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Volume 18 No. 3 Winter 2015

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T

he Journal of Wealth M

anagement

Winter 2

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5, Volum

e 18

, No. 3

Risk Management and Monitoring in Private BankingRONALD JANSSEN AND BERT KRAMER

RISK MANAGEMENT AND MONITORING IN PRIVATE BANKING WINTER 2015

Risk Management and Monitoring in Private BankingRONALD JANSSEN AND BERT KRAMER

RONALD JANSSEN

is head of the private wealth management department at Ortec Finance in Rotterdam, The [email protected]

BERT KRAMER

is a senior consultant in insurance risk management at Ortec Finance in Rot-terdam, The [email protected]

Potential clients in private banking have more and more questions and want to be better informed with respect to private banking’s expected

risk, return, and costs. In 2012, the European Securities and Markets Authority (ESMA) published guidelines on aspects of the Markets in Financial Instruments Directive’s (MiFID’s) suitability requirements, risk management, and risk and return (ESMA [2012]). These ESMA guidelines and the increased demand for transparency from (potential) clients have implications for private wealth managers, not only for the initial (investment) advice to the client but also during follow-up and moni-toring. Private wealth managers should give more and better insight into risks, and they should have a well-founded risk management process in place.

Among other things, the MiFID suit-ability requirement guidelines state that advisors should ensure that any invest-ment product recommended is suitable for their client. Advisors should have in place appropriate arrangements for meeting the suitability requirements on an ongoing and consistent basis for any client, including retail clients. Advisors also must obtain the neces-sary information to understand the essential client-specific facts to be able to assess the suit-ability of any investment for that client. That is, they must consider the client’s objectives, financial situation (ability to take risk), risk

tolerance (willingness to take risk), knowl-edge, and experience. Assessing suitability is necessary to act in the client’s best interest and to manage expectations in the best way. Finally, advisors should have access to ade-quate and up-to-date information about the client at any given moment. To realize this goal, the advisor should adopt procedures to regularly update this information; in other words, the advisor should monitor progress with respect to the client’s objectives and his or her financial situation.

In 2011, the Netherlands Authority for the Financial Markets (AFM) and the U.K. Financial Services Authority (FSA) performed exploratory investigations into a large number of (banking) investment firms concerning the quality of investment advice and wealth management they provide. From the results, both the FSA and the AFM con-cluded that there is room for improvement. Areas requiring special attention are the lack of insight into the client’s situation and goals, the Know Your Customer rules (AFM [2011]), and the difference between willing-ness and ability to take risk (FSA [2011]). In 2014, the AFM concluded that for the majority of investment firms and banks, the quality of proffered advice still needs to be improved (AFM [2014]).

The investigations by the AFM and the FSA show that the current focus of expertise at many investment firms lies primarily with

JWM- JANSSEN.indd 8 10/17/15 10:15:20 AM

THE JOURNAL OF WEALTH MANAGEMENT WINTER 2015

investment products and not with client needs. This lack of a sense of fiduciary responsibility is a crucial issue that should be addressed. Investment firms’ focus should be on getting to know the client well, acting in the best interest of the client, and properly informing the client. In our opinion, a goals-based approach is important to ensure that investment risks are appropriately calibrated to meet various client needs over various time horizons with various required probabilities of success.

ESMA emphasizes the need for suitable invest-ment solutions. The client’s objectives must be central when issuing advice. At a later stage, as well, it is impor-tant that progress with respect to goals is monitored. Thus, the focus should be on both the intake and the monitoring phases. This implies that an active policy is needed to achieve the client’s goals. In employing an active policy, the advisor ensures that at all times the investment portfolio is suitable for

• the changing economic environment• the client’s situation• the client’s goals, and• the (maximum) risk he or she is willing and able

to accept.

To meet MiFID guidelines, we believe quantita-tive (Monte Carlo) scenario analysis is required. This method enables the advisor and the client to measure and monitor the attainability of the client’s f inancial goals. However, in 2010 only 25% of European private wealth managers applied quantitative scenario analysis to assess the robustness of asset allocations (Amenc et al. [2010]). Fifty-six percent of wealth managers base asset allocation on scenario analysis using qualitative scenarios (such as “recession” or “high inf lation”), and 43% use stress scenarios to test the inf luence of very negative and extreme, but plausible, market conditions on the value of the investment portfolio (Amenc et al. [2010, p. 51]). According to Amenc et al. [2010], only quantitative models that rely on Monte Carlo simulations to estimate the expected stochastic path of portfolio returns make it possible to generate a wide range of continuous sce-narios in a systematic manner. In general, these stochastic models—if fed with sensible parameters—should provide the most accurate results. Stochastic scenarios can be used to establish how much risk a client is able to bear.

Another interesting f inding from Amenc et al. [2010, p. 71] is that—according to their survey respon-

dents—the two most important areas the private wealth management profession needs to improve over the next few years are “taking into account risk and investment horizon preferences” and “customized risk management across client objectives.” So, according to the respon-dents, private wealth advisors should better take into account the client’s risk profile and goals, and risk man-agement should be improved.

In this article, we describe how risk management can be improved, taking into account different client objectives and risk and investment horizon preferences. The general structure of the risk management process we propose closely follows the general literature in this field. As far as we know, our article provides the first descrip-tion of how the different stages of this general risk man-agement process can be applied to the advisory process in private banking. Special attention will be paid to the monitoring phase because an adequate implementation of a monitoring system is key to ensuring that the suitability requirements are met on an ongoing and consistent basis for different service channels and client segments.

The remainder of this article is organized as fol-lows: in the next section we will describe the risk management process and its main components. In the sections thereafter, we will focus on two aspects of the monitoring phase of the risk management process: mon-itoring implementation risk and monitoring the risk of not reaching goals.

THE RISK MANAGEMENT PROCESS

According to ESMA, advisors should have in place appropriate arrangements to be able to meet the suit-ability requirements on an ongoing and consistent basis for any client. Advisors should acquire adequate and up-to-date information on the client and adopt procedures to regularly update this information to monitor the development of wealth and income over time, including the attainability of financial goals. Monitoring develop-ments and progress over time is an integral part of the standard risk management process that all private wealth advisors should have in place, but risk management in private wealth advice does not stop at monitoring progress over time. In this section, we will describe the highlights of a risk management process that can be used to meet regulatory requirements. In the following sections, we will focus on the monitoring stage of this risk management process.



The risk management process and the methodology used herein should be consistent for all clients, irrespec-tive of the service channel used (execution only, advice, or discretionary management) or the client segment (retail, mass aff luent, high-net-worth individual, or ultra-high-net-worth individual). Furthermore, it is important that risk management not only focus on risks to avoid (the non-rewarded risks), but also on risks that are deliberately taken to realize the goals of the client (the rewarded risks).

There is much literature on risk management in general and how a risk management process should be structured (see, for example, Chapman [2011]). The general outline of the risk management process as shown in Exhibit 1 is very similar to other applications. Like Chapman [2011] and others, we see the stages in the risk management process as incremental phases of an iterative process. As far as we know, our article contains the first description of how the different stages of the risk management process can be applied to the advisory process in private banking.

The First Stage: Goals and Risk Attitude

Ideally, every financial decision consists of carefully establishing a strategy with an explicit risk–return

trade-off, making sure the implementation is in line with this strategy. The risk management process starts with establishing the client’s relevant context; that is, determining the objectives (goals) and risk profile (attitude) of the client. First, the client should set real-istic goals, taking into account his or her willingness and ability to take risk (see also Janssen, Kramer, and Boender [2013]).

Most currently used questionnaires do not suffice to determine the client’s goals. Often, the client can only f ill in one goal, when in fact most clients have multiple goals (see also Nevins [2004]; Chhabra [2005]; Brunel [2003, 2011]; and Das et al. [2010, 2011]). The possibility of multiple client goals should be taken into account during the intake. Furthermore, goals should be made concrete, and the investment horizon of the client should be made explicit; that is, what amount (real or nominal) is required at what point in time. Depending on the client’s goals, it might be necessary or useful to divide the investment horizon into the investment horizon for the accumulation phase (for instance, 10 years—from the current age a 55-year-old client to the retirement age of 65) and the horizon for the decumula-tion phase (for instance, 20 years, from the age of 65 to the age of 85). In other cases, one investment horizon of, for example, 30 years can be used, and an investment solution can be based on a dynamic life cycle scheme.

Most currently used questionnaires also do not suff ice to determine the client’s risk tolerance. The behavioral finance literature can help to improve ques-tionnaires with respect to this aspect (see, for instance, Pompian and Longo [2004]).

The Second Stage: Risk Identification

The second stage of the risk management process involves identifying (potential) risks. In this risk identi-fication stage, three levels can be distinguished:

1. the company level2. the product level3. the client level.

Risks on the company level. Examples of risks on the company level include whether

• different advisors within the same company use the same economic view (the same return and risk

E X H I B I T 1The Risk Management Process in Private Banking



expectations determined by the strategic invest-ment department)

• different advisors are consistent in their advice and how they apply the risk management process

• the client (risk) profile is adequately matched to the strategic asset allocation

• the actual portfolio adequately matches the stra-tegic asset allocation or risk profile of the client

• the suitability of the advice is adequately tested and monitored over time

• communication with the client is effective and sufficient

• there is a consistent process, enabling different advisors to produce the same risk profile for a client.

To minimize the company level risks, it is impor-tant to standardize procedures in the advisory process and to use standard information documents. However, it is also essential to customize the advice to individual client’s situations instead of using a standard question-naire. Tools can help obtain and utilize the necessary information with respect to the client and support the advisor when informing the client. For instance, an advisor can use visual aids to indicate the consequences of specific choices for the client. Finally, it is important to ensure that the suitability of the advice is adequately monitored over time and that the process automatically signals when a client needs attention.

Risks on the product level. Examples of risks on the product level are market risk, the risk of (insufficient) diversification (or concentration risk), and implementation risk. Investors deliberately take market risk, with the intent to achieve positive returns or better returns compared with a benchmark. Concentration risk, in contrast, is not expected to be rewarded. After all, a portfolio that is well distributed across various countries, sectors, and issuers is less sensitive to a particular risk and there is, therefore, little reason for the market to pay a premium to investors running this risk. Implementation risk is the risk that the risk of the actual portfolio diverges too greatly from the risk of the strategic asset allocation or risk profile of the client. How to measure and monitor implementation risk will be further discussed in a later section.

Risks on the client level. Finally, an example of risk on the client level is the risk of not reaching specific goals: for example, insufficient income during retirement, not maintaining the asset value corrected for

price inf lation and taxes, longevity risk, and inf lation risk. How to measure and monitor the risk of not reaching goals will be dealt with in a separate section.

In general, clients are mainly interested in the growth of their purchasing power and in the real return on their investments rather than in the nominal return. Longevity risk involves considering whether the client will outlive his or her funds: Will the return on the investment portfolio be sufficient given the uncertain remaining lifetime of the client?

According to a survey of aff luent Americans, ensuring that their assets will last a lifetime is a key con-cern for 68% of those surveyed (Merrill Lynch [2012]). Longevity risk can be insured by buying an annuity (for instance, starting at retirement age). By guaranteeing a fixed or variable stream of cash f low for the entire life-time of the investor in exchange for a fixed up-front pre-mium, annuities act as an effective hedging strategy for longevity risk (Chhabra [2005]). Of course, insurers will require compensation for taking over longevity risk, and clients run a significant interest rate risk at the moment the annuity is purchased. Advisors can help clients in making the right choice, for example, by showing how long the clients’ funds will last given a certain prob-ability level for different investment solutions. Clients with their own investment portfolio should weigh the pros and cons of buying an annuity (now or at a later stage, depending on the level of the interest rate, using only part of or all of the built-up funds) or keeping the investment portfolio and slowly withdrawing funds from this portfolio (see also Vernon [2014]). See Exhibit 2 for an illustrative example of how longevity risk can be presented for different investment solutions.

Exhibit 2 shows until what age different invest-ment solutions are expected to last given a specif ic probability level. The client must choose between the defensive portfolio, with minimum longevity risk and a higher expected return, and the balanced portfolio, which is in line with the risk profile of the client.

The Third Stage: Risk Measurement

Risk identification is followed by risk measurement and risk analysis, the third stage of the risk management process. The return on an investment portfolio is uncer-tain: It depends on the client’s choices (such as strategic asset allocation) and external factors (such as asset class returns, price inf lation, and interest rates). Reported risk



measures should be linked to the client’s goals. After all, what people want most is not to beat some market bench-mark or to outperform their peers; what they find most important is to achieve their personal goals (Laster, Suri, and Vrdoljak [2013]). Das et al. [2010, 2011] also state that risk should not be defined as the standard deviation of return but as the probability of not achieving goals, which is the way that most people intuitively define risk.

Worldwide, scenario analysis is gaining ground as the preferred method of gaining insight into the risk and return of investments. In some countries, it has reached a level of acceptance that has led regulatory bodies to include it in their framework. The Dutch regulator (AFM), for example, has defined use of scenario analysis as a best practice. Sce-nario analysis can be used as a basis for the creation and selection of investment strategies focused on maximizing the probability of reaching the client-specific goals.

Clients have goals on different horizons, so it is important to match scenario characteristics with different investment horizons. Long-horizon scenarios are needed for initial advice, when a strategic asset allocation is set that best suits the long-term goals of the client. During the monitoring phase, it can be necessary to also look at the short-term attainability of certain goals, which requires scenarios with a short horizon, potentially at a higher frequency. It is essential that a consistent scenario set is used for both the initial advice and the monitoring phase: For the same horizon, scenario characteristics

should be the same irrespective of the application (initial advice, implementation of the advice into the actual port-folio, and monitoring). Realistic and plausible scenarios are required for developing strategies to meet long-, medium-, and short-term goals, as well as for monitoring and managing the risk of the selected strategies against the original goals. Realistic and plausible scenarios include, among others, realistic growth paths from the current situation to long-term averages (see Janssen, Kramer, and Boender [2013] and Steehouwer [2010] for how scenarios can be generated that contain all the real-world features and dynamics that are relevant for the client to measure and monitor the risk of not reaching goals and that are consistent for both long and short horizons).

In contrast to analyses based on a limited number of (qualitative or stress) scenarios, methods based on Monte Carlo scenario analysis enable us to answer ques-tions like the following:

• Given an investment strategy, what is the prob-ability of the client reaching his or her goal?

• What is the maximum shortfall relative to the target?

• Which investment strategy minimizes the max-imum shortfall on different investment horizons?

• Which investment strategy best f its the client’s goals and the client’s willingness and ability to meet a loss?

E X H I B I T 2Longevity Risk—Advice and Insight in Different Investment Solutions



• How much do we have to change the deposit, the risk of the portfolio, or the goal to obtain an acceptable probability of reaching the goal?

After the relevant risks are measured and analyzed, they can be evaluated by the client and a well-funded choice can be made.

The Final Stage: Monitoring

The final stage of the risk management process is the monitoring phase. After the advice has been given and the investment portfolio has been implemented, the advisor should monitor the strategy and implementa-tion. The advisor should react and proactively advise when goals are no longer realistically attainable and adjustments should be made. For example, when a new financial crisis emerges, it is important for the advisor to know which clients to contact first; these would be the clients who would have problems with realizing certain goals as a result and would need advice on pos-sible solutions or measures. It is also important to know which client goals are primarily at stake and whether potentially affected goals are the client’s most important goal or simply minor ones; for example, clients usually have more difficulties in dealing with insufficient pen-sion income than with transferring less wealth to their children.

Monitoring also involves checking whether the strategic asset allocation is still in line with the cli-ent’s risk profile and whether the current portfolio is still in line with the strategic asset allocation. Alterna-tively, monitoring can involve a regular check regarding whether the current portfolio is still in line with the risk profile of the client. In the latter case, strategic asset allocation is only used in the initial advice to set the acceptable bandwidth for risk (the standard deviation) and to construct the initial investment portfolio.

Adjustments can be related to all aspects of the advice, such as a change in the investment policy, the contributions or withdrawals, the retirement age, etc. If the actual realization differs too much from the initial expectation, it might be necessary to start all over again with a new plan and new advice, reconsidering the cli-ent’s goals and risk attitude.

The following sections will discuss how imple-mentation risk and the risk of not reaching goals can be measured and monitored.

Measuring and Monitoring Implementation Risk

Implementation risk—the risk that the risk of the actual portfolio diverges too much from the risk of the strategic asset allocation or risk profile of the client—can be determined based on either ex post data (realized returns) or ex ante data (simulated future scenarios). The guidelines for calculating the risk indicator in the Key Investor Information Document set out by the Com-mittee of European Securities Regulators (CESR) are based on ex post risk measurement (CESR [2010]). However, we advise ex ante risk measurement, as port-folio risk can vary over time, and therefore ex post risk indicators are not always good indicators for the risk that can be expected over the remaining investment horizon.

In monitoring the implementation of the strategy, we look at both short- and long-term developments. By long term, we mean a period of three years or longer, and by short term, we mean merely one month. The actual portfolio is modeled by starting at the individual positions in the portfolio and mapping them to several hundred risk categories (factors or sub asset classes), which serve as input for the simulation. When the factors and sub asset classes used for the mapping are properly defined, the risk of the collection of these classes should be representative of the risk of the actual portfolio.

The goal of monitoring implementation risk is to test, on a regular basis, whether the actual portfolio still sufficiently matches the strategic allocation and risk pro-file of the client and whether the ex ante standard devia-tion of the actual portfolio still sufficiently matches the ex ante standard deviation of the strategic asset alloca-tion. To test the latter, we use critical values of the F-test to set the acceptable range around the standard deviation of the strategic asset allocation. We call this acceptable range the risk budget. See Exhibit 3 for the steps to be taken in the implementation risk monitoring process.

Graphs can be very helpful by providing a quick visual overview of which aspects meet the client’s requirements and which do not. See Exhibits 4 and 5 for an example.

First signal: the risk of the portfolio is not in line in Exhibit 4. From Exhibit 5, it is clear that the extra risk is caused by the asset-category equity. The left side of the graph shows the traditional way of monitoring the portfolio: by gauging whether the percentage of equity



E X H I B I T 3Steps in the Implementation Risk Monitoring Process

E X H I B I T 4Visual Overview of Implementation Risk Monitoring Results—I

Note: The risk of the portfolio is not in line in Exhibit 4.

E X H I B I T 5Visual overview of Implementation Risk Monitoring Results—II

Note: The left panel shows the relative allocation and the right panel shows the standard deviation.



is within the bandwidth (independent of what kind of equities; e.g., an equity fund or a single company like Apple). The right side shows the risk, standard deviation in this case, of the portfolio. Implementation risk moni-toring involves checking whether the actual allocation is within the acceptable area (left panel) and also whether the actual standard deviation is within the risk budget of the strategic asset allocation (right panel). If it is,a positive signal can be transmitted; if it is not, a warning should be transmitted. In the latter case, the actual port-folio will have to be adjusted.

Measuring and Monitoring the Risk of not Reaching Goals

Measuring and monitoring the risk of not reaching goals is the last stage in the risk management process. The advisor should take great care in monitoring the attainability of the client’s goals over time. This also implies that the advisor regularly contacts each indi-vidual client to verify that his or her financial situation and goals are unchanged.

Scenario analysis can be used at a client level both for the initial advice and to monitor the risk of not reaching the goals over time. Exhibit 6 gives an example of how scenario analysis results for different invest-ment strategies could be summarized in a graph. The uncertainty of the investment performance (in this case measured as the standard deviation) is on the horizontal axis. The client’s willingness to take risk determines the maximum uncertainty allowed. The probability that the goals can be achieved is on the vertical axis. The ability of the client to take risk is measured here as the minimum acceptable probability of achieving the goals. Acceptable strategies are in the top left corner.

In the initial advice, graphs like these can be used to determine optimal strategic asset allocation; this would be the asset mix that maximizes the probability that goals are reached given the client’s willingness to take risk (restriction). If there is no acceptable strategy, the advisor and the client should reconsider the input (goals, contributions and withdrawals, retirement age, etc.). During the monitoring phase, graphs like these can be used to check whether the client is still on track

E X H I B I T 6Probability of Achieving the Goals



and whether the current strategic asset allocation is still optimal. It is a way to continuously monitor the suitability of the solution.

When a wealth manager has a large number of clients and wants to monitor progress on a frequent basis, at least part of the monitoring process should be auto-mated to be able to exercise duty of care, especially in the retail and mass aff luent segments. For instance, alerts for client accounts can be generated based on criteria like the current probability of reaching goals, the remaining investment horizon, or the assets under management. Clients with the lowest probability of reaching their goals or those with the shortest remaining investment horizon can then be contacted with priority. This allows the advisor to analyze possible areas for amending advice to improve the probability of achieving goals.

SUMMARY AND CONCLUSIONS

Current and planned European regulatory suitability requirements for private wealth service pro-viders and the increased demand for transparency from potential clients require a solid, well-founded risk man-agement process. This process should not only focus on the initial advice given to clients (including determining the goals and risk attitude of clients and identifying and measuring the relevant risks). Suitability requirements also require monitoring the attainability of the client’s goals over time, including procedures to take action and adjust advice when necessary. That is, the suitability of the advice should be adequately tested and monitored over time. Furthermore, a well-defined risk management process can highlight possible conf licts between willing-ness and ability to take risk and the client’s goals.

In this article, we have described how risk manage-ment can be tailored to the advisory process in private banking, such that private banks and retail banks can be MiFID compliant. We divided the risk management process into four stages: defining the goals and risk atti-tude of the client, risk identification, risk measurement and analysis, and monitoring. We view these stages in the risk management process as incremental phases of an iterative process. To meet MiFID guidelines, quan-titative Monte Carlo scenario analysis is applied in all stages. Through a well-defined risk management process and Monte Carlo scenario methods, client expecta-tions can be better managed, leading to increased client satisfaction.

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To order reprints of this article, please contact Dewey Palmieri at [email protected] or 212-224-3675.


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