European buy side still lags in risk management

The Edhec European Asset Management Practices Survey, carried out last summer and published late last month by French business school Edhec, aims to provides an insight into the key areas of risk management, IT and strategy and investment processes at 60 European asset managers.

Even though the levels of sophistication typical of buy-side firms’ risk management technology and processes is vastly inferior to that of the sell side, there is an urgency - driven by and large by the regulators - to remedy the situation. So concludes the Edhec European Asset Management Practices Survey, published last month by Noël Amenc, professor of finance and director of the Edhec Risk and Asset Management Research Centre.

The report also argues that risk management on the buy side has become a key contributor to a company’s competitiveness, as opposed to an aspect of the business developed to satisfy the regulators’ demands. This shift has led financial institutions to go well beyond their legal obligations in the area of risk control

The survey says that, to date, the risk and compliance regulations applicable to investment managers have focused more on arithmetic criteria and obligations, such as diversification of risk and counterparty limits, than on financial approaches.

The development and use of internal risk measurement models, which contributed to the reshaping of the investment banking industry in the 1990s, has not yet attracted a similar level of interest from the investment management community.

As an illustration, only half of the respondents - about 30 asset managers - systematically measure the extreme risks of their portfolios, which is most likely due to the absence of buy-side regulatory constraints.

Equally, risk measurement of off-balance-sheet positions is not widespread. This perceived ‘weakness’ is partly linked to European asset management firms’ limited use of such methods, either for cultural reasons or because certain countries have a restrictive approach to the use of off-balance-sheet instruments.

But asset managers are likely to seek to take better charge of off-balance-sheet activities partly because of the evolution in the regulations, the desire to offer risk-return profiles that differ from those typical of the market and the wish to improve the returns of interest rate products through credit derivatives.

Credit risk
With the recent interest in credit derivatives for fixed-income strategies and the appearance of analytical models based on active fixed-income allocation, the issue of credit risk management is now becoming a priority for most investment managers.

Buy-side firms have not yet adopted either the techniques or the tools of investment banks. And although quantitative models and value-at-risk (VaR) constitute the core of the methods proposed by the Basel II capital adequacy accord for integrating credit risk, they are still not widely used by asset managers.

Only 36% of the survey’s respondents integrate credit risk in the global VaR of their portfolios. Evaluating the credit risk of investments is very often part of financial analysis, whether external (50%) or internal (38%). Quantitative models are mainly used in very specialised funds that base performance on credit risk, involving either allocation (high-yield funds, for example) or arbitrage (say, fixed-income arbitrage).

Operational risk
Meanwhile, only half the investment managers surveyed feel they are affected by the regulatory changes proposed by the Basel II accord on capital requirements for operational risk.

The vast majority (82%) of investment managers have not examined the issues that could result from the implementation of operational risk measurement models in their organisation, despite the potentially large regulatory capital savings to be made within the context of the new European capital adequacy directive.

This ‘wait and see’ attitude is consistent with the views of professional associations, which maintain that empirical and academic evidence show that capital requirements are aimed more at managing systemic risk than at managing the idiosyncratic risk represented by operational losses.

Future risk investments
So if European asset managers have a genuine desire to improve their risk management systems, how are they looking to do so? Planned investment in risk management naturally favours the compliance aspects. But another aim of future investment is to keep buy-side firms up-to-date regarding extreme risk measurement and risk analysis for off-balance-sheet positions, an area set to expand.

Risk reporting tools is another area set for growth, as firms start transferring their risk focus from internal issues to those pertaining to their clients. Third-party accounts cannot be managed without a good description of the risk associated with the mandate. And the poor stock returns of recent years have highlighted clients’ need for information in this area.

Client reporting is a key element in making mandates legally secure. The interest in implementing risk reports for clients - 71% of respondents aim to do so - is evidence of a turning point in the nature of investments in the area of risk management for the major asset management firms. Such companies no longer merely adhere to the regulations, but feel risk management represents genuine added value in their investment management process.

Regulatory capital: no use for buy side?
Noël Amenc, professor of finance and director of the Edhec Risk and Asset Management Research Centre in France, says what he found most surprising about his research was "the low level of extreme risk monitoring" among the 60 buy-side firms he polled. "But the explanation for that is that there are different regulations on the buy side than for investment banking,"he says.

"The regulators do not oblige asset managers to manage those [extreme] risks. Also, when the markets were good in the late 1990s, clients did not care about volatility or extreme risk," he says. "But in the past three years, the buy side has started focusing on extreme risk management, although it takes time to implement technology for systematic measurement of extreme risk events."

When asked about the potential impact of the Basel II accord on buy-side firms, with specific reference to regulatory capital, Amenc criticises the Basel Committee’s stipulation requiring buy-side institutions to comply with its proposals. "Asset managers are not prepared to spend a lot of money on research and technology, because they are less concerned by operational risk issues," he says. "They are not convinced they need to invest in this area at the moment, and they will wait for the last moment."

And Amenc is not satisfied that Basel II offers a satisfactory method of managing and mitigating operational risk. "I am not convinced that regulatory capital is good for operational risk across the industry," he says. "Operational risk is not a systemic risk - it is idiosyncratic. It is difficult to find academic evidence supporting regulatory management of idiosyncratic risk.

"It is probably better to encourage investors to be more demanding and asset managers to behave more professionally than to oblige them to set aside money," Amenc adds. "Because if you experience catastrophic risk, regulatory capital is hopeless. With Long Term Capital Management, for instance, don’t expect regulatory capital to have covered that!"

About the survey
The questionnaires for the Edhec European Asset Management Practices Survey were addressed to the top 400 asset management companies in Europe in summer 2002. The study generated responses from 60 European asset management companies representing as of July 31, 2002, a total volume of €6.2 billion in assets under management.

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