Assessing the importance of liquidity and climate risk in an evolving risk landscape

In a Risk.net webinar sponsored by S&P Global Market Intelligence, five experts discussed the challenges that evolving risks pose and how the buy side is having to adapt its approach. This article examines the key themes that emerged from that discussion

For a whole generation of investment risk managers accustomed to low interest rates and low volatility, the current market environment presents completely new challenges in liquidity risk management. Alongside this, there is more pressure than ever from investors and regulators to design metrics and frameworks for climate risk modelling.
 

Drivers for change

The general consensus is that there is significant scope for active management to deliver substantial rewards in this environment. However, to optimise the chances of success, it is imperative that risk management processes are in lockstep with the investment approach. “The pressure on active management to really deliver during volatile times means risk management needs to be there every step of the way,” noted Luke Armstrong, head of buy‑side risk at S&P Global Market Intelligence.

From a risk perspective, asset managers need to be increasingly focused and specific in their risk assessments. This means risk teams need to continue analysing risk from a top-down perspective, but bottom-up risk is much more pertinent to identifying issuer-specific risk.

Indeed, the increased number of variables at play in this volatile environment means that, although there is a greater opportunity to make money, there is a greater chance of losing it. Yury Dubrovsky, chief risk officer at Lazard, said: “There are many more variables in the equation, not just interest rates, but each point in the curve. Understanding the market dynamics in this environment is becoming much more important.”

The potential for model risk is also a driver for change. Partly because of the volatile environment, and partly because of the impact the Covid-19 pandemic had on historical data inputs, investment and risk managers are also having to pay closer attention to their modelling approaches and how they interpret model outputs. Dubrovsky explained: “Models need inputs, and inputs rely on historical data. However, at the start of the pandemic, systematic investing patterns flipped. For example, investments in consumer staple stocks dropped and [demand for] exercise equipment boomed. The predictability of the models was immediately questioned. Now, investors and quant portfolio managers have to adjust for this by ignoring, in certain cases, the output or by fine-tuning the time period involved in the calculation.”

Finally, investment managers face growing pressures from the increased risks associated with climate change. The pressures are twofold. First, there are external pressures to satisfy growing regulatory and investor demand for enhanced reporting. Second, investment managers need access to high-quality data and established methodologies to model climate risk.

Titos Matsakos, director and product manager at S&P Global Market Intelligence, commented: “Externally, there is a fast-evolving regulatory landscape and investors who want to understand the exposure of their portfolios to climate risk. Internally, there are data challenges; we need new sources of high-quality data to measure climate risk. There is also a need for established industry methodologies to model and analyse climate risk.”
 

Liquidity risk management

Recent crises, such as the collapse of Silicon Valley Bank in the US and the liability‑driven investment (LDI) crisis in the UK, have shone the spotlight on liquidity risk management. The prevailing opinion was that the underlying drivers for these risk events, such as issues with asset-liability matching in the case of the LDI crisis, were not new to the industry. Rather, the issue is that institutions are operating in a substantially different environment and need to adapt their processes.

Ying Murdoch, head of fixed income risk at Columbia Threadneedle Investments, observed: “With the rapid rate moves and the high‑volatility environment, some of the practices that sustained institutions for decades when rates were nearly zero can no longer be used. An alarm is sounding for all risk managers, and those taking risks, to take an honest look at their practices, business activities and investment strategies in this new environment.”

The need to adapt practices is particularly important given the role social sentiment can play in liquidity risk. The failure of Credit Suisse is a case in point; the Swiss bank had strong Tier 1 capital, but was adversely affected by negative sentiment. In a similar vein, there is also the domino effect of social media to consider, where viral posts can play a role in the collapse of institutions. Considering the speed at which investors can withdraw and make redemptions, managing this social sentiment is critical.

Partly due to the speed of redemption, another concern of asset managers is managing the less liquid assets in their portfolios. Armstrong noted: “With low interest rates over the past 10–15 years, some asset managers have accumulated a significant amount of private assets. In this current environment, those illiquid assets are less attractive but, by definition, they are not as easily divested from a portfolio. Asset managers are going to be really tested on the liquidity of those assets and how they manage those going forward.”
 

Model risk management

The predictability of market and liquidity risk models has increasingly come under question since the pandemic, which brought about significant changes to data inputs. As a result, many portfolio managers and risk managers have had to adjust their approaches by either ignoring certain inputs, or fine‑tuning the time periods involved in their calculations.

Alongside this, the changing liquidity environment also raises the question of how to best manage liquidity models and risk management processes. “Investment managers need to consider whether the risk model provides the answers for the extreme risk or daily events they are trying to manage,” said Sudipto De, head of investment risk at Principle Asset Management. There are always limitations with any model, and it is critical that risk managers understand the underlying assumptions and what the model can and cannot predict.

Given this context, the ability to recalibrate models so they are reflective of the current environment is essential. Armstrong commented: “With the right technology, you can refine models so they are representative of the current environment. This is key to making sure you stay current with the volatility regime at play in the market.”
 

Climate risk

New and changing expectations are a key challenge for asset managers when it comes to climate risk. Matsakos commented: “Regulations are evolving quickly and investors have been demanding improved transparency on the climate credentials of portfolios for some time now. While simple scoring approaches have been sufficient to date, regulators and investors are starting to require more sophistication around the measurement of portfolio climate risk.”

One of the key regulatory challenges is the lack of alignment between jurisdictions in their approaches to climate risk. While there is some overlap, markets are moving at different speeds, but asset managers have a global footprint and need to satisfy these differing regulatory frameworks.

To add value from a climate risk perspective, risk managers also need to consider the approach to modelling climate risk, as it will likely become a new investment risk factor. However, before they can do this, there are challenges with data and analytics that need to be resolved. Matsakos explained: “With climate risk, risk managers are looking for solutions that can encompass all the relevant data to generate meaningful insights by providing bespoke climate risk scenarios.”

On the analytics side, the industry still needs to start identifying and measuring climate risk before it can truly manage it. Having a climate risk system integrated with a traditional market risk system enables risk managers to leverage standard stress-testing frameworks for scenario-driven and forward‑looking analysis, based on different climate scenarios.
 

Integrated risk management technology

The move to cloud-native technology has been one of the biggest shifts in risk management technology. A cloud-native approach provides risk managers with much greater flexibility around how work is performed. Armstrong said: “Cloud-native technology provides risk managers with the ability to scale up and down as required, and provides them with more intuitive access to data. They can slice and dice data in different ways and feed into different tools.”

Alongside the shift to the cloud, there is also a greater focus on integrating the different types of risk into a single platform that is also integrated with the front office and investment processes. This integrated approach is more important than ever, given the intertwined nature of many of the risks; it also enables investment managers to establish connections and correlations across their portfolios. Principle Asset Management’s De noted: “In the era of digital risk management, the emphasis is on dedicating more time to risk mitigation rather than identifying the source of risk. Having an integrated system offers a holistic view, streamlining the process of risk identification and allowing for a more focused approach to risk mitigation.”

This integrated approach doesn’t just stop with technology; it is also important to take a more cohesive approach with the company structure and risk teams. “When various teams operate in isolation, they function in silos. However, when risk teams collaborate across the organisation, they gain a more comprehensive understanding of the different risks within their portfolios,” noted Matsakos.
 

Conclusion

The shift in market conditions, the demands of climate change, the increasingly interconnected nature of risk and the significant advances in technology are pushing asset managers to rethink their approaches to risk management. Traditionally, firms have used a patchwork of solutions to manage risk but, today, a more integrated approach is called for. Integrated platforms covering a range of risks and asset classes, combined with a horizontal approach to risk management, will provide firms with a more holistic overview of their portfolios and the risks faced. The use of cloud-native technology will also play a vital role, providing firms with much-needed flexibility as they rethink their approaches to risk.

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