Evaluating risk is not the end of the process

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Article on Linked In: https://www.linkedin.com/pulse/evaluating-risk-end-process-gregory-kennedy/ - Photo by Loic Leray on Unsplash

 

Since the global financial crisis, there has been an increased focus on systemic and idiosyncratic risks in the banking sector. Far less attention has been paid to reducing risks in the asset management industry, but in the European Union at least, a lower profile does not mean risk in the fund industry is being overlooked.

Luxembourg's CSSF Circular 18/698, which took effect on publication in August last year, aligns the risk management requirements for UCITS and alternative investment funds, and defines a 'three-lines-of-defence' model for investment fund managers.

The first line of defence is the individual operating units that take on or acquire risks and carry out controls within a predefined policy; the second is the business's permanent risk management functions that conduct independent risk controls, as well as support functions such as IT and accounting; and the third is a group's internal audit function, which is required to maintain an independent, objective and critical evaluation of the two other risk control elements.

 

Options for asset managers

This approach may appear to oblige business units and departments to conduct their own modelling to set risk weightings, assign values and interact with each other to provide a comprehensive view of all the risks an asset manager may encounter, from market and liquidity risk to individual assets and the counterparties and stakeholders with which firms interact.

However, the Luxembourg regulator does not prescribe what risk models asset managers should adopt. That leaves them with the option of designing and implementing their own internal models, or using a third-party solution. In either case, non-standard and non-harmonised models can lead to inconsistencies within each fund management group and across the Luxembourg industry as a whole.

To this, the European Securities and Markets Authority has added stress testing for bond funds and liquidity and leverage tests for all UCITS and AIFs, under guidelines that take effect in April 2020. Here too, the EU authority sets out what fund managers need to cover, not how to do it.

 

Model risk management solutions

A natural response for asset managers is to look toward consulting firms, especially the Big Four, for assistance in determining their risk management approach. However, the consultants may not be able to offer the most effective software tools.

Efficient and effective risk management is critical to the industry. No manager wants to have to tell investors that they have lost money because an investment failed, or have to gate, suspend or even liquidate their funds, as happened with the UK's Woodford Equity Income Fund because its assets were too illiquid to be sold quickly enough to meet redemption requests. But updating and harmonising risk systems is complex and often costly.

A model risk management solution is not just about calculating risk in isolation. The CSSF Circular also details the roles and responsibilities of senior management and board members in areas including risk. Risk modelling tools can automate identification and calculation, but they cannot proactively act on that information. Therefore fund groups considering a risk modelling upgrade should also pay close attention to the alert functions and dashboards designed to enable senior management to identify and act on risks before they become critical.

 

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