Exclusive: Regulators Scrutinize Financial Risk-Modeling Firms

U.S. government officials recently proposed creating scorecards to measure the potential threat posed by firms that offer risk models, amid concerns that large financial institutions may be too dependent on the same products, according to documents reviewed by Reuters.

The review marks another area of scrutiny for the Financial Stability Oversight Council, a group of regulators that has already imposed tougher rules for companies including insurers, banks and market utilities such as derivatives clearinghouses. The council is also generally responsible for identifying emerging risks to the larger financial system.

In a closed-door meeting on March 25, FSOC staffers delivered a presentation about a niche group of third-party firms that sell asset valuation, investment advice and risk measurements to pension funds, asset managers, insurance agencies and banks, according to the documents.

The documents lay out the government's concern that financial firms may rely too heavily on the same outside risk models and valuations, and that any flaws in these services could result in a wide misunderstanding of the true risk of firms' investments and other assets.

A Treasury spokeswoman told Reuters that the proposed scorecard approach is consistent with the council's mandate to look at issues across the financial system. She added that no decisions have been made on the approach, that it is not designed for any particular company or industry, and should not be read into.

Among the service providers mentioned were BlackRock Solutions, a unit of giant fund manager BlackRock, Bloomberg LP's Bloomberg Asset and Investment Manager (AIM), MSCI's RiskMetrics and BarraOne, Citigroup's Yield Book, Barclays' POINT, BNY Mellon's HedgeMark, FactSet, IBM's Algorithmics and Charles River's Charles River Investment Management Solution.

Though the documents viewed by Reuters list 10 examples of third-party service providers that help institutional investors evaluate risk, the presentation highlights one company - BlackRock Solutions. The documents say that BlackRock offers what are known as 'end-to-end' services, meaning it helps clients throughout the entire investment process.

They also contain a 'draft scorecard' for BlackRock Solutions, focusing on risk factors such as user reliance on its investment decision and valuation services, and the amount of assets and liabilities.

The document did not describe why staffers chose to highlight BlackRock Solutions, a unit that provides investment management technology systems, risk management services and advisory services for a fee.

The FSOC has already been exploring whether parent company BlackRock, with $4.3 trillion in assets under management, should be designated as a 'systemically important financial institution.' The group can dub large financial firms as 'systemic' - a tag that imposes additional oversight by the Fed.

BlackRock and its competitors have resisted the designation, saying asset managers are already highly regulated by the Securities and Exchange Commission and pose no systemic risks.

The documents from FSOC highlight several products offered by BlackRock, including Aladdin - a proprietary system that provides data to help clients manage their portfolio. As of December 2013, the platform processed $13.7 trillion in assets, according to the FSOC documents. The unit's revenue rose 11 percent to a record $577 million, according to BlackRock's 2013 annual report.

'BlackRock Solutions configures a unique instance of Aladdin for each client,' said Tara McDonnell, a BlackRock spokeswoman. 'The system is highly flexible and aggregates third-party data from a variety of sources, as determined by the client, and clients can use Aladdin or other models to conduct analysis in support of their objectives. Aladdin does not make investment decisions or replace a company's risk management function. It simply aids a company's risk managers, portfolio managers, traders and operations professionals in managing their workflows.'

Spokesmen for Citigroup, Barclays, FactSet and BNY Mellon declined to comment. Spokespeople for MSCI, Bloomberg and IBM had no immediate comment. A spokesperson for Charles River could not be immediately reached.

MONDAY MEETING
Concern surrounding the sharing of pricing, custodial and analytical services by asset managers is expected to be discussed on Monday when the FSOC hosts a conference on the asset management industry, according to a person familiar with the council's thinking.

At the heart of the council's discussions is whether asset managers, pension funds and insurers may be relying too heavily on such third-party service providers to value their assets, manage their risks and make investment decisions.

For instance, some consulting firms help other asset managers price less liquid bonds and determine how much margin should be required to manage the risks of trading them.

If too many money managers all rely on the same models, it could reduce the amount of independent analysis and 'expose the financial system to significant risk that may result from asset mispricing, faulty risk reporting or related outputs from such products or services,' according to the documents, which are not public.

Flawed risk models played a major role in the 2007-2009 financial crisis. Financial firms' internal modeling and assessments from credit rating agencies did not anticipate the systemic effect that a significant drop in housing prices could have on global markets.

The issue grabbed the spotlight again in 2012 when JPMorgan Chase & Co's risk models failed to capture the dangers of its 'London Whale' trades that led to a $6.2 billion loss.

Firms that provide risk-modeling services are not strictly regulated. The FSOC's staff review of these services is at an early stage, and any eventual policy response is unclear.

ADDITIONAL OVERSIGHT
The FSOC is a council of regulators created by the 2010 Dodd-Frank Wall Street reform law to help monitor the market for emerging risks. It is chaired by the Treasury Secretary and comprised of the leaders of every major U.S. financial regulator, including the Federal Reserve and the Securities and Exchange Commission.

The in-house group focused on model risk from third-party service providers is called the Systemic Risk Committee. That committee is tasked with scouring the marketplace for emerging risks, and it is not involved in the designation process.

According to the documents, the committee started holding preliminary discussions about the consulting services on January 28 and has also held several conference calls with companies in the sector.

At the late March meeting, a group of staffers presented a draft 'scorecard' that it said could be used as a tool to quantify the potential risks of each service provider. The documents propose completing the score card and distributing it to the various FSOC member regulators.

'Although imperfect, a survey may be the best approach to narrow down the field of providers that may require additional review/analysis,' the documents say.

It was unclear what kind of regulatory action the committee may consider, or whether the findings could affect the FSOC's decision to designate some firms as systemic.

Last year, the FSOC's research arm issued a report which found that certain activities by large fund managers could pose broader systemic risks.

One such concern cited was 'herding' behavior, in which funds all crowd into the same assets at once.

In the documents from the March meeting, the council's Systemic Risk Committee suggests that reducing reliance on third-party service providers could help reduce herding risks in the market.

REUTERS