Conflicts of Interest in Asset Management

Risk Assessment and Risk Appetite
 

As discussed in the previous blog “Topic 1 – Why does it matter?”, conflicts of interest are expected to exist in asset and wealth management. Very rarely can they be fully avoided.

To ensure the scarce control and mitigation resource is applied as effectively as possible, firms need to identify the material inherent risk and identify which existing or future controls are likely to keep or bring the firm’s risk exposure back to within the appetite for conflicts of interest risk.

This blog sets out some useful concepts on how to undertake such risk assessment and a viewpoint with examples on how to assess and articulate the appropriate risk appetite.
 

How to assess the Conflicts of Interest Risk
 

A key part of a firm’s overall risk assessment is the identification and assessment of all areas where conflicts of interest can arise. To assess the inherent risk level, it is important to understand the contributing factors to the conflicts risk, the likelihood of the risk and its potential impact on clients or the firm.

To assess the likelihood of a conflict of interest risk, it may be helpful to take into account factors of probability, such as:

To assess the impact of a conflict of interest risk, it may be useful to consider impact factors such as:

Based on the likelihood and impact of the assessed risk, a high inherent risk rating can be an indicator for inclusion of the conflict type in the firm’s risk appetite statement. While not all conflicts can be included in the risk appetite statement, high inherent conflict risks should be considered for inclusion.

A detailed risk assessment output supports the articulation of the firm’s qualitative and inherent risk appetite and informs the management’s decision on the acceptable level of risk after the application of mitigants and controls, the residual risk appetite level.
 

Articulating a Conflict of Interest Risk Appetite
 

Conflict of Interest Risk is typically a material risk within the risk profile of asset and wealth managers and should be part of the articulation of a risk appetite. The appetite expresses the amount of risk that a firm will accept in pursuit of its strategy and business plan and includes qualitative statements and quantitative measures. A firm-level top-down articulation by the Board or Senior Executive committee, based on the guidance of the Business and Risk or Compliance functions, should be supported by bottom-up quantitative business-level risk appetite articulation based on metrics. These metrics and their thresholds reflect the Business’ interpretation and reflection of the firm-level risk appetite.
 

1. Firm-Level Qualitative Conflicts of Interest Risk Appetite Statement

The firm-level or top-down view of risk appetite sets out the management’s expectations and provides guidance for the Business and staff to translate into their daily risk management activities. It should be supported by a bottom-up articulation from the Business to explain how the Business meets the expectations of adequate risk management to remain within the stated appetite.

A firm-level qualitative conflicts of interest risk appetite statement should make clear:

• the level of risk is acceptable in the ordinary conduct of business;
• when increased risk should be escalated for information; and
• when actions or decisions by management are required to be taken.

An example of a firm-level qualitative conflicts of interest risk appetite could be:

Since the types of conflicts vary with each business activity, it requires the management of the firm to underpin the firm-level risk appetite with the set of bottom-up metrics for each high-risk activity with a limit-based monitoring and reporting process.

2. Business-Level Quantitative Conflicts of Interest Risk Appetite

To ensure effective transposition and support of the firm-level conflicts risk appetite, the underlying business-level appetite framework should:

• Be set at a level to constrain risk-taking within risk appetite;
• Be established for each business activity that presents with material risk concentrations;
• Apply metrics that are actively used by the Business;
• Be monitored regularly and allow the measure of adherence to the firm-level risk appetite.

An example of a business-level qualitative conflicts of interest risk appetite could be:

Implementing and transposing a business-level qualitative risk appetite into a quantitative risk appetite based on measurable metrics is the next task for the business. Key to success is a clear understanding and articulation of the causes of this risk, the business activities and areas that generate this risk inherently and how this risk can be identified and controlled.

In most cases, the quantitative risk appetite is a combination of inherent risk, control breach or exception risk and of control performance risk metrics, which need to be combined to ensure all aspects of the risk emerging are captured.

The following is an example for the Side by Side conflict of interest risk type of a transposition of a qualitative business risk appetite into a set of quantitative metrics. For this example, the industry typically uses a combination of inherent risk metrics supported by performance, holding overlap and risk dispersion metrics to target the risk from a variety of angles:

3. Scorecard Approach to monitoring the Conflicts of Interest Risk

To monitor and manage the risk appetite effectively, capturing all aspects of each conflicts type sufficiently, a methodology for risk weighting and aggregation of the control metric values is needed.

This can be accomplished for example with a Scorecard approach, where each risk metric receives:

• A warning threshold (a limit for a metric that is meant to highlight an increase in the risk and/or to pre-empt a breach of a risk appetite), often reflected with an Amber risk rating status; and
• A breach threshold (a limit for a metric that when breached exceeds the risk appetite, calls for escalation and remediation and/or corrective action, often reflected with a Red risk rating status
• A metric weight, reflecting the stronger or weaker contribution of each control measure to the overall risk exposure, to allow the aggregation of the actual risk exposure and the comparison with the aggregated limit representing the risk appetite for each risk type. A metric weight also reflects that not all controls are equally contributing to the mitigation of the risk.

This approach is exemplified in the table below:

The aggregated and risk weighted limit and its individual metric components are established via back-testing of historic metric data to calibrate the quantitative risk appetite articulation and set an aggregated risk appetite limit.