The new Risk Standards Working Group's recommendations are so ambitious, even proponents worry few will comply

By John Thackray

The Risk Standards Working Group (RSWG) road show had its closing performance in New York in mid-December 1996, after earlier appearances in Los Angeles, San Franscisco and Chicago. The message of this ad hoc group, architects of the first risk standards for institutional managers and investors, seemed to be that this was but a small acorn that will take years to become an oak. To be sure, this is also true of other, earlier risk management frameworks. "It is three years since the emergence of the G30 framework," said Tanya Styblo Beder of Capital Market Risk Advisors, midwives to the working group, "and there is still not compliance across the board."

The RSWG's proposal is packed with ambitious precepts and goals, and embraces far more risk than those posed by derivatives. The dozen- member working group studied the G30 and other frameworks like Principles and Practices, then filled in the gaps. "And believe me there were many gaps," said Suzanne Brenner, associate director of investments for the Rockefeller Foundation. However, the group strove to keep RSWG to a modest 30 pages. It could have easily swollen to three and four times that size. One of the comment letters that it received was a massive 60 pages.

Risk galaxy

The RSWG stressed the ubiquity of risk to the 100 or so members of the New York audience. Indeed, one of the more dramatic slides showed a "galaxy" of some 30 different categories of risk. They computed that the total losses suffered by public and private funds from derivatives since the mid-1980s are in the $6 billion range, principally from structured and stripped CMOs and structured derivatives. In most of these cases, the group pointed out, the risk controls that were in place failed utterly. One common type of rule focuses on credit quality, prohibiting investments that are less than AAA and are restricted to two-year maturities-all criteria that were observed by Orange County. Other forms of traditional risk controls (like no commodities, or no speculation) are equally dysfunctional, RSWG said.

Perhaps the greatest area of cultural lag singled out by some members of the RSWG panel is the lack of analysis by institutional investors of the different sources of outperformance. Yet another rarity is risk-adjusted manager compensation. Ontario Teachers is reportedly one of the few institutional investors with a comprehensive system that uses risk-based evaluation for both performance and compensation of managers.

Hard to swallow

The ultimate impact of the RSWG's effort is a little hard to estimate. There seemed to be an undercurrent of pessimism among the presenters. It is as if they believed the medicine they were offering would not be taken any time soon, at least not by a large population of institutional investors. As James Seymour of The Common Fund noted, many investors make all kinds of judgements about a manager's performance, style and personnel, but fail to look closely at the internal control. In part this is because of costs. "There is a lot of talk, but very little is being done," Seymour added, "because it is a big job. It is expensive to hire people. It is also difficult to hire independent risk oversight experts and to educate your staff and the fiduciaries."

"What will people do with these standards?" asked Maarten Nederlof of Capital Market Risk Advisors. One answer from the panel: They will act as a tool to help investors and managers with self-assessments on risk. Another point is that they will probably spur a few more managers and custodians to get out front and use risk management capabilities as a competitive weapon. But adoption of all the RSWG's recommendations is not something that institutional investors are likely to do en masse. And the few who go down this path will find it hard slow work. Said Nederlof: "There is no way that you can adopt these standards in, say, 12 months without missing a deadline or two." (The full RSWG document is downloadable at http://www.cmra.com or http://www.gte.com)