Investment risk management

1 Introduction to Investment Risk 1 Dream versus rude awakening 1 Book structure 3 2 The Beginning of Risk 5 Risk and business 5 Case study: The shark and its risk 5 Case study: The ruin of Cr´edit Lyonnais (CL) 7 Case study: ABB engineering 7 Investment scams 9 Banking risk and sharks 9 Risk management as a discipline 10 Humans and risk 11 Case study: High-street retail store losses 12 Case study: Allied Irish Bank (AIB) 12 The state of the investment game 13 Risk types 13 Reputation risk 14 Case study: Equitable Life 14 Credit risk 15 Market risk 15 Operational risk 16 Risk and damage 17 Viable alternatives 18 3 Investing under Risk 21 Human behaviour and investment choice 21 Portfolio management 22 Value-at-Risk (VaR) 25 Monte Carlo simulation 28 Collective use of mathematical tools 29 Position keeping 30 TLFeBOOK vi Contents Investment managerial control 31 The treasurer’s role 31 Trading and risk management 32 Investment risk experts 38 Case study: A large UK PLC defined benefits pension fund 39 Who controls whom 39 4 Investing under Attack 41 Investor disenchantment 41 Risk-bearers and risk-takers 41 Professional investor/shareholder 41 Investment companies/fund managers 42 Investment banks 43 Auditors 43 A look in the risk mirror 44 Risk-averse 44 Risk-neutral 45 Risk-takers 45 Investor analysis 46 Types of CEO – birds of a feather 47 The CEO eagle – The M&A addict 47 The CEO dodo – Risk-phobic 48 The CEO ostrich – Risk-ignorant 48 The CEO owl – Risk-acceptable 48 The CEO magpie – Risk-seeking 48 Company structure and risks 49 Case study: The executive background check 49 Risk vanities 51 Pensions mis-selling 52 Case study: Boo.com 53 Corporate misgovernance 53 Accuracy of corporate losses 54 Classes of instruments and their risk components 55 Derivatives 56 Bonds 57 Equities 60 Investment as a project 62 5 Investing under Investigation 63 Instinct versus ability 63 Checking corporate fundamentals 64 Formulate a business plan 64 Due diligence 67 Risk support and methodology 68 Investor cynicism 69 Case study: LTCM 70 TLFeBOOK Contents vii 6 Risk Warning Signs 73 Prevailing risk attitudes 73 Reputational risk 74 Case study: Enron 74 Airborne early warning (AEW) 76 International accounting standards (IAS) 77 Credit ratings 78 The ratings procedure 79 Business lines 80 Law and risk management 81 Case study: the UK Football League 81 What the law covers 82 Completeness of contract 82 Case study: Merrill Lynch versus Unilever pension fund 83 Sarbanes–Oxley Act for audit control 84 Insurance 85 Risk retention: self-insurance 87 Case study: Insuring big oil projects 88 Case study: the Names and Lloyds, London 89 Sharing, transferring or mitigating risk 89 Search for risk management 92 Alternative theories 92 Causality and managing investment risk 92 Value-added chain 93 Risk management to pick up the pieces 94 Scenario analysis 94 Case study: Business Continuity, lessons from September 11th 94 Case study: Guaranteed annuity payments 96 Stress testing 96 Bayesian probability 97 Artificial intelligence (AI) and expert systems 97 Case study: Anti-money laundering 97 Risk maps 99 7 The Promise of Risk Management Systems 101 Current state of systems 101 Risk management methodology – RAMP 102 Activity A: Analysis and project launch 102 Activity B: Risk review 102 Activity C: Risk management 102 Activity D: Project close down 103 Financial IT system support 103 The Basel II Loss Database project 103 Case study: Algorithmics systems in a bank 105 Integration and straight-through processing (STP) 106 IT systems project failure 107 TLFeBOOK viii Contents Case study: IT overload 107 Tying financial system functionality to promise 108 Risk Prioritisation 108 Giving the go-ahead 109 Building risk management systems 109 Finding the “best” risk management system 109 The invitation to tender (ITT) process 110 Business functionality requirements 110 User’s functional priorities 111 Business flirting – the user’s system specification 113 Business flirting – the supplier’s reply 113 Judging the ITT beauty show 114 System priorities 115 Project life cycle 116 Risk management project plan 117 A – Our risk strategy 117 B – Risk review 117 C – Risk management 117 D – Project close down 119 8 Realistic Risk Management 121 Intentional damage 121 Fraud, theft and loss 121 Fraud perceived as the main criminal threat 122 419 – not a number, but a way of life 123 Operational risk in emerging markets 124 Parachuting in the experts 125 Case study: Chase Manhattan in Russia 125 Unintentional damage 126 Case study: Split capital investment funds 126 Rogue staff 129 Exposure to fraud at the top 129 Exposure to fraud lower down the rung 131 Case Study: Deutsche Morgan-Grenfell, 1996 132 An operational risk perspective 132 Operational risk protection: the “roof” 133 Investment project growth 134 Phase 1: High skill 135 Phase 2: High performance 135 Phase 3: Client growth 135 Phase 4: Asset growth 136 Case Study: Soros Quantum Fund and Buffett’s Berkshire Hathaway 136 Phase 5: Skill decline 136 Investor risk skills 137 Investment management skills in the market 137 Hiring star managers and CEOs 138 Investment managers and governance 138 TLFeBOOK Contents ix Creating a winning fund management team 139 Building for investment resilience 140 Moving ahead from the investment herd 140 Recap on operational risk 141 9 The Basel II Banking Regulations 143 Current banking problems 143 Basel II – a brief overview 143 1 Pillar one: Capital requirements 144 2 Pillar two: Supervisory review 145 3 Pillar three: Market discipline 146 Cost-benefits under Basel II 146 Risk for financial institutions and insurance 148 The Basel II OpRisk principles 150 Loss database 151 Loss database drawbacks 152 Scenarios for Basel II OpRisk 154 Next steps: After Basel 154 10 Future-proofing against Risk 159 Moral hazard 159 Risk detection 160 Case study: Marconi 161 Risk countermeasures 163 Case study: The Yakuza and shareholder meetings 163 Risk firepower 164 Case study: Huntingdon Life Sciences (HLS) 164 Insurance: the buck used to stop here 166 Risk monitoring 167 Case study: WorldCom 168 Forensic accounting 169 Appropriate risk management structure 170 Case study: BCCI bank 171 Facts, not figures 174 New risk focus 175 11 Integrated Risk Management 177 Developments in the finance sector 177 Organic risk management 178 Separating reputation from risk management 180 Case study: Enron 181 Future for risk management 184 The case for organic risk management 184 Case study: Hunting for staff deceit 187 Unintentional (ostensibly) and legal 187 Intentional and illegal 189 The reigning investment ideology 189 TLFeBOOK x Contents 12 Summary and Conclusions 195 Summary of risk management 195 Identify stakeholders and interests 195 Match risk appetites 196 Match risk time horizons 197 Organic due diligence 198 Value for money 199 Reputation risk 199 The corporate governance model 200 Hitting back 200 Keep your eyes on the prize 201 Conclusions 203