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Uncalculated risks

Both institutional investors and companies often fail to make sense of geopolitical risk. Derek Leatherdale asks what ordinary investors should do about it
December 27, 2018Derek Leatherdale

International investment companies rely on predictability and certainty. But with global geopolitical volatility as high as at any point since the end of the Cold War, investment managers face enhanced risk to the profitability of their own companies, and from the companies in which they invest.

Risk now comes from the politics of Western markets, while the underpinnings of geopolitical stability across Asia are slowly – perhaps imperceptibly to some – coming unstuck. Deteriorating US-China economic relations are plain to see, but confrontation could also come from elevated naval activity in the East and South China Seas.

And to the list of risk issues in the Middle East, that hardy perennial of geopolitical concern, we can now add a deepening regional sectarian stand-off, and fresh question marks over Saudi stability as Riyadh’s well-meaning, but ultimately untested, socio-economic reform experiment gathers pace.  

Investors clearly know this. Surveys consistently show geopolitical issues high on the agenda for management teams in the financial sector, presumably because they know that risks of this kind can lead to potentially sharp negative market impacts with little or no notice.

But global companies could do far more to protect the value of assets, investments and underlying business models. Investment managers could also do more to ensure the companies in which they invest are managing this complex risk-type risk as effectively as possible.

Not only is it prudent to do so, but regulators expect it. Some rule books explicitly require companies to account for geopolitical issues in their capital adequacy and business risk process. In failing to keep up, investment managers therefore put themselves on the wrong side of regulatory expectations.

 

Room for improvement

It would seem uncontroversial to assume global investment companies responsible for trillions of dollars of client money strive to the best possible understanding and risk management of geopolitical uncertainty.

But this is not happening. Too often, even where investment companies consider political risk in a formal setting, their identification and monitoring of key risks are amateur. And frequently it is economists or accountants within investment companies who make judgments on political risk, based on little more than that morning’s newswires or the public statements of governments.

A typical company’s structure also gets in the way. Political risks are routinely approached through the prism of individual risk-management silos, often as line-items in the data-centric quant models used variously by a company’s country, sovereign or market risk teams, drawing on uncoordinated inputs from an inchoate and costly mix of ultimately unaccountable political consultancies. The bigger the company, generally speaking, the worse the corresponding inconsistency.

Geopolitical issues are also frequently hived off into a company’s operational risk function, on the basis that they are external. This is unhelpful and assumes that geopolitical issues do not track through into asset values, or the capital and liquidity positions of companies, and can therefore be conveniently labelled as ‘non-financial’ risk.

What does this mean in practice? I have heard of examples of group risk committees receiving one advisory paper that says risk limits within and across regional equity and bond funds should be relaxed because the country risk model’s political risk score has stabilised, while receiving other advice that geopolitical issues in the region mean a capital and liquidity risk review is needed.

Either assessment might be accurate, but they cannot both be right. Neither do they add up to the consistent and coherent risk assessment approach expected by regulators. Without a common view of risk a company cannot, by definition, undertake enterprise-wide risk management.

 

Doing better

Investment managers favour quantitative risk measurement. As a result, they often struggle with risks that defy numerical categorisation.

But this need not be hard, and with the increasing deployment of stress-testing and reverse stress-testing in recent years, investment companies have tools at their disposal. The Basel Committee on Banking Standards’ Stress-Testing Principles, while focused on banking, nevertheless point the way to the widening of test scenarios for the whole financial sector.

Nor does the challenge for companies lie in an absence of advice about the external political environment. Political risk consultancies have multiplied, vying to explain why they read geopolitics better than their competitors. Ex-diplomats and finance ministry officials also cluster around the finance sector, mistakenly assuming that the geopolitical preoccupations of their former employers automatically carry over into global finance.

In fact, the greater challenge for large investment managers is how to manage, identify and monitor multi-faceted risks that do not fit neatly within any one silo. The solution lies in improving internal risk/impact assessment processes, driven by properly professional risk monitoring, and overseen by robust governance at the top of the company.

 

Investor due diligence

Managing geopolitical uncertainty is not just important for fund managers’ own risk management; it is of upmost importance when investing client money in companies, industries and regions.

Company reporting requirements mean this is easier in respect of a company’s financial performance. But understanding a company’s approach to tackling other types of risks, including geopolitical uncertainty, is much harder.

Look at a recent annual report of almost any multinational company, and you will see some reference to a senior management which “recognises geopolitical uncertainty has substantially increased”. This is normally accompanied by the claim that a company’s “risk management committee is satisfied risks are sufficiently mitigated and do not represent a threat to the viability of the company”.

Statements like this essentially mean investors have to take on trust that the company in question has kept up with increased geopolitical uncertainty. There is no real way of knowing more, unless investors ask probing questions.

What should they ask? For starters, investors could (and should) ask what procedures and policies a company has in place for effective management of political and geopolitical risk exposures, and how these have been updated and refined as uncertainty has increased in recent years.

Investors could also ask whether companies undertake regular enterprise-wide risk assessments, and how further work to identify possible impacts of risk scenarios is undertaken. They could ask who at the board or executive level is responsible for overseeing the company’s work on political risk, or whether the company maintains a professional capacity to monitor geopolitical issues.

Questions like this are not unprecedented. Investors routinely interrogate companies on environmental, social and governance issues. Multinationals are also under pressure to explain what safeguards they apply to lobbying activity, while investor groups have also previously urged the EU and US to incorporate geopolitical risk exposure into company reporting requirements.

The world’s biggest investment companies manage systemically significant amounts of money. In an era of enhanced geopolitical uncertainty, they should be upgrading their approaches, both in their own risk management and in their investment counter-party due diligence process. Not doing so puts them on the wrong side of regulatory expectations. But it also leaves companies exposed to a risk type that is becoming more unpredictable, not less. Both institutional and ordinary investors should be doing more in response.

Derek Leatherdale is managing director and founder of GRI Strategies, which works with financial institutions to improve their management of complex political and geopolitical risk. Prior to this, he founded and ran HSBC’s Geopolitical Risk function.