FSA: Firms Must Retain Investor Confidence
February 11, 2008
The U.K.'s Financial Services Authority (FSA) on Jan. 29 released its Financial Risk Outlook--a yearly look at industry developments that the agency sees as risks to its regulatory objectives. The 2008 outlook was significantly less rosy than last year's report, which spoke of "continued stability." The FSA noted that "financial market conditions deteriorated considerably in 2007 as investors reassessed risks in their portfolios," adding that "these conditions will persist, particularly if investor confidence in some markets and financial institutions remains low."
The study added, however, that firms "must not divert attention away from focusing on conduct-of-business requirements" and will need to "ensure they treat customers fairly, continue to tackle market abuse and other areas of financial crime, and address other conduct-of-business requirements." FSA head Callum McCarthy, who called the outlook "a prudent attempt to highlight the risks that could impact consumers and firms in a less benign economy," noted that "firms and consumers need to recognize there are both short- and long-term risks and should think about the implications." Excerpted here are sections of the report on asset management and capital markets.
Recent financial market events have focused attention on asset managers' resources to value and trade the increasingly complex range of instruments in use, as well as the back- and middle-office support available to process them. The market dislocation of the second half of 2007 also highlighted the importance of asset managers understanding how their portfolios could behave under stressed scenarios.
Over the past year, the asset management industry has seen continued evolution and innovation in products across both retail and institutional markets. A trend has emerged of traditional asset managers introducing alternative investment products into their offerings. Some alternative managers have also sought to emulate the traditional business model through actions such as listing their management company on global exchanges. Asset managers have continued to face tough competition for high-quality staff from other market participants, including hedge funds and investment banks.
Recent market events have highlighted the shortcomings of many investment banks' ability to value illiquid and complex instruments such as asset-backed securities (ABS). Asset managers have relatively fewer resources to value these instruments in-house and could be over-reliant on third-party or counterparty valuations.
In such cases, there is a risk that they do not have the ability to value and trade a portfolio, which could result in the unfair treatment of consumers, and reduced consumer confidence. While recent market events have highlighted the ABS sector, other assets such as property, private equity and venture capital trusts could pose similar illiquidity and complexity issues.
The increasing use of derivatives by asset managers poses a range of risks. There is a risk that managers could start using derivatives before appropriate middle- and back-office systems and controls for the risk management and compliance monitoring of these are developed. An increasing number of fixed-income managers, for example, are using credit default swaps in corporate bond-style strategies, but the systems and controls needed to trade, value and book credit default swaps can be very different from those used for corporate bonds and managers therefore need to be adequately resourced.
There is also a risk of asset managers and clients not being sufficiently aware of how using derivatives changes the risk characteristics of their portfolios. For example, derivatives introduce implicit leverage into portfolios, something which needs to be monitored against mandate restrictions, such as client risk tolerance. Using over-the-counter derivatives also introduces the need to manage counterparty risk through suitable collateralization arrangements.
