Warning from the World Bank

In his keynote speech at the Risk 2002 USA conference in Boston last month, Gary Perlin, chief financial officer at the World Bank, warned that the spate of disclosures of corporate malfeasance in recent months, concerns over terrorism and problems with emerging market investments could have an enduring effect on investors’ risk tolerance. Perlin said these factors are all diverting capital that would otherwise support risk-taking.

Perlin, who is in charge of the World Bank’s $300 billion-plus balance sheet, said the multilateral recently completed a review of its pension plan’s strategic asset allocation in light of lowered return expectations on a range of asset classes. The one event that would require it to go back and change all its assumptions, Perlin said, would be “a permanent loss of confidence in the quality of reported earnings in corporate America. If this happens, we would take further risk off the table.”

However, it is difficult to decide when, exactly, such a change has taken place – there are no metrics for investors’ faith in corporate disclosure. Indeed, despite anecdotal evidence that indicates investors are stepping back from higher-risk investments, it is too soon to tell if today’s lower investor risk tolerances and higher financial market volatilities represent a fundamental ‘paradigm shift’ or merely reflect changing economic realities, Perlin said. “We need to avoid falling into a spiral of falling risk tolerances, where we continually hit one another’s stop losses,” he said.

Perlin also questioned whether some of the broad assumptions used in risk modelling were still valid in the current economic climate. Risk managers are currently operating in the most challenging of environments, he said, adding that it is a time they may have planned for, but possibly one that they most feared. “When stress-testing, we often use scenarios that we barely imagine could happen in reality. Now we are actually working through them,” Perlin said.

Events such as Enron’s collapse, US corporate credit events and Argentina’s sovereign default have called into question some aspects of current thinking on risk management. “We are now questioning whether some of the broad assumptions underlying our models are still valid.”

Perlin also warned that investors should choose their benchmark indexes carefully to avoid being forced into positions they would not otherwise want. Index composition is particularly important with less liquid and transparent asset classes, such as emerging markets and hedge funds, he said. Perlin noted that one emerging markets index rallied after Argentina’s default – but only because Argentina was removed from the index and those managers benchmarked to it had to increase their exposure to its other constituents, despite the fact that some of those constituents, such as Brazil, were not attractive.

“We need benchmarks that make things more transparent and do not make people more risk-averse,” he said.