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

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).

In reading the published accounts of the U.S. Securities and Exchange Commission ("SEC") settlement with the AXA Rosenberg Group and various related entities, I'm reminded of many articles I've written that warn about the limitations of models and the critical need for ongoing tests and oversight of said models. According to the document published today regarding the AXA Settlement With the SEC, certain senior managers who were apparently made aware of a coding error (that "was introduced in 2007" and discovered in late June 2009) responded by instructing junior staff to "keep quiet about the error."

Models are designed by human beings and require constant care and feeding. For one thing, market conditions change which therefore requires that models be revisited for their accuracy and the extent to which underlying assumptions still hold true. Second, most investment models are complex in that multiple calculations are used to generate final outputs. Third, some models are "nested" in the sense that data inputs for an ultimate algorithm are themselves modeled.If the modeled inputs are flawed, it's no surprise that Garbage In, Garbage Out ensues.

For example, interest rate paths (levels, direction, volatility) and prepayment assumptions are integral inputs for mortgage backed security pricing models yet must first be modeled. If rates have just fallen considerably and a large number of home owners have refinanced, another fall in interest rates is unlikely to encourage yet another large spate of prepayments. The underlying assumptions that drive interest rate paths directly influence the estimates of time-valued projected cash flows associated with the mortgage bond so questions must be asked about how the inputs and the outputs are generated.

Model errors are seldom self-contained and create a Pandora's box for those investors or traders who commit money to the "wrong" numbers. Let me elaborate.

Suppose a trader hedges a portfolio of securities based on incorrect model outputs. The net result will be protection that is excessive (thereby costing that trader in the form of opportunity costs) or insufficient (thereby forcing the trader to realize losses that were meant to be avoided).

Another situation relates to end users that allocate part of their portfolio to a quantitative investment strategy such as pension funds or endowments. If the "quants" get it wrong because of sloppy modeling work (and that includes errors that are not caught right away because of poor oversight, bad math or both), these institutional or individual investors have unnecessarily lost money as well as the opportunity to have allocated elsewhere. According to "AXA Rosenberg to Pay $242 Million Over 'Coding Error'" by Jakema Lewis (Securities Technology Monitor, February 3, 2011), the School Employees' Retirement System of Ohio, Los Angeles Fire and Police Pensions, the City of Fresno Retirement System, Florida State Board of Administration and the Montana Board of Investments voted with their dollars by terminating their respective relationships with AXA Rosenberg. According to "AXA Rosenberg finds coding error in risk program" by Mark Weinbraub with Jennifer Ablan, Reuters, April 24, 2010, the Marin County Employees' Retirement Association pulled $16.5 million from an AXA Rosenberg international small-cap portfolio.

Email contact@fiduciaryleadership.com if you are interested in learning more about investment model due diligence. In the meantime, articles listed below provide information about model risk:

• "The Risks of Ignoring Model Risk" by Susan Mangiero, Chapter 5B, 2005 Cumulative Supplement to the Litigation Service Handbook: The Role of the Expert, John Wiley & Sons, 2005
• "Asset Valuation: Not a Trivial Pursuit" by Susan Mangiero, FSA Times, Institute of Internal Auditor, Q1-2004
• "Financial Model Risk Looms Large" by Susan Mangiero, The Investment Lawyer, November 2002
• "Model Risk is Serious Business" by Susan Mangiero, "Derivatives Diary," AFP Exchange, September/October 2002

Every investor must exercise care and diligence in asking tough questions and being satisfied with the answers. At a bare minimum, this requires that each investor:

• Gain an intuitive understanding of the model and what results should raise red flags because the "smell test" fails
• Ask to meet with the architects of the model and have them explain how they stress the model and whether there is a consistent error rate associated with outputs
• Understand the data issues and whether quality varies across vendors, how outliers are identified and addressed and whether the model is sensitive to frequency and form of data inputs
• Inquire as to who has the authority to modify the model and on what basis
• Query whether internal and external auditors are comfortable with the traders' model(s) and if not, explain their concerns.

Risk management is about so much more than good numbers. Process is everything and that includes comprehensive oversight of the models and when they are likely to fail and for what reasons. Common sense is a critical component of managing risk and will never be replaced by a number or computer. Keep in mind too that with FAS 157 and international accounting equivalents, not to mention U.S. Department of Labor mandates for ERISA plans, an investment fiduciary who invests in complicated strategies and/or securities on the basis of a "black box" approach is just asking for trouble.