Since the G30 report of 1994, white papers on risk management have rained out of the sky. Every conceivable authority has had some pronouncements to make: bankers, regulators, accounting firms. Everybody except institutional investors. This lacuna was corrected late in July when the ad hoc Risk Standards Working Group gave birth to proposed standards for use in the investment management process. A full text of the draft has been sent to 60 regulators, institutional investors, broker-dealers, academics and exchanges for comments and suggestions. After these comments are incorporated, a standard will be released to the public domain, with copies available via the Internet. The group consisted of thinkers from pension funds, insurance companies, foundations and endowments. Mutual funds did not participate.

Why have institutional investors been mum so long? One reason, to be sure, is that because they operate under ERISA or the Investment Advisor Act they are much less actively regulated than other financial institutions. Second, lacking a forum, many of the larger institutional investors quietly grappled with risk management issues on their own. Third, a sense of urgency didn't build until the respected Common Fund lost $138 million last year because of inadequate risk management. Capital Market Risk Advisors, which decided to be midwife to the collective effort, did much of the legwork and organization that made it possible.

Broad reach

Since the package is under wraps at press time, it's difficult to judge the contents, which cover 33 topics. But the Risk Standards Working Group makes no secret of its goals, agenda and the issues addressed. In a nutshell this is a much broader document on risk than its predecessors, because it reaches far beyond just derivatives to address all types of investment vehicles. It addresses risk from the perspectives of the fiduciary and oversight managers, regarding the monitoring of external managers, portfolio pricing and asset valuations. It is also very light on rules and dogmatic pronouncements. "We wanted to create a public domain document that investors could use as a benchmark, a goal, even a checklist if you will, to look at those risk exposures that came up on the radar screens of this group," says participant Christopher J. Campisano, manager of trust investments at Xerox. " A large part of my motivation was to go through the exercise of analysis with my peers."

Much of the material asks basic questions like: a) Do you have risk-adjusted performance measures and attribution analysis, or b) Do you have risk limits, stress testing and back-testing? or c) Have you considered model risk? The document also leaves no contingent risk exposure unexplored. "It is a bunch of risk-awareness tools rather than rules," says Jon Lukomnik, Deputy Comptroller of the City of New York. "I can tell you that we in New York City don't comply with all the guidelines, and I suspect no fund does. These are goals-I want to make that clear."

The group hopes that the document will educate and also make some aspects of derivatives and other risks more respectable. "Now institutional investors will have a document that they can take to their boards," says Richard Rose, chief investment officer at the San Diego County Employee Retirement Association. "We hope it will be the groundwork for generally accepted standards. After two to three years of two-inch headlines of horrific investment losses, my sense is that pension boards or committees have taken the approach that if anyone on the staff mentions derivatives they'll just go nuts. They'll say we can't afford that kind of publicity and so on. But having a set of risk standards that are embraced by other boards should raise their comfort levels. If we can show that controls are in place to prevent an Orange County, then the boards may listen to some of the more innovative things that the staff is proposing that could help add value to the fund."

Another of this document's possible social utilities: investors can use it as a weapon to control their independent managers. "As a result of greater awareness and consciousness on the part of the institutional investors it will be in the manager's best interest to address these standards," says James Seymour, vice president of The Common Fund. "This is putting notice out in the community that there is a large group of investors who feel that standards should be much more stringent and better defined."

Eternal fears

The initial meeting of the group dealt with a set of concerns regarding externally managed investment portfolios that were largely raised by Michael deMarco, director of risk management at GTE, whose pension fund is two thirds managed externally, and which had already been working on some guidelines for these managers' use of derivatives. "We make considerable use of derivatives internally and externally," he says. "The heightened level of public attention to derivatives and derivatives-based strategies raised the perception at GTE of the need for some more formal risk management process."

Subsequent meetings addressed the risk aspects of internally managed funds and then brainstormed into a wide range of contingencies from the fiduciary perspective. And some of the possibilities considered were relatively far out, like a manager's backup and disaster recovery plans. "Let's say I hire an equity manager in San Francisco," theorizes Campisano. "There is an earthquake. The manager comes to work next morning and the building is gone-no systems, no nothing-and by the way the market is down 150 points. So I'm exposed to a risk and I need to know before the event takes place that managers have disaster recovery plans that will allow them to continue to manage those assets."

Yet another risk contingency that the group discussed: securities lending. "There are many plan sponsors that engage in securities lending," Campisano continues. "For them the issue is how deeply should they look through the securities lending function and understand where the value-added is coming from. Is it from the ability to negotiate a superior rebate rate or from aggressively investing the underlying cash collateral? Investors need to drill down and study potential loss scenarios from securities lending and determine what risks are acceptable."

Local Govs Warned

Almost a year ago the Government Finance Officers Association (GFOA) tried to raise the alarms on derivatives-using state and local governments, which could be waiving some of their rights if they agreed to the voluntary guidelines in the New York Fed's "Principles and Practices for Wholesale Financial Transactions." The GFOA, along with the National Association of State Auditors, Comptrollers and Treasurers, plus the National Association of State Treasurers, warned that broker-dealers are under no obligation to tell customers if they followed the principles and practices or not, and that broker-dealers have no obligation to opine on the suitability of derivative or other investments.

Since then the GFOA has kept up the pressure on the broker-dealer community. It has published and sent out to state and local governments 2,000 copies of a sample investment policy statement, which has been of considerable influence in those states where legislatures have mandated investment policies-for example, Wisconsin, Texas, California, Ohio and, notably, Maryland. The GFOA is particularly keen to spread its own written version of ideal broker­dealer agreements, in part because of concern that sellers of derivatives could be framing these documents partly to nullify the effects of legislative toughening and in ways that country rubes might not catch.

Texas is a case in point. There broker-dealers are trying to float a standardized agreement that local governments can sign off on, claiming that they are acting pursuant to the tough restrictions imposed last February by the legislature. "The act, however, doesn't require it," notes Betsy Dotson, assistant director/legislative counsel of the GFOA's legislative arm. "We are concerned that in cases like Texas the standard agreement negotiated with the broker-dealer community may lead to public investors giving up more than they need to." Her warning to government end-users: "Don't sign off thinking that it is the same language as before. What the broker-dealer industry was not able to achieve legislatively, they will work to put into their version of standard documents."