Risk Management Challenges for Asset Managers

September 25, 2009 at 5:37 pm Leave a comment

By Uday Gulvadi

Parkview Risk Advisorswww.parkviewconsult.com

The proposed financial sector regulatory reforms such as the Hedge Fund Transparency Act and the Treasury Department’s Financial Regulatory Reform proposals resulting from the acute crises in the financial sector are expected to have a deep and wide spread impact on the health of the financial sector.

Asset management firms and hedge funds in  particular are widely expected to come under the regulatory ambit. Due to recent scandals such as the Madoff and other Ponzi scheme and investment frauds, there has been increased anxiety in the investment community over the management of assets. Any organizational structure that separates the asset management from asset ownership is likely to experience greater scrutiny and require heightened assessment of risk management practices.

It is widely anticipated that larger hedge funds above a certain size of assets under management, and that represent a systemic risk, will come under the regulatory ambit. There is still uncertainty as to what the final shape of such regulations will be. Certain basic provisions requiring registration of hedge funds with the SEC, establishment of Anti Money Laundering procedures and enhanced level of disclosures are widely expected. There is some concern due to the potential of increased operating costs for asset managers due to the burden of these new regulatory compliance procedures. This concern is somewhat justified based on the initial experience of public companies’ implementation of the Sarbanes Oxley Act, adopting a broad brush approach which increased the costs of compliance.

Over the last several quarters, hedge funds have been subject to greater redemption pressures given the economic uncertainty and therefore effective liquidity management has become critical. However, this is a great time for proactive asset managers to put their house in order and gain the trust of investors and regulators alike. Investors in hedge funds have become increasingly sophisticated with the entry of pension funds and other institutions. Investors and regulators are looking for tangible evidence of propriety and adequate oversight in management of funds. Investors are looking to gain comfort about the asset manager’s risk management capabilities across the entire value chain including investment management, execution, and management of counterparty risk,
operational risks, and vendor / third party risks. It is therefore imperative for asset managers to establish a comprehensive framework of policies for risk management and risk reporting. For those that already have these policies in place it would be  advisable to conduct a “fresh look” assessment, especially in light of the market turmoil that may necessitate a change in risk postures.

During a time of crisis, companies are pressured to cut costs and reduce staff. This leaves companies especially vulnerable to operational risks. The workload gets redistributed among fewer employees leading to increased work pressure, and stress levels and also exposes the organization to fraud risks due to the weakening of natural process level checks and balances and segregation of duties controls and potential for management override. A good place to start would be to establish a clear and effective Corporate Governance and Risk Management Structure including a Board or Risk Oversight Committee. Establishment of a Code of Ethics and comprehensive policies and procedure guidelines and periodic independent assessment and monitoring of design and operation of internal controls including fraud controls would help asset managers rebuild trust.

Other aspects to review include the integration of information systems to ensure aggregated views ofrisk from all sources and a timely reporting mechanism that enables prompt attention to potential and actual risk exposures. Leading firms are using tools such as stress testing and scenario analysis to enhance their preparedness to respond to potential opportunities and upheavals in the markets. They are also increasingly using third party administrators to provide an independent fund administration, accounting and valuation function.

Regular and transparent communication with the investor community is also key especially since most hedge funds and alternative investment funds deal in a complex variety of products and derivatives instruments that make it tough to accurately measure and quantify risk, and disclose the true carrying value of these investments. The need for greater disclosures will obviously have to be balanced with the need to protect proprietary information related to investment strategies. A huge challenge for regulators would be to introduce alignment and consistency of regulatory and compliance practices across countries as regulatory inconsistency among different countries tends to create arbitrage opportunities. From a broader long term view, the US market is looking at a return to increased savings rates which will in turn lead to increased investments in traditional as well as alternative savings avenues.

In conclusion, asset managers that take proactive measures to strengthen corporate governance, risk management and disclosure practices and seek to understand and address investor and client’s concerns and needs will emerge stronger in the new landscape.

Entry filed under: Asset Management.

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