the three r's of the investment management industry

© 2009 The Tower Group, Inc. May not be reproduced by any means without express permission. All rights reserved.© 2009 The Tower Group, Inc. May not be reproduced by any means without express permission. All rights reserved.

The Three R’s of the Investment Management IndustryRisk. Regulation. Reinvention.

Dayle ScherResearch DirectorInvestment Management

July 16, 2009

© 2009 The Tower Group, Inc. 2

Risk Management Changes


Important areas of risk

• Credit (losses due to the deterioration of a debtor’s credit quality and ability to repay an obligation)

• Counterparty (counterparty to a transaction will be unable to meet its future payment obligations)

• Liquidity (inability to raise capital or inability to sell instruments due to a lack of buyers)

• Market (financial losses due to changes in the market value of securities held on a balance sheet)

• Operational (losses due to compliance failure or due to the lack of robust processes and procedures)


Important areas of risk (continued)

• Portfolio (aggregation of the risks in the individual components that make up the portfolio)

• Regulatory (regulation will affect the value of a holding or impede the ability to earn revenues)

• Reputational (negative publicity will cause a decline in the customer base, revenue or incur litigation)

• Settlement (settlement failure due to counterparty inability to deliver securities or cash)

• Sovereign (foreign countries take actions that reduce the value of assets held in that country)


Significance of various risks differs across Securities and Investments firms

Hedge Funds

European Universal Banks

SettlementOperationalCounterparty

LiquidityMarket Portfolio

CreditSovereign

Source: TowerGroup

Registered Investment

Advisors

Institutional Broker-Dealers

Execution Venues

Traditional Asset Mgrs

Retail Broker-Dealers

RegulatoryReputational

Low Significance High SignificanceKey:


Risk will be one of the few areas where CIOs will spend more money in 2009

Where will CIOs spend their risk dollars?

Accurate and timely data for securities valuation (Derivatives, illiquid instruments)

Upgrade data management infrastructure

Data Management

New risk applications

Data warehouse

Improve risk models (greater robustness)

Alternate approaches: Scenario analysis, etc.

Infrastructure for enterprise-wide risk mgmt

Apps/Infrastructure

Hire risk personnel

Raise profile of risk function: incentives, reporting structure

Greater training and reporting

Organizational


Regulatory Changes


10 Regulatory Initiatives and their Impact

1. Oversight of derivatives, structured products

2. Hedge fund registration

3. Valuation of illiquid instruments

4. New standards for leverage; capital adequacy

5. Reinstatement of uptick rule, limits on short selling


10 Regulatory Initiatives and their Impact

6. Executive compensation

7. Strengthening mortgage regulations

8. Changes in accounting rules

9. Revamping of credit rating business

10. Amendments to money market funds


Regulators Will Enact New Derivatives Rules at the Organizational and Industry Level

Organization

Derivatives

Industry

Client qualification

Segmentation of collateral

Off-balance-sheet accounting

OTC position reporting

Capital requirements

OTC clearing

Infrastructure improvements

Information reporting

Exchange listing

Ratings agency reform


Count on more accounting change

• Fiduciaries to independently value illiquid instruments instead of solely relying on third parties

• Debate on mark-to-market versus fair-value accounting

• Conversion from US GAAP to IFRS

Source: TowerGroup


And while not regulatory, GIPS changes are unavoidable

Error Correction 2010 Exposure Draft• Compliance Statement

• Fair Value

• Risk Disclosures

• Verification

• Non-fee-paying Portfolios

• Standard Deviation

• Proprietary Portfolios


Emboldening of regulators has four key technology implications

Data Integrity Data Models Data Governance

Data Management Stress Tests Models Scenario Analysis

Valuations

Confirmations Affirmations Performance

measurement

The Basics!

Credit Risk Market Risk Operational Risk

Risk Management


Reinvention in a capital-constrained environment


Securities and Investments Firms’ IT Spending by Region (2007–12P)

Source: TowerGroup estimates

(USD in Millions)CAGR = –1.7%

CAGR = –1.7%

CAGR = 6.1%


Restructuring of market practices in OTC derivatives

Issue Business Impact

Regulation Firms will have to improve automation to comply with regulatory demands.

Regulators will demand better reporting and more transparency.

Market structure evolution As the battle between pure OTC, OTC with clearing, and exchange listing heats up, brokers have to prepare for all scenarios.

Central clearing Regulators will force certain contracts to be cleared centrally.

Brokers will have to manage collateral with central clearing parties in addition to counterparties.

Product and process standardization

Product standardization is a prerequisite for the process automation demanded by regulators.

Buy-side firms will gravitate to standard, transparent products.

Pricing, valuation, and risk Enterprise risk management becomes a competitive differentiator.

Best practices for pricing and valuations will include multiple independent price points.

Source: TowerGroup


Consolidation is underway

•Combination of Credit Agricole and Societe Generale asset management businesses

• BlackRock acquisition of BGI


43.5% 42.8% 40.9% 40.1% 39.5% 38.7%

18.7% 19.8% 20.9% 21.1% 21.2% 21.5%

17.8% 18.6% 19.3% 19.4% 19.4% 19.5%

11.1% 9.7%

9.1% 9.2% 9.4% 9.5%

8.9% 9.1%

9.8% 10.2% 10.5% 10.8%

0

10,000

20,000

30,000

40,000

$50,000

2007 2008 2009E 2010P 2011P 2012PINTERNAL EXTERNAL-HARDWARE

EXTERNAL-SOFTWARE EXTERNAL-PROFESSIONAL SERVICES

EXTERNAL-OUTSOURCING SERVICES

IT Spending shifts to external development…

Source: TowerGroup estimates

2007–12P CAGR ($) %Internal –4.0%External-Hardware 1.1%

External-Software 0.1%External-Professional Services –4.4%External-Outsourcing Services 2.0%

(USD in Millions)


…and a growing shift to hosted software

Internal

Why?• Variable cost model

• Technology advances

• continuous enhancements

• common user interface

• flexible administration

• security

• privacy

• business continuity

External


Conclusions

Investment management firms face daunting objectives of client focus, operational excellence, and risk management.

Firms ranging from the most traditional to the most alternative face new regulation to address investor protection, market practice, and accounting standards.

The reinvention of the industry started with the dissolution of two brokerage stalwarts and continues to evolve with technology needs hampered by an environment of strict cost control.

Smart spending today on flexible technology will determine a firm’s future success


Questions

TowerGroup is a wholly owned subsidiary of MasterCard Worldwide and operates as a separate business entity with complete editorial independence. MasterCard Worldwide is not responsible forand does not necessarily endorse any opinions, statements, or other content presented by TowerGroup.

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