Buy-side risk management

PRMIA / ISDA presentation

Steve Farrall Chief Risk Officer Schroders August 2009

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Contents

Thoughts on Buy Side Risk Management

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Schroders 2.

Internal priorities 3.

External priorities 4.

Investment risk 5.

Operational risk 6.

Liquidity in funds 7.

8.

Market Transparency Forward-looking risk measures – stress testing 9.

Capital requirements and ICAAP 10.

Implementation 30441

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1. Schroders

– Asset Management (£113bn AUM) and Private Banking (£11.2bn AUM) – Operating in 26 countries across UK, European, Asia-Pacific, US, Americas regions – From Global products to Local-Local products – Institutional and Intermediary distribution – Operate across asset classes – Equity, Fixed Income, Commodities, FX, Property, Structured, LDI, Multi Asset, Property, Private Equity, Hedge Funds, Funds of Funds – Operational Centres eg: Luxembourg for UCITS funds and Zurich for private banking operations – Outsourcing with key partners – Listed FTSE 100 company, also with Family ownership 30441

2. Internal Priorities

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Executive requirements for risk management

– – Clear scope and mandate Cover investment risks, market and liquidity risks, principal and agency risks. What could really damage us?

Proactive, forward-looking (people and reporting) Increase business understanding (include wider range of experience) Focus on actions – the risk process should lead to identifiable actions taken to mitigate or accept risk Be proactive during crises, providing mitigation advice Keep costs manageable and minimise burden on business No duplication with Audit and Compliance Follow a principles-based approach that can adapt to new business or one-off situations Ensure clear accountability in the governance process Escalate and advise rapidly when there are issues – good advice early may be more useful than complete and validated advice too late – Provide enough bench strength that key processes are not dependent on single individuals

3. Industry priorities

4 – Term credit risk, completeness of counterparty risk – Due diligence around third party funds and funds of funds – Liquidity – and shift in investor preferences – Walker and shareholder activism – process and practice – Risk culture –escalation – Risk culture – involvement at new products stage – Risk culture – forward looking and identifying tripping points, rather than reactive – Bringing risk into the strategic debate – Truly defining and articulating risk appetite – Stress testing and stability analysis – Need to reconcile independence of the risk function with proximity to the business – Clearer and more focused management reporting 30441

4. Investment Risk

5 – Recognise a key fact: Investment managers are the primary risk managers –but: independent challenge and oversight is vital – Mandate compliance and performance attribution tools strong – Risk decomposition and concentration risk tools strong – More needed on stress and scenario testing – forward looking measures under defined conditions – Group Risk team to focus on independent review and challenge: – Stress and scenario testing – Leverage and illiquidity – Independent price verification – Review of outlier P&L – New products – Testing wider industry concerns 30441

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5. Operational Risk

– Historical issue: Comprehensive processes but little value added – Divorced from the business – Need to show an impact, as well as meet regulatory requirements – the real use test – Refocus the Group Operational Risk team: – Clear allocation of end-to-end process responsibility – Risk mapping to be driven by business mapping –not a detached exericise – More rapid escalation of errors, issues and losses - resolve first, then document.

– Analysis of trends and exceptions – ensure lessons learned are shared – Comprehensive record of controls – but driven from what actually happens in the business.

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6. Liquidity in Funds

– The industry has provided liquidity as a free option in many cases – Markets have thoroughly tested this – At product design stage –what would be the liquidity of this product under stress market conditions?

– Design a product or pricing method that reflects this – Stay on top of the issue with regular stress testing.

– Stress testing needs to consider potential cash outflows, as well as the ability to get product into market under stress conditions – how lumpy is the client side?

– Also consider from the start the need to protect the ongoing investor –clearer guidance over use of bid/offer spread and side pockets.

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7. Market Transparency

– Historically the market has accepted little transparency in the hedge fund and fund of funds space – Changing perceptions post Madoff – Requirement to be clear over the due diligence that fund managers should be expected to undertake, and what the hedge fund or fund of fund provider should provide – Reliance on external indicators such as UCITS – Auditors, pricing agents, regulators – Provision of information – articulation of strategy – Ability to backtest – transparency and execution of performance: proprietary strategies and reticence in data provision.

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8. Forward looking measures – stress testing

9 – Risk appetite should be defined from board level – across all risk factors – High level stress tests as well as detailed risk limits (eg: mandates) – Credit risk – counterparty stress tests and collateral stress tests – Market/Investment risk – macro stress tests on markets, micro stress tests on individual investment strategies (eg: cash/futures basis) – Liquidity risk - macro tests such as withdrawal of capital from an asset class, micro tests such as loss of the most significant investors in a fund – Operational risk – resilience tests such as withdrawal of a major service provider or failure of a market system – Engagement at the highest level – the most significant should be discussed with the Board – who should be engaged in the process – Actions taken based on the results – Keep the scenarios relevant to the business and up to date 30441

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9. Capital Requirements and ICAAP

– These risk measures should feed the ICAAP – Stress and scenario testing under Pillar II – Need to ensure that they are considered appropriately - not simple addition – Senior management of the firm should be engaged in the development and testing of the ICAAP – not just something for risk or finance – Builds credibility, and a more proactive consideration for the need for capital – Amend for material transactions 30441