Good Risk Governance Pays - Investment Best Practices | Risk Management | Valuation

Some suggest that the fallout related to a recent settlement about LIBOR rate setting is just the beginning of a spate of questions about what it all means. According to "LIBOR scandal could hit pension funds depending on derivatives trades" (July 4, 2012), Investment & Pensions Europe reporter Cecile Sourbes describes the kind of information that has to be vetted.

She adds that any gain or harm due to possible mis-pricing will largely depend on whether a pension plan has used derivatives and/or has invested in an instrument that is priced off the London Interbank Offered Rate (also known as "LIBOR"). As her article correctly adds, the economic cost (or benefit) to a plan sponsor will likewise be a function of its directional exposure at given points in time which in turn will depend on the nature of the investment and/or hedging strategy (assuming that a derivative instrument was used to hedge).

To illustrate, consider a plan that entered into an interest rate swap where it received a variable cash flow tied to LIBOR. A quantification of the impact on that pension fund would necessarily have to take into account the difference between the actual rate used to determine the periodic cash flow and the alleged "correct rate," adjusting for day count and deal size, among other factors.

For those pension plans that allocated money to asset managers who in turn deployed derivatives and/or financial instruments with a link to LIBOR, there will likely be questions about the fees paid for investment performance.

It is no surprise that the article concludes with a prediction that pension funds are likely to commence litigation as a result of the recent news about how LIBOR rates were set in the mid 2000's. Indeed, lawsuits have already been filed against some banks.

It is pretty clear to this blogger, Dr. Susan Mangiero, how the math should proceed and the kind of analyses that could be done. This assumes that the resolution of a dispute would require an estimate of "but if" damages (which is not a given and depends on the outcome of a judicial review and assessment of facts).

After the last few years, it seemed that risk managers were finally getting their due respect. Alas, a new survey suggests that more work remains to be done. According to "Too good to fail? New challenges for risk management in financial services" by Rob Mitchell with the Economist Intelligence Unit, "Inculcating and embedding a stronger enterprise-wide risk culture remains an ongoing challenge."

Sponsored by SAS, this March 2011 inquiry (and June 2011 report) finds that organizations still grapple with complexity, with about half of the 315 executives expressing concerns that their "employer's risk management processes are well placed to deal with volatility" and roughly one out of three organizations being able to thoroughly vet tail risk. (Note that "tail risk" is typically defined as the chance that investment prices or returns will be "extreme" in that realized performance falls outside of three standard deviations from the average.)

Other findings of the survey suggest that the risk management function is getting support, albeit limited, from atop the corporate food chain. More than forty percent of respondents announce that "their management boards have beefed up their risk expertise." One-half of polled professionals claim that "their boards are demanding more rigorous risk reporting."

A central message of the survey is that risk management reforms are underway but that risk management needs to be seen as less of a support function and more of a strategic mainstay that addresses organizational fortunes on a holistic basis. When asked about areas in which the skills of risk management professionals should be improved, one out of every three respondents cite the "ability to see the interdependencies between different categories of risks to the organisation."

Main barriers to effective risk management include regulatory uncertainty, "poor communication across departments," incomplete data, absence of authority for the risk management role, "lack of adequate investment" and poor real-time "(intra-day) risk management." With Basel III looming for a 2019 implementation, systematically important financial institutions ("SIFIs") could see profits lowered as capital requirements tighten, forcing more and better attention to be paid to the relationship between the cost of offering various products and services and risk mitigation.

In Risk Management for Pensions, Endowments and Foundations, Dr. Susan Mangiero talks about the urgent need for training across functions and job titles so it is alarming that 44 percent of respondents cite a 7 percent drop in the risk management training of the general workforce in 2011 from 2010. Fifty-four percent of risk executives describe a 9 percent decline in data quality and integrity with mergers and acquisitions leading to a related problem of disparate information technology systems. Without a good process in place to collect information, it is hard to measure and manage risks thereafter.

At a time when risk management is arguably as important as it has ever been in terms of protecting enterprise value, Financial Times reporter Justin Baer writes that "US regulators are warning banks to protect their risk-management staff and systems from any planned cost cuts as Wall Street grapples with a challenging year of meagre results." "US banks warned against shedding risk staff" references the Senior Supervisors Group of global bank regulators as urging financial institutions to do much more in the area of building a robust risk mitigation infrastructure.

Should an elephant fall, the audience will hear a thud. Should global financial institutions give short shrift to improving risk management policies, procedures, systems and practices (for those companies for which this applies), the economic "noise" will be deafening. Now is not the time to move backwards with respect to risk management.

Note to Readers:

• Click to read "Observations on Developments in Risk Appetite Frameworks and IT infrastructure," Senior Supervisors Group, December 23, 2010.
• See "Too Good to Fail? New Challenges for Risk Management in Financial Services" for a summary of the 2011 SAS sponsored survey conducted by the Economist Intelligence Unit.
• Download "Life in Financial Risk Management: Shrinking Violets Need Not Apply" by Susan Mangiero, AFP Exchange, July/August 2003. Note that BVA, LLC now does business as Fiduciary Leadership, LLC.
• Click to order Financial Engineering: The Evolution of a Profession by Tanya Beder et al (John Wiley & Sons, 2011).

Courtesy of Strafford Publications, Dr. Susan Mangiero spoke on the topic of ERISA investment fiduciary pain points and the role of service providers. She was joined by esteemed colleagues Andrew L. Oringer (Partner, Ropes & Gray) and Christine A. Dart (Vice President, Chubb & Son) in a lively and informative debate about current ERISA litigation trends, "must do" action items regarding ERISA fiduciary liability insurance procurement and the vetting of investment decisions relating to fees, third parties, use of derivatives, hard-to-value investing, leverage and risk management.

Click to read the transcript of comments by Dr. Susan Mangiero on the topic of ERISA investment fiduciary considerations.

Click to order a recording of the full 90-minute program entitled "ERISA Fiduciaries Under Attack: Key Litigation and Regulatory Developments."

In case you missed it, CFTC commissioner Bart Chilton gave a memorable speech about new species making their way into the financial ecosystem. Asserting that speculators are an important part of the futures market, Mr. Chilton adds that nearly $200 billion of money from hedge funds, pensions and index funds (what he labels the "Massive Passives") reflects concentrated positions that "has the potential of moving markets, of influencing true price discovery" and causing grief for "hedgers who use markets to manage commercial business risks." Until a new rule to mandate speculative position limits is in place, the regulators will need to track who does what and when and in what amounts. Click to read "New Species: How Market Participants Have Evolved in Financial Ecosystems: Speech of Commissioner Bart Chilton to the American Public Gas Association Winter Conference," February 1, 2011.

Elaborating on his animal kingdom analogy, he refers to high frequency and algorithmic traders as cheetahs and worries that "cheetahs could roil a market." He's right that technology is so much more powerful than in the past, allowing millions of dollars to flow within seconds. What is less clear is whether and how the CFTC and other regulators will slow down the pace to allow commercial hedgers to execute transactions at a reasonable price (if indeed the net economic effect of trading slowdowns will benefit hedgers).

To get a better handle on optimal policy, the U.S. Securities and Exchange Commission ("SEC") sought comments from the public in 2010 about equity market structure, including "high frequency trading, order routing, market data linkages, and undisplayed, or "dark," liquidity." In September 2010, the U.S. Commodity Futures Trading Commission ("CFTC") and the SEC presented their "Findings Regarding The Market Events of May 6, 2010" with a description of rapid price swings that day, the role of a large "algo" trader and the absorption of selling pressure by high frequency traders, fundamental buyers using futures and equity market arbitrageurs. According to "Flash crash report will not stop HFT debate" by Aline van Duyn and Telis Demos (Financial Times, October 5, 2010), three areas of concern remain:

• Who should be constrained in terms of trading limits
• How transparency can be achieved for all trades
• Whether time outs from trading in a particular instrument can stem the tide of rapid fire responses by market participants.

From an institutional investor perspective, transparency around trades seems to be an increasingly important sticking point with respect to how their billions of dollars are treated by financial institutions that are hired to trade on their behalf. Mounting lawsuits about fees, conflicts of interest and pricing is evidence that some concern exists about whether the buy side thinks they are getting a fair shake.

In "'Swaps' Add a New Risk" (February 7, 2011), Wall Street Journal reporter Ari I. Weinberg writes that little is known about the use of over-the-counter derivative instruments by mutual funds and that the risk of non-performance by a swap counterparty must be considered.

Having worked on several derivative trading desks, I have direct experience dealing with swap contracts, pricing, hedging and counterparty risk. As the saying goes, there is no free lunch. The use of an interest rate, credit and/or currency swap can help an asset manager hedge price variability or enhance returns. The ex-ante economics must consider the riskiness of the party on the opposing side of the contract and much more.

Since Enron and other mammoth bankruptcies of companies that used swaps in large amounts, U.S. bankruptcy law has changed to allow for netting of bi-directional cash flow obligations. Additionally, collateral is often posted (with the amounts being determined by a host of factors such as creditworthiness of the posting entity, type of collateral, existing borrowing facilities, deal structure and so on). New regulations mandate the use of a central clearing house for swaps, heretofore traded privately among mainly large global banks. Even with all of the so-called reforms, work remains.

Attorney Rose DiMartino with Wilkie Farr & Gallagher LLP is quoted in the Wall Street Journal article about her observation that the quality and quantity of disclosure about the use of swaps by investment funds can vary considerably. Attorney Mark Perlow with K&L Gates LLP urges guidance from the regulators about the use of swaps as a leverage creation mechanism. I concur with both sentiments but add that measuring leverage is part of the challenge. Moreover, with respect to disclosure, it's critical to understand what derivative instrument has been used and how, along with understanding more about collateral posted and the nature of the counterparty involved. Consider the following example:

• An equity swap is used by Investment Fund A to hedge its long positions.
• The same structure swap is used by Investment Fund B to take an activist stake in Company X, in anticipation of a management reshuffle and an increase in share price sometime soon.
• Yet another asset pool managed as Investment Fund C may employ the identical type of swap as part of a multiple leg transaction that allows it to gain exposure to a sector not otherwise available by investing directly.

The  risk-return profile is going to differ across funds. Even if all three mutual funds reported the identical swap on its filings, one would still need to play financial detective (assuming he or she had access to further details) to understand how the use of swaps is likely to change things.

In addition, there is the issue of valuation. Some swaps are straightforward to price and some are not. You could have the same over-the-counter swap valued by two or more independent pricing services and get different numbers that are far apart if the derivative has a complex structure that veers from the standard fixed to LIBOR arrangement.

Investors do need more information about the use of derivatives by mutual funds. The question is whether they will get sufficient clarity to properly assess risk.

Interested readers can link to "SEC Proposes Joint Rules with CFTC to Define Swap Related Terms" (December 3, 2010) and/or "SEC proposal would give customers clarity on pricing" by Sarah Nl. Lynch, Reuters, February 2, 2011.

Also check out "The Role of the Financial Expert in Valuation of Derivative Instruments" by Susan Mangiero, Expert Evidence Report, BNA, 2004. Note that BVA, LLC is now known as Fiduciary Leadership, LLC.