Presentatie: Non-Financial Risks: A focus on Operational Risk van Ben Gunnee. De presentatie is gegeven op 25 november 2010 op het Mercer Investment Consulting seminar.

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. 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
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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
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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
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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
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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
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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
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8. Operational Risk
Investment Managers and Custodians

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."
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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
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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. 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
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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
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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