Asset managers run for cover

UK investment firms are facing increasing risk management pressures, thanks to new regulatory initiatives, legal challenges and a shift in operating environment. Coping will require a major investment in technology infrastructure – especially in the front office.

Over the past 18 months, the world has become an infinitely riskier place, when viewed from the desk chair of a managing director of a UK asset management company. In the wake of the Merrill Lynch/Unilever case, the potential for legal risk is soaring. Regulatory risk is reaching news heights, thanks to a number of new UK government initiatives. And these changes – as well as others – are driving new concerns about operational risks at asset management companies that could well lead to the need to make substantial investment in front-office technology.

These challenges are mounting just when fee income is under real pressure for the first time in more than a decade, market volatility is high and institutional investors are rethinking their overall strategy for allocation of funds to management companies. Richard Kent, co-head of asset management risk management consulting at Ernst & Young in London, says: “What we are going through is a period of unprecedented regulatory change for the asset management business.”

The challenges to UK asset management businesses are coming from a wide variety of directions. Internal and external communication, via technology systems, must be dramatically improved in order to measure and manage new enterprise-wide risks. “A lot of this is happening against a backdrop of firms who have historically not spent a lot on information technology,” says Tim Gillbanks, a director in the global risk management practice at PricewaterhouseCoopers (PwC) in London. “And now there are increased pressures on costs. All of this puts a lot of strain on operational risk.”

The outcome of the Merrill Lynch/Unilever case – Merrill settled with Unilever out of court – has highlighted the importance of communication of portfolio mandate compliance both within firms and with clients. “There needs to be more effective integration of risk measurement tools into risk control and performance measurement processes,” says Thomas Garside, a director at London-based consultant Oliver, Wyman & Company. “Also, there must be a closure of the op risk ‘gaps’ between client portfolio management mandates and the resulting asset management allocations, vis-à-vis implicit or explicit fund performance clauses.”

Although the Merrill Lynch/Unilever case has focused attention on mandate compliance communication issues, other trends in the industry have also drawn attention to this problem. Paul Yates, head of UK business at UBS Asset Management, based in London, says his firm decreased the amount of assets each manager handles because each manager has more restrictions to monitor on those assets. The risks are high for firms that don’t implement effective communication systems, he says.

Indeed, Yates notes that his firm now has an 18-person regulatory and legal compliance team for the asset management division in London, while eight years ago it was just two people. Not only are concerns about legal risks rising, he says, but regulatory risk is also growing. Consultation Paper 97 (CP-97), issued by the UK’s Financial Services Authority in June 2001, is perhaps the biggest cause of stress among executives. The consultation period ended in December 2001, and Ernst & Young’s Kent says it might take two years for the final document, also known as the Integrated Prudential Source book, to emerge. But asset management companies are already eyeing up the provisions relating directly to their business. “In essence, CP-97 proposes a coherent approach to the identification and management of operational risks. Asset managers will need to be comfortable that their risk and control framework meets this requirement,” says Kent. “In the past, op risk was often managed implicitly rather than explicitly.”

Regulators don’t just want firms to have error-reporting systems, Gillbanks says. They want asset managers’ systems to also “demonstrate that things are going right [systems are functioning properly, etc]. That’s a real shift”.

The op risk aspects of the Basel Accord proposals will also hit UK asset management firms, because it is likely that an EU directive will apply the proposals to all investment firms, and that the FSA will adopt this directive. “A number of significant asset managers are beginning to look at these issues,” says David Logan, an asset management partner with Andersen Consulting in London. These firms are starting to establish risk functions focusing on op risks, and to do analysis of the loss incidents in preparation for building databases and other information systems. To qualify for treatment under the advanced Basel proposals, firms will need five years of such operational risk data, says Logan.

Myners Report
The Myners Report, published in March 2001 by the UK Treasury, is also on asset management firms’ radar screens. It suggests that firms should improve transparency and communication between pension fund trustees and asset managers, among a host of other things. “This is going to ripple through the industry,” says Clare Porter, vice-president of marketing strategy at SunGard. “Asset management firms must increase the transparency around their decision-making process all the way through their organisational structure.”

For example, one part of the report that has been translated into a proposed law would make it the duty of both asset managers and pension fund managers to be “active shareholders”. The would permit institutional investors and fund managers to be subject to civil damages if they are found to have missed signs of corporate wrongdoing or neglect while performing standard corporate governance oversight. The proposal law, which the UK government published at the beginning of February, has already drawn the wrath of the UK-based Investment Management Association.

It is no coincidence that these transparency and communication-orientated regulatory initiatives are hitting the industry at the same time. Volatility in the securities markets over the past two years has led many firms to report underperformance in their funds, and op risk losses on their balance sheets. Kent says that in firms without good reporting structures, errors can take two to three weeks to uncover, and that the higher the volatility in the markets, the higher the likelihood that there will be a substantial operational loss associated with correcting the position. He notes that erroneous gains are usually given to the client, so unlike a bank where operational gains and losses due to errors can cancel themselves out partially, the equation is one-sided with asset management firms. Says Kent: “We’ve heard in the press of some fairly large errors that have happened at asset managers, with some large cash penalties.”

Asset management firms suddenly must be able to absorb, process and display information about their own activities much more efficiently than in the past, to please both regulators and clients and to get a better handle on the risks the firm faces. “Capturing trading information, pushing that through the system and getting that information back on investment managers’ screens to make decisions is actually a real challenge, unless you have a straight-through processing environment,” says PwC’s Gillbanks. “Very few fund managers have achieved that.”

Gillbanks notes that many investment management firms still use spreadsheets, especially on their fixed-income desks. For these firms to achieve an STP environment will take “18 months to two years, lots of cash, and lots of effort”, he says.

Much of the upgrading will be focused on the front office. “Typically, in the past, asset management firms always looked to the back office for technological efficiencies,” says Gillbanks. “I think there is going to be a shift in the focus of where they spend their money.” Most firms have their equity managers and fixed-income managers on different front-office systems, while at other firms entire front office systems remain mostly manual.

During high volatility, operational errors can be more frequent and take longer to catch, increasing op risk costs. Firms able to get their entire organisation on one system, creating the ability to build a comprehensive picture of the performance of the firm’s products and manage the risks associated with those products in a more holistic way, will have a competitive advantage, he says.

But the need for asset management firms to invest heavily in risk measurement, management and communications technology has come at a bad time. “Business in the UK is a lot more fragmented now,” says UBS’s Yates. The industry used to be dominated by three to five asset management firms, he says. Now it is divided up among an increasing number of domestic, foreign and specialised players. “As a result, we carry more overhead per unit managed than four or five years ago.”

For example, Oliver, Wyman’s Garside says an evolving trend among institutional investors is to allocate a substantial portion of their funds to a low-cost index-tracking product, and the remainder to more actively managed ‘satellite’ funds. They are doing this because many more traditional active funds deviate very little from the overall index composition, and thus essentially produce passive fund returns at active management fee levels. By splitting their funds up in this new way, institutional investors are trying to boost performance and reduce fee levels. But as a result, assets under management at more traditional active funds are declining, reducing fee income for many asset management firms substantially, Garside says.

There are other pressures as well – many institutional investors are shifting into bond funds after recent equity volatility and concerns about a new accounting rule, FRS 17. Bond funds traditionally have lower fees than equity funds. Overall, funds under management have been hit simply because markets have declined so dramatically over the past 18 months, again reducing fee income. In short, times are tough for asset management firms As a result, fees – and thus revenue – are declining for many firms. A study by UK-based consultants Bacon and Woodrow found that the UK’s 10 largest asset management firms have seen fees rise by 13.2% in 2001. But the average rise for all managers across the industry was just 2.8%. “Considerable pressure is being placed on fee income through falling asset values and reduced margins,” says Ernst & Young’s Kent. “Consistent with the sentiment outlined in the Myners report, we can see trustees and institutional investors wishing to take a more active role in questioning the asset managers’ approach toward managing the risks to their business as well as the specific risks to the portfolio.”

“Risk measurement and management is going to be at the forefront of people’s minds,” says Garside. “But many of these firms are also under a lot of cost pressure. I hope the lessons learned [from recent experiences] are translated into improved business processes, as opposed to people thinking ‘this will never happen again’.”Risk