Operational risk back in the spotlight

Oct 10, 2005 @ 12:01 am

By Vince Calio

NEW YORK - Operational and political risk are back in vogue, thanks to the Enron Corp.-type blowups and to regulatory changes implemented in recent years, according to a new Bank of New York Co. Inc. survey endorsed by Harry Markowitz, the money management industry icon and Nobel laureate.

Unlike during the pre-tech-bubble days, operational and political risk now carry the same level of importance for pension plans as investment risk, according to the survey, "New Frontiers of Risk: The 360-degree Risk Manager for Pensions and Non-profits."

The survey of 76 executives at pension plans and non-profit funds was conducted to determine what risks plan sponsors are facing and how they rank them in terms of importance.

Internal process failure

Some 91% of respondents still considered investment risk the most important type of risk, yet they spent an average of 40% of their time focusing on operational and political risk.

Additionally, 80% of respondents said they would dedicate more time in the future to focusing on operational and political risk.

Operational risk is the risk of a loss in assets resulting from failure of internal processes and systems at the plan sponsor level, the money manager level and the individual-company level. Political risk is the risk of loss resulting from inadequate preparation of regulatory changes and from possible regime changes in foreign countries, especially emerging markets.

Operational and political risk were the focus of attention nearly a decade ago, when the Risk Standards Working Group, an ad hoc group comprising money managers and risk experts, produced in 1996 a list of 20 best-practices risk management standards to hedge against investment and operational risk.

At the height of the tech bubble, however, that focus seemed to shift to investment risk.

For example, in 2000, Robert Maynard, chief investment officer of the $8 billion Public Employees Retirement System of Idaho in Boise, said of the working group's risk standards: "Many of the standards are not right for public funds. There are common practices that have been developed for most risks public funds have" that are not in line with the group's proposals.

Now, however, "plan sponsors are no longer concentrating just on their investments," Debra Baker, a managing director of the global risk services group at The Bank of New York, said in an interview. "What we found in the survey is that they are taking a much broader view of total plan risk."

In the survey, participants identified two main types of operational risk. The first is "headline risk," or the risk of exposure to a negative news story. "Effective and timely crisis communications is the key to counteracting negative press and minimizing the likelihood of an organization becoming a household name for all the wrong reasons," the report on the survey said.

The second is "service-level risk," or the risk that outside vendors do not deliver the type of service that is expected. "One way to manage service-level risk is by drawing up a service-level description with external providers to delineate performance levels and service expectations," the survey said.

The report also found fund executives were wary of the amount of regulatory changes since 2000, such as the passage of the Sarbanes-Oxley Act; the USA Patriot Act; and the Basel II accord, which recommends that financial institutions institute capital requirements to hedge against the risk of operational loss.

The survey recommends that plan sponsors survey macroeconomic trends to get a sense of future political risk. "Changes in economic growth, employment, and producer and consumer prices play a key role in a country's future political course."

"It's no longer companies like [Houston-based] Enron that contribute to headline risk, but it's also individual executives that caused this headline risk to go to another level," Ms. Baker said. She added that the pension-funding crises in recent years, particularly in the auto and airline sectors, also have contributed to a heightened awareness of headline risk.

"When a company is experiencing a financial crisis because of the funding level of its pension plan, it puts the focus squarely on the pension plan. Headline risk is becoming a large part of the operation of pension plans," Ms. Baker said.

Intertwined risks

The push into hedge funds and other alternative investments by pension plans has caused certain types of risks to become intertwined, said Karyn Williams, a managing director at Wilshire Associates Inc. of Santa Monica, Calif., which worked on the survey.

"As you move into categories such as hedge funds, derivatives and other private-equity investments, your operational risk exposures as well as your investment risks certainly become increased. These risks can no longer be looked at as stand-alone," she said.

Ms. Baker agrees. "Hedge funds represent the biggest area of growth since the late 1990s," she said.

"A lot of the participants that we spoke to said when they hire

a hedge fund, there is investment risk, but there's also operation-

al risk because of the lack of

transparency."

In the investment risk category, Mr. Markowitz, whose modern portfolio theory is credited as being the first to analyze portfolio risk quantitatively, noted that plan sponsors now regularly use mathematical techniques to analyze their managers' portfolios.

Mr. Markowitz assisted in coming up with questions for the survey.

One of the questions was: How often do you directly or indirectly use formal mathematical-based or computer-assisted analysis in managing or analyzing your portfolios? Some 57% of respondents said they regularly used quantitative techniques to analyze the risk/return characteristics of their portfolios. "That's something that's really great to see," Mr. Markowitz said.

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