Bank / Financial
November 10, 2022
Institutional investors, still reeling from the impact of the COVID-19 pandemic, know the risks of unlikely but devastating “black swan” events. However, many are ill-prepared for those they fear most, according to a new survey from PGIM, the $1.2 trillion global investment management business of Prudential Financial, Inc.
The survey of 400 senior investment decision makers from institutional investors in Australia, China, Germany, Japan, UK and US, with combined assets under management of over $12 trillion revealed that while tail risks varied by region, the predominant concerns center around the US-China relationship, market functioning in times of stress, and dependence on technology. in the financial markets. While more than half of large institutions ($50 billion and above) actively monitor tail risks, overall, for institutions of any size, less than 4 in 10 do so (38%). A tiny proportion (3%) of institutions have a manager dedicated to extreme risks and less than a third (32%) prepare response plans to specific risks.
“Too often investors are surprised by things that in retrospect stared them in the face,” said Shehriyar Antia, head of thematic research for PGIM. “The pandemic, the global financial crisis, the dotcom bubble – these events were all predictable to varying degrees. Financial institutions must either plan for the unexpected or expect to be caught off guard.
Three scenarios that keep investors up at night
Presented with geopolitical, economic, social and environmental scenarios ranging from a eurozone country’s debt default to a nuclear attack, respondents named their top three tail risks:
- An unexpected liquidity crisis in the main capital markets (US Treasuries, commodities, etc.) which leads to a stock market crash. The extreme risk scenario considered to have the greatest impact on the market and the one for which investors are least prepared is a major liquidity event in financial markets. A liquidity event in a “safe haven” like US Treasuries would have cascading effects that neither capital providers nor investors would necessarily be prepared for.
- Military conflict in Taiwan Strait or South China Sea. A military conflict in the Taiwan Strait or the South China Sea would have significant ramifications for global financial markets, so it is no surprise that institutional investors have cited such a conflict as their second highest tail risk, and the one they feel least prepared for. According to the Semiconductor Industry Association, if semiconductor production in Taiwan were to halt for a year, the cost to annual revenue for device makers worldwide would be $490 billion.
- A cyberattack disables a major financial platform or government agency for a significant period of time. Only 30% of respondents said they were ready to face such a major cyber attack, even though it is considered one of the extreme risks most likely to occur in the next three years.
Investors can do more to prepare for the worst
By definition, extreme risks are rare and unexpected, which makes them extremely difficult to anticipate. But there are ways for investors to hedge their bets.
- Investors recognize a variety of shortcomings and shortcomings in their oversight of investment risk, chief among them the inability to detect risk early (36%) or react to it quickly (41%).
- More than a third also say they are unable to predict black swans (36%) and, worryingly, nearly 3 in 10 identify risk management complacency as a key challenge.
- Institutional investors deploy three main approaches to monitoring investment risk: holistic monitoring of all asset classes (44%), regular analysis of risk scenarios (41%), and regular assessment of the effectiveness of risk management process (41%).
“The best insurance against such rare and complex events is to take a long-term view and diversify portfolios,” Antia advised. “Active managers can build portfolio strategies that will protect investors in a variety of scenarios.”
Monitoring leverage, collateral agreements, and liquidity positions through these shocks can help investors avoid becoming a forced seller as the event unfolds. When considering risks subject to extreme (and potentially undiversifiable) outcomes, investors should also consider stress testing rather than looking at traditional statistical measures that make assumptions that may not be realistic for certain exposures.
For more information and country-specific data, read the full report: Global Risks Report 2022: Extreme Risks.
For more business news, visit NYC News Now.