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Non-Financial Risks: A focus on Operational Risk

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Non-Financial Risks: A focus on Operational Risk

  1. 1. November 2010 Non-Financial Risks A focus on Operational Risk Ben Gunnee – European Director, Mercer Sentinel Mercer Limited is authorised and regulated by the Financial Services Authority Registered in England No. 984275 Registered Office: 1 Tower Place West, Tower Place, London EC3R 5BU
  2. 2. 2008 - The Year that put Non-Financial Risks on the Map 7 Sep ’08: US Government bails out Fannie Mae and Freddie Mac, the mortgage 15 Sep ’08: Bank of America buys financiers. Agreeing to inject up to US$100bn per company Merrill Lynch inUS$50bn emergency acquisition 18 Sep’08: 17 Mar’ 08: Bear Stearns 14 Sep ’08: Lehman, the 158 LloydsUS$22bn collapses sold to JPMorgan for Jul ’08: Alliance & year-old investment bank Rescue take over of HBOS. files for bankruptcy after US$20bn per share Leicester, was bought by Spanish bank Banco failing to attract Fed help, Government waives antitrust provision to Santander. or a buyer allow merger 21 Sep ’08: Governments of the 17 Jul ’07: Two Bear Netherlands, Belgium and Luxembourg agree to a partial nationalisation deal worth Stearns hedge funds investing in sub-prime US$15.5bn investment collapse to stabilise Fortis. Subsequently, Fortis’ operations in Belgium and Luxembourg were purchased by BNP Paribas for 2 Apr ’07: Bankruptcy filing of New Century US$20.1bn Financial, one of the 16 Aug ’07: Countrywide Financial, the biggest sub-prime largest mortgage in the US run into liquidity lenders in the US problems. Fed responded by a 50 bps cut of the discount rate 30 Sep ’08: Dexia Partly Nationalised by Governments of Belgium, Luxemburg 8 Oct ’08: UK Government 10 Mar ’08: Further US$236bn and the Netherlands in announces a scheme to provide 14–17 Sep ’07: Northern a deal worth Boost from Treasury security loans £400bn of support to the and cash loans to banks in Europe 7 Mar’ 08: Rock experienced a bank run until a government blanket US$9bn banking sector including a capital injection and guarantees for banks’ guarantee was issued on 17 US$20bn Sep 07. 13 Oct ’08: borrowings. Co-ordinated 50bps Cash loan Fed European Governments unveil benchmark rates cuts by all major intervention to central banks. Nationalisation of all banks and bond €1.85tn co-ordinated plan to three major Icelandic banks market dealers recapitalise banks and guarantee banks’ borrowing. UK Government announces £37bninvestments in 16 Oct ’08: RBS, HBOS and Lloyds TSB. UAE UBS agrees “bad bank” deal with the central bank to take Ministry offers US$19bn liquidity injection to banks US$60bn in toxic assets off its balance sheet inaddtion to a SFr6bn capital injection 14 Oct ’08: US government guarantees new debt issued by banks for 3 years and announces plans to injectUS$250bn in banks Mercer 1
  3. 3. Non-Financial Risks versus Financial Risks Financial Risks Market Non-Financial Risks Credit Implementation Interest rate Operational Liquidity Reputation Non-financial risks can have a financial impact Mercer 2
  4. 4. Putting non-financial risk in context Defining the key elements of operational risk Operational risk is the probability of a loss/cost resulting from inadequate or failed internal processes, people and systems, or from external events, including legal losses but excluding systemic and reputational losses1. Key elements: Loss classifications: Compliance & oversight framework those that occur frequently and entail modest losses; Management & staff competence those that occur infrequently but may Investment processes & controls entail substantial losses Portfolio administration processes & controls Technology infrastructure support & controls Third-party contracts and outsourced relationships management & controls Security of physical and virtual assets 1. The Bank for International Settlements, 2004 Mercer 3
  5. 5. Areas where Operational Risk exist Transition managers Dealers, market makers ECNs and dark pools Investor Custodian, administrator & affiliated bank Depository & Payment systems Investment Manager Lending agents Brokers & Clearing agents commission arrangements Direct or contract relationship Relationship because of investor Mercer 4
  6. 6. Translating Operational and Implementation Risk into Costs A paradigm for evaluation Illustration using a global equity core example Inefficient 9 bps administration 50 bps Unreclaimed taxes 125 bps Excess return Excess Median 5-year net explicit 38 bps trading global equity costs costs 80 bps 80 bps alpha 28 bps 28 bps Investment manager fee Add back Potential 45 bps implicit & excess return opportunity net explicit Custody, costs costs accy. & admin 7 bps •All numbers are median, range data available on request fees ** Resources: Mercer MPA, Mercer Global Custody Database, Inalytics, Elkins McSherry,& Globe tax Mercer 5
  7. 7. Work still to be done Increased attention on operational activities, but still can do more 80% % 70 % 70% 67 60% % 6% 56 % 55 % 5 52 % 50% 46 % % 41 40% % 38 36 % 33 30% % % 23 21 20% % 13 10% 0% Stock lending? Cash Counterparty Collateral Transaction Custodian Review the back management? exposure? management? costs? efficiency? office controls at the investment Red = 2008, Yellow = 2009 managers Mercer 6
  8. 8. Operational Risk Investment Managers and Custodians
  9. 9. Many investors do not look beyond the shop window Oh dear, yes; I know him extremely well," replied Mrs. Palmer;--"Not that I ever spoke to him, indeed; but I have seen him for ever in town." Mercer 8
  10. 10. Investment manager operations are complex…. Front office activities Back office activities Middle office activities Investment Transaction Transaction Core custody Asset Reporting Service and management initiation processing services administration and risk relationship and settlement and reporting management management Transaction Counterparty Safekeeping Cash and Third party Portfolio Valuation relationship order and and reporting currency modelling execution confirmations management registration management Transaction Admin. functions Securities Corporate actions Research Support cash Transaction & income collection Tax (restructures lending and FX & currency reporting execution management) authentication & administration & transitions) management management Risk Research Investment management Transacting Management house surveys Proxy Performance decision and pre-trade reporting reporting & consultant compliance processing notification liaison Strategic Admin. functions expense Trade Tax hedge and Fee rebate, advice withholding alternative settlement verification and payments and reclaim investments Portfolio Post trade constructions Cash and compliance and liquidity Unit pricing risk reporting management Product Systems and developments Asset Unit registry technology valuation support Sales and marketing Securities Cash flow lending management Mercer 9
  11. 11. Inefficiency Erodes Alpha! - What Gets Measured gets Managed Custodian Commission Fund Manager Securities Recapture Fees Fees Lending Share Share ently Appar d e Manag but… FUND MANAGERS // CUSTODIANS FUND MANAGERS CUSTODIANS Manager/custodian interface Securities lending Trading costs Interest rates ge Leaka Custodian’s process Income collection s occur Foreign exchange Commission recapture Opportunity Opportunity Mercer Costs Costs 10
  12. 12. A model for assessing operational risks Pre-onsite Onsite work Assessment On-going Build knowledge Documentation Focus on the Trust but verify base & perspective issues Due diligence questionnaire Comprehensive work Work papers completed on- Assign follow-up priority program site based on overall assessment General research Behind-the-scenes, desk-side Two levels of peer review and Critical feedback forms basis Questionnaire analysis technical checking of on-going dialogue review and process leading to report pre-write confirmation with staff Assign ratings Work program review Controls demonstration and Adjust expectations for firm On-site responsibilities validation size and institutionalization assigned On-site at operations centers, Provide manager with critical including 3rd parties and feedback & verify on-site multiple geographical observations locations Validate ratings and opinions Observations of “the life of a trade/investment” in practice Issue summary report with detail report available upon Validate pre-write and request evaluate control culture From paper to practice Mercer 11
  13. 13. Summary Points Understand your potential operational and implementation risk sources Identify clearly who is responsible for what and ensure your contracts and service level agreements reflect these arrangements Evaluate your custodian’s/administrator’s systems, history, capabilities and controls Assess your managers and key service providers, including services, operations, execution and internal controls Establish mechanisms to assess the reasonability of your explicit and implicit costs Mercer 12
  14. 14. Mercer Limited is authorised and regulated by the Financial Services Authority Registered in England No. 984275 Registered Office: 1 Tower Place West, Tower Place, London EC3R 5BU

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