Board (HFSB) itself as one Asset owners are paying closer attention to asset example. The HFSB has a sufficiently flexible governance manager activity structure to adopt new ideas as required. Over the past decade hedge funds have been responsible for drawing more complicated strategies such as merger and The HFSB standards provide a model template for asset convertible arbitrage into the mainstream. Hedge funds rose to owners to assess a managers’ approach to risk management. prominence in part because they offered better risk-sharing In the past, manager searches tended to place little focus on with clients. Performance hurdles such as high-water marks risk management. Today, asset owners take a much more suggested that these new businesses would structure their fees thorough approach covering virtually all dimensions of the in relation not just to the ups, but also the downs of their investment management business just like the HFSB standards. performance.

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More stringent due diligence is the order of the day A change in behavior is required Andrew Stalker, head of operational risk at Insight Investment, Just as politicians are grappling with how best to make their says that clients now demand more portfolio information. countries more stable, buy-side investors believe that a host of new behaviors are necessary within financial services. There is “They want more frequent updates on their exposure – and a more integration and interaction between portfolio managers far wider range of analytical information than in previous and risk managers and focus on risk is shifting to the years. I think it is only a good thing for all parties,” he says. boardroom. These pressures also mean that corporate governance is becoming more prominent and some financial institutions are choosing to dispose of capital intensive businesses. “Investors now spend considerable time discussing the risk process of a fund prior to Integration and interaction between portfolio managers and risk management. considering an investment.” To cope in this evermore complicated, interconnected environment, Lewis emphasises that even a medley of skills in -Andrew Lapkin, President of the managed account platform provider, the risk department is not sufficient to monitor the downside. HedgeMark The exercise has to spread further into the organization. “We see the portfolio managers as the first line of risk management “In the past, many investors spent very little time digging into internally,” he says. a hedge fund manager’s risk process,“ recalls Andrew Lapkin, President of the managed account platform provider, Francis agrees that modern portfolio managers have to share in HedgeMark. “It used to be much less common to see a risk analysis. “I am able to see at any moment in time the risk dedicated risk manager at a hedge fund, whereas today, not to the BTPS posed by its relative exposure to sovereign and having a risk manager is more of the exception. Investors now country risk across equities and bonds. “I can also pull out the spend considerable time discussing the risk process of a fund aggregate risk posed by any single entity issuing securities in prior to considering an investment. There is a deeper our portfolio,” he says. But it must be the portfolio managers appreciation for the benefits of a strong risk culture and strong – almost all external now for BTPS - who evaluate each risk management within the investment process.” Lapkin also potential outcome from the mixing of those entities. So, for adds, “In addition, more and more investors are seeking example, Francis can see the indebtedness of public Eurozone independent risk oversight. This can be as little as a monthly, banks but not the myriad relations with institutional lenders independent, position based risk report or as involved as daily and creditors of that bank. “I expect the portfolio managers to monitoring of investment guidelines or concentration limits, as be devouring that data,” he says. well as daily independent risk and performance reporting.”

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For Fenton that broad view has to be shared by the front executives who view risk in all its guises across the business,” office. “Risk management is best thought of as a series of he says. He emphasises that those executives have to come conversations with our portfolio managers,” he says. “Some from product development or sales as well as portfolio have a quantitative outlook and so enjoy our approach – the management for a company to understand the conversation is like a second voice on what they are doing,” he interconnectivity of all its risks. says. “Others are much more for getting out of the office and examining investee companies directly.” “In the years ahead, senior executives in every department are going to have to weigh up risk. It has to be a consideration in every department. I can envisage a time where new business development is not based just on gaining market share but on “Risk management is best thought of as a the net risk to the organization. So if an insurer is holding too series of conversations with our portfolio much equity risk overall, then it might look to launch mortality managers.” risk products to offset that equity risk.”

-Forbes Fenton, Head of M&G Investment Management Risk Analysis, M&G “In the years ahead, senior executives in every department are going to have to weigh up risk.” But by engaging, Fenton believes risk management has been elevated from its traditional silo as a mid and back-office -Joe Celentano, CRO at Pacific Life function into the processes of portfolio managers.

David Remstein, global head of JP Morgan’s Investment Analytics & Consulting, gives a similar example of connectivity Celentano’s is an admirably holistic view that takes risk beyond between the traditional risk and return functions. “There are financial markets and puts in the wider commercial operation plenty of risk specialists now sitting within proprietary trading of institutional investors. If pension funds and insurers are teams at hedge funds and investment banks, informing the repositories for more and more opportunities via their traders. It is evident that specialist risk skills such as stop-loss investment portfolio, then more and more of the employees of mechanisms are now incorporated upfront as part and parcel of those institutions, especially at the executive level, should be the daily business of portfolio trading.” involved in risk management.

Risk shifts to the boardroom One such example of commonality is given by Gordon Burnes, Celentano, for example, wants a more holistic commercial director of marketing for risk analytics at IBM. “There is a lot approach where portfolio risk is not isolated from the of overlap between compliance and risk controls but often the corporate strategy. “For this to happen, it has to be senior two are run separately, often in multiple silos across countries

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and business lines. Insurers looking at regulatory demands to Dodd-Frank does not cover Pacific Life, a US insurer, directly allocate more capital for the sake of systemic stability are as the company recently divested its ownership in a bank. This looking at combining the functions in a programmatic way.” chimes with the view of Greene that America’s largest handful of banks are increasing their girth as lesser players exit or sell Poizot agrees: “To be successful, risk management has to be on unattractive businesses. In this respect, the problem of ‘too part of the culture of an organization, practised by all big to fail’ persists as buy-side institutions as minority employees and not just located in a small room at the back of shareholders eschew regulatory hassle. “It is getting harder to the office.” do business,” notes Greene.

In the future, integrated risk data will inform the decisions of The Volcker rule on the separation within banks of market- senior executives in pension funds, insurers and sovereign making and proprietary trading – incorporated into Dodd- wealth funds, not merely their risk departments. But the Frank – has helped the largest banks grow larger but also numbers alone will not suffice to run a successful buy-side spurred many ‘prop’ desks to find new homes reincarnated as institution. hedge funds. This only raises the need for fresh analysis of these entities by prospective clients. As Francis observes, Corporate governance will become more prominent interconnectivity can wax and wane even at the same time. Greene notes that shareholder activism is growing as a lever in holistic risk management by buy-side financial institutions. Some shareholders will not sell minority stakes but rather stand their ground and shake up investee companies for the “That’s what experience teaches you. It is like benefit of all. “The era of low standards and false profits is when a child learns that Father Christmas over,” he says. “Better corporate governance – the alignment of the interests of management and shareholders – is going to be does not exist.” a major topic in the years ahead.” -Wyn Francis, head of risk at the British Telecom Pension Scheme New trends and new regulation will likely affect buy-side institutions in different ways. Some will embrace corporate

governance as a means to allay concerns over boardroom The risk management function is changing management. Others will sell and move on. Given the material changes that are going on around them, it is not surprising that the risk management function of virtually Some organizations will choose to dispose of businesses all buy-side institutions is adapting to deal with these internal In tandem with their political masters, regulators are trying to and external pressures. There is increasing recognition that protect economic growth by means of improved risk there is still no substitute for experience, and there is a distinct management. In general, heads of risk believe the regulation shift to becoming a more proactive function as their influence “amounts to a series of rifle shots” that cannot hope to scare off grows. The significance of risk means that more investment is each likely risk to the system, not least because of the being made in enabling technology to help manage increased unintended consequences. For example, Celentano notes that complexity, in shorter time frames than in the past.

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Experience counts For Francis, the antidote is a wise head that can remember Sound experience and an intuitive sense of how the markets previous such correlations in behavior. “Experience is a great work and why has to inform managers’ interpretation of the advantage in looking beyond market cycles,” he says. While daily numbers. Francis assimilates large amounts of data on a daily basis, he contrasts the ability to make a long-term evaluation with the On the importance of interpretation, Wyn Francis, head of risk noise of newsfeeds: “I am amazed that analysts under 30 soak at the British Telecom Pension Scheme (BTPS), likes to talk of up politicians’ daily pronouncements on the fate of the the ‘Father Christmas’ moment. This is the rude awakening for Eurozone as gospel,” he remarks. university graduates fresh to the activity of running real money on a daily basis. Transition from a passive to a pro-active function with influence “We have graduates come in every year from top centers of A similar story is told at Caisse De Dépôt et Placement learning and invariably they suffer a “Father Christmas” Quebec, which post-Lehmans beefed up its risk department moment,” he says. “At some point, the theories they believe with four new hires, including deputy chief risk officer, work for risk management crumble. The markets behave in an Marc-André Lewis. “I have a background as a inexplicable manner. That’s what experience teaches you. It is portfolio manager,” he says. “The other three business unit risk like when a child learns that Father Christmas does not exist.” managers bring relevant experience, so that we aren’t just running numbers for the portfolio managers. We don’t make Francis himself has experience in spades. He was a fixed the decisions but we have enough knowledge and experience income trader for ten years and was at the screen thefateful day to influence.” in September 1992 when the UK crashed out of the European Exchange Rate Mechanism. It is such experience which he Francis explains that such influence was unlikely in days believes holds the key to successful risk management. gone by because historically risk management grew out of “I encourage people to apply the sniff test,” he says. “If it risk reporting, which in itself was an adjunct of performance doesn’t smell right, then it probably isn’t.” measurement. As such, the numbers were there for others to assimilate and act on but the function per se was Of course it takes many years in financial markets to develop essentially passive. the nose for a good deal and one of Francis’ strengths is that he has not spent all his time in the City doing the same job. Lewis feels that those days of risk departments “just running He has a trader’s confidence which, underpinned by the numbers” are over. “There was time when the same type of advanced risk analytics employed at BTPS, enables him to person, with a PhD in maths or science, would be recruited challenge, where necessary, the stories of the portfolio into risk departments,” he says. “They wouldn’t understand the managers. activity of portfolio management. Today at CDPQ the risk

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managers are not experts in every strategy but we ensure the global head of JP Morgan’s Investment Analytics & portfolio managers are held to account on the risks taken not Consulting, says that through recent crises these premier asset merely the returns they have earned.” The modern risk owners have weathered the storms of uncertainty well. “I don’t management department certainly has a broad array of risks to think there is much fundamentally that needs to change among analyse as portfolios have widened into so many different the world’s best investors in the years ahead. When we look at fields. CDPQ, for example, holds approximately CA$16bn in their risk scenarios versus those of their underlying managers, private equity alone. To understand this asset class, one has to in general the two have been pretty close. So most asset owners evaluate illiquidity of a different order to public securities. have the systems and the capabilities in place already to deal “Marked-to-market measurements probably are not as useful with the challenges that lie before them. Their strength has in private equity,” notes Lewis. “My colleagues specialising in been that they understand what risk means to them in the private equity risk and management have to look at issues such context of their liabilities.” as exit opportunities and the ongoing operation of the underlying businesses.” Gordon Burnes, director of marketing for risk analytics at IBM agrees. “Buy-side institutions in the vanguard already have vast In other words, risk managers, even those sitting side by side in amounts of data on where risk lies within their various the same office, no longer have the same job. Heterogeneity of divisions. The next five years is going to see them figure out investments breeds heterogeneity of risk management. how to use that data not just to satisfy the regulators but in order to best direct incremental dollars to grow the business.” Increased investment in risk technology “There are great challenges and great opportunities to improve Dealing with increased complexity a lot of our practices,” says Gilles Garnier, chief investment Asset owners’ risk management departments are bigger and officer at PRO BTP. “It is quite hard to achieve genuine busier than ever before as they cope with more sophisticated diversification among assets. And then there is the increasing investment strategies and reporting requirements. and frequency of market crises. That is the big reason why we have invested in greater risk technology and why we have got to Fenton notes that M&G now has 86 of its own staff doing move to global management of risk factors.” nothing else but analysing the creditworthiness of European companies. M&G has a large footprint across not only fixed Earley explains “The availability of stochastically driven income, where it has created imaginative and popular debt approaches is an exciting development, because it allows for products in real estate and social housing, but all the major academic techniques that have existed for a while to be put into asset classes. This is a provider that moves quickly to identify practice. Specifically, they allow us to do large scale simulations the needs of its varied client base. involving both assets and liabilities.” Insight Investment, is also based in London, has also profited According to one service provider of approximately 300 of the from the preference for fixed income among its institutional world’s largest institutional investors, they are already on top of clientele. The move to bonds includes bond derivatives, or risk management in the twenty-first century. David Remstein, synthetics. In seeking to better match liabilities, pension

12 13 The interconnectivity of risk

schemes lower some risks but raise new ones. Entering swap velocity of change: what used to be a trickledown effect is now agreements, for example, brings counterparty risk from an happening more quickly. The kingpin is regulation and as a key investment bank. In the case of traditional mandates, equity driver, this is having a domino effect on the whole buy-side risk might be cut; duration risk might be cut but this new risk – which is now more interconnected than ever before. (and others such as the shortfall of returns) surfaces. Asset owners are more demanding. We find that asset owners “These various new strategies do not just remove risk but are asking far more questions of their providers in the due transform it into different types of risk,” says Stalker. The fact diligence process. The days when promised returns on that two major investment banks, Bear Stearns and Lehman investments left risk management in the shadows are over. Brothers, went out of business in 2008 while several others Client requirements demand greater disclosure on the quality wobbled, explains why clients want daily information on their and implementation of risk management within the investment exposures. “The desire for alignment of interest is uppermost process of their service providers. Almost all face a future in in clients’ mind,” says Fenton. “It is a matter of long-term which holdings will become ever more diverse, touching a investors such as pension funds – who are going to be needing greater range of assets and agents. pay-outs for decades - putting the question to investment banks: ‘How much skin do you have in the game?’” Both Ultimately, understanding the uncertainties inherent in a more Stalker and Fenton emphasise, however, that the trend is net varied portfolio is going to ask more transparency of their asset positive. ”People put the blame for lots of crises on managers. The latter in turn accept the need to divulge more derivatives,” says Fenton. “But this kind of liability about their strategies and underlying positions to clients in management is evidence, just like currency forwards, of how order to meet new compliance standards, but also more derivatives dampen volatility and take risk off the table.” practically to win business. These drivers also bring new business to specialist service providers, who now find themselves in demand from asset managers, including hedge funds, who wish to either outsource part of the risk function or, “These various new strategies do not just more commonly, seek third-party verification of their standards remove risk but transform it into different of reporting and compliance. types of risk.” Behaviors and the risk function are changing. Asset owners are spending more on technology and personnel in order to better -Andrew Stalker, head of operational risk at Insight Investment evaluate common and extraordinary risks in their business. Great value is placed by senior risk managers on the buy-side Earley adds “Today’s insurance products are more varied and on experience: the ability of their staff to evaluate deals based complex than traditional term life policies. Consider a variable on their own working lives as traders or portfolio managers. annuity, where an insurer may make a guarantee about the Heads of risk at various asset managers believe lessons have value of that annuity. Liabilities become tied to capital markets, been learned from recent and ongoing crises by all these and interconnectivities just shoot through the roof.” related parties. Notably, clients are demanding greater detail on their exposures; portfolio managers are more prepared for a dialogue with the risk department; and those responsible for Conclusion risk monitoring grow in number.

The interconnected world of risk is not necessarily an entirely Life, after all, is likely to get more complicated as the asset new phenomenon, but the realization and acknowledgement of class coverage for investors grows and grows. its existence can no longer be disputed. The difference is the Risk management is changing its role from oversight to

14 Business Analytics

insight. The days of the risk department acting as the police of resources, balance risks against expected returns and work to the company, intervening where necessary to put an end to meet regulatory requirements. By making analytics widely policy breaches, are over. That job is more and more becoming available, organizations can align tactical and strategic the occupation of external auditors. Instead, risk data internally decision-making to achieve business goals. has a far brighter future as part of the decision-making process, not just for senior executives but virtually all team leaders in For more information buy-side financial institutions. Pooled information on For further information please visit operational, commercial and portfolio risk can better inform www.ibm.com/business-analytics. the efficiency of all departments. Smart organizations are Request a call already using such pooling programmes across the globe when To request a call or to ask a question, go to assessing and comparing operations. There is also a direct www.ibm.com/business-analytics/contactus. impact on their asset servicers who are increasingly adding risk An IBM representative will respond to your inquiry within two capabilities to their core platforms in response to growing business days. demands from their clients for outsourced risk services. The pressure from regulators and shareholders is only likely to Notice catalyze the progress of others, although the road ahead is not The information contained in this documentation is provided for informational purposes only. Although efforts were made to verify the completeness and straightforward for all. accuracy of the information contained in this document, it is provided “as-is” without warranty of any kind, Express or Implied. In addition, this information is based on Algorithmics’ current product plans and strategy, which are subject The old adage is that business is a series of great opportunities, to change by Algorithmics without notice. brilliantly disguised as impossible situations. For those organizations willing to grasp the opportunity, the Algorithmics will not be responsible for any damages arising out of the use of, or otherwise related to, this document or any other materials. Nothing interconnectivity of risk presents scope to transform and grow contained in this document is intended to, or shall have the effect of creating their business. It creates the opportunity to develop new any warranty or representation from Algorithmics (or its affiliates or their suppliers and/or licensors); or altering the terms and conditions of the solutions and innovative ways of doing things such as Solvency applicable license agreement governing the use of Algorithmics software. II compliance services, supplying liability driven investment References in this publication to Algorithmics products or services do not imply that Algorithmics intends to make them available in all countries in which (LDI) vehicles, as well as liability proxying capabilities. These Algorithmics operates. topics merit further attention and will form the focus of further For any reference to an Algorithmics software program, the software program research over the coming months. can be used to help the customer meet compliance obligations, which may be based on laws, regulations, standards or practices. Any directions, suggested usage, or guidance provided by the software program, or any related materials, About Business Analytics does not constitute legal, accounting, or other professional advice, and the IBM Business Analytics software delivers data-driven insights customer is cautioned to obtain its own legal or other expert counsel. The customer is solely responsible for ensuring that the customer and the customer’s that help organizations work smarter and outperform their activities, applications and systems comply with all applicable laws, regulations, peers. This comprehensive portfolio includes solutions for standards and practices. Use of the software program, or any related materials, business intelligence, predictive analytics and decision does not guarantee compliance with any law, regulation, standard or practice.

management, performance management, and risk management. Any information regarding potential future products and/or services is intended to outline Algorithmics’ general product and service direction and it should not be relied on in making a purchasing decision. Any information mentioned Business Analytics solutions enable companies to identify and regarding potential future products and services is not a commitment, promise, visualize trends and patterns in areas, such as customer or legal obligation to deliver any material, code, functionality or service. Any information about potential future products and services may not be analytics, that can have a profound effect on business incorporated into any contract. The development, release, and timing of any performance. They can compare scenarios, anticipate potential future features or functionality described for Algorithmics’ products or threats and opportunities, better plan, budget and forecast services remains at Algorithmics’ sole discretion.

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