But how could a mid-sized asset manager compete against a large international bank? How on earth could he manage risks better than a bank with far more resources? Well-run institutions, such as Citi, have access to strong teams analysing, documenting, assessing legal implications, approving and following-up each process. As a result, they thoroughly understand their customer needs, as well as the different characteristics of each market in which they operate.
From a regulator’s perspective, the potential failure of a bank is something to be dreaded; the central banker must therefore protect the depositors base (and particularly the retail clients), so he is literally forced to impose heavy capital requirements. However, a fund that is targeting “well-informed” investors, unless it is large enough to be considered “systemically important” by the regulating authorities, can often fly below the radar. Of course, the investors who do care for their each and every penny, this is an entirely different story…
Indeed, it is very difficult for a mid-sized asset manager to reach the level of control we typically find in a well-run bank, so the number of things that could go wrong or simply get unnoticed until it is too late, is significantly higher. Lending money, if based on an ad-hoc pursue of opportunities in different countries and sectors, can definitely become a very perilous line of business. Asset managers need, therefore, to limit their risk-taking activities to businesses they can control better, such as:
- Lending to a large number of obligors, so that the laws of large numbers prevail. For mid-sized funds this can only be achieved by investing in large pools, such as those offered by the US LendingClub.
- Lending to well-defined and controlled businesses, such as structured commodity trade finance, which can be “commoditized” if run properly.
Asset managers can -and by all means should- exploit the tools banks are using for managing risks, even if this is not yet a regulatory requirement for them. For example, they should:
- Develop internal models allowing them to segregate their portfolios in clusters of various credit quality levels
- Estimate default probabilities (PD) and loss-given-default (LGD) parameters for various types of obligors and transactions.
- Estimate the expected and potentially unexpected loss, i.e. the provisions and the capital that should have been set aside, should the exposure be undertaken by a bank.
- Run regular stress tests, as those of EBA, FCA and other banking authorities.
Let’s just hope that asset managers will be more creative and thorough in their quest for proper risk management, so as to avoid the pitfalls that banks have fallen into over the last decade…
