Gambling on awinning handInvestors oftenbank on skilland luckPage 2

Inside »InfrastructurefundingBig projectsrequire a delicatebalancing actPage 4

Upheavals areglobal concernPolitical unrestin Europeposes problemsPage 3

FT SPECIAL REPORT

Risk ManagementMonday March 17 2014 www.ft.com/reports | @ftreports

Geoff Taylor has been roundthe block. He used to moni-tor the production linerisks facing sportsweargroup Nike and jeans

maker Levi Strauss – checking thesolidity of trainer soles and the sturdi-ness of denim seams.

These days, as a risk solutionsexpert at Willis, an insurance broker,he is more focused on making sense ofthe financial crisis – but is convinced“real economy” companies have valu-able lessons to teach the risk expertsin the banking industry, many ofwhom misread the danger signs in theboom before the 2008 bust.

“Seven or eight years ago,” Mr Tay-lor recalls, “I remember sitting in astrategic risk council meeting withrepresentatives from different indus-tries. The banks there were verycocky. I remember them saying theyhad a 99.9 per cent confidence levelabout their risk modelling.”

Within a couple of years, WallStreet and the City of London hadexperienced an unprecedented col-lapse, as the fallibility of their creditand market risk models was exposedin ghastly fashion.

For the banks and other financialinstitutions that were battered by thecrisis, the natural response has beento elevate the importance they attachto risk. The chief risk officer (CRO) isno longer the irritating geek draftedin to sign off clever deals. The role,particularly in the US, is now often aboard-level position and has becomefar more integral to the way financialinstitutions operate.

The CRO’s focus has also changed.Bankers, as Mr Taylor’s anecdote

suggests, traditionally thought ofthemselves as the smartest people inthe room. Bank risk managers wouldmodel the default risk of the most

obscure credit derivatives, or the trad-ing risk of the most abstruse currencyforward, confident that the better themodel, the more money they and theiremployer would make.

As all the risk experts now recog-nise, models are only as good as theinformation fed into them. And theextreme volatility in market prices –and the swift evaporation of tradingliquidity – were largely absent frommodels because they were bothunprecedented and unimaginable,even for seasoned hands.

But if the crisis exposed the naivetyof banks’ assessment of credit andmarket risk parameters, its aftermath– characterised by a persistent regula-tory and legal crackdown on boom-time excesses and misdeeds – hasshone an even harsher light on a thirdshortcoming of the financial sector: abad misjudgment of operational risk.

“The trouble with operational riskis that it’s about human error,” saysCharles Beresford-Davies, head of riskmanagement for the UK and Irelandat Marsh, the insurance broker. “It’sabout events that life throws at us.It’s a lot more difficult to measure.”

That has made many aspects ofoperational risk alien concepts tobankers and their traditional proc-

esses. But the humdrum dangers ofeveryday operations have for manyfinancial services companies becomejust as important an area of risk astheir core credit and trading opera-tions.

Much of the work of risk consult-ants is now focused on transferringthe operations applied at non-finan-cial clients into the risk frameworksof financial groups.

Even those who have built theircareers within the financial industryexpress frustration at the lack ofattention banks have traditionallypaid to the gamut of operational risk.

“The trouble with the term is that itsounds as though you should be ableto fix it with a screwdriver,” saysCarol Sergeant, a former UK regulatorand Lloyds’ chief risk officer who isnow a non-executive at Denmark’sDanske Bank. “But it’s crucial to somuch of what a company does: how itserves customers, how its staffbehave, how they are paid, the reputa-tional risk that all this poses.”

Although the financial crisis islikely to be remembered most for thehundreds of billions of dollars lost onbad loans and the havoc wreaked onlenders’ capital and funding, most oftheir woes these days are operational,as pre-crisis greed and underinvest-ment come home to roost, rogue oper-ators become more sophisticated, andpolicy makers pursue a mission toclean up the system.

Technology shortcomings are aprime example. “Banks are effectivelytech companies these days,” says MrBeresford-Davies. “The failure of theirtechnology has caused huge reputa-tional damage.”

Problems have been manifested in avariety of ways. Royal Bank of Scot-land has suffered the most embarrass-ing glitches with the hardware andsoftware that underpin its retail bank-ing services, leaving customers with-out access to cash for hours, days andon one occasion weeks at a time.

Back-office technology has alsocome up short: failing to spot and stopmoney laundering, sanctionsbreaches, and rogue trading perpe-trated within the banking system.

Hacking and other forms of high-tech theft have become ever moresophisticated, posing challenges notjust to banks but to a vast chunk ofthe global economy.

Reformers agree that poor remuner-ation structures underpinned much ofwhat went wrong at the banks, withtraders incentivised to take far morerisk than was sensible. The same canbe said of mis-sold retail and smallbusiness products, such as PPI loaninsurance, and interest rate swapsacross a sweep of countries, particu-larly in Europe. Many of these exam-ples fall outside banks’ traditionalways of thinking about risk, says MsSergeant, and need new approaches.

Certainly, as more and more evi-dence has emerged of sharp andshady practice across the financialindustry, reputational damage hasbeen inflicted on some of the world’sbiggest institutions, from GoldmanSachs to Barclays.

One traditional fallback – insurancecover – is probably not the answer,admits Mr Beresford-Davies. In areas,such as mis-selling, where traditionalprofessional indemnity policies wouldhave provided protection, mass blow-ups such as PPI have scared off under-writing capacity.

“Some of banks’ operational risksare outstripping the insurance indus-

try’s ability to cover them, in theareas of technology failure, mis-sell-ing, data security for example. Theconventional approach isn’t fit forpurpose – the scale is just too large.”

So, if it is impossible to model andhedge against all these risks, and

increasingly difficult to insure them,what should financial companies do?The answer, risk experts agree, mustbe to devise better ways to catch prob-lems early. Governance needs toimprove, with better management ofall kinds of risk, and a fostered cul-

ture of whistleblowing. Stress testingneeds to become a routine continuousprocess, focused on realistic grada-tions of downside risk, not just disas-ter scenarios. Most of all, manage-ment priorities need to shift fromshort-termist risk-taking and reward.

Humbledfinanciersreassesstheir cultureMisjudgment of human factors, the failure oftechnology and rogue traders have caused hugereputational damage, writes Patrick Jenkins

Technical glitch:Royal Bank ofScotlandcustomers wereleft without cashfor days Getty

‘The trouble withoperational risk isthat it’s abouthuman error . . . alot more difficultto measure’Charles Beresford­Davies

2 ★ FINANCIAL TIMES MONDAY MARCH 17 2014

The $120m poker matchbetween James Bond and thevillainous Le Chiffre in thefilm Casino Royale demon-strates the fictional British

spy’s inexhaustible capacity toembrace risk in pursuit of huge stakesand glamorous women.

But in reality, no one enjoys Bond’sendless good fortune. Calculating pos-sible outcomes of games of dice andcards has intrigued mathematicianssince the Renaissance, laying thefoundations for modern ideas aboutrisk management that play a vitalrole in investing today.

In his classic book Against the Gods,Peter Bernstein explores the deep con-nections between gambling andinvesting and shows how analysinggames eventually transformed theperception of risk from “chance ofloss into opportunity for gain”.

Just as a gambler tries to win a bet,so investors hope to profit from stak-ing their money in financial markets,basing their choices on a combinationof skill and luck.

Winning a poker hand or closing aprofitable trade is often accompaniedby a rush of “feel good” hormones.

However, rising levels of adrenalin,testosterone and dopamine during awinning streak can turbocharge riskappetite to dangerous levels. Butspikes in market volatility are also

associated with higher levels ofpsychological stress that can raisecortisol levels and lead even sophisti-cated traders to become irrationallyrisk-averse.

Jekyll and Hyde traits are also evi-dent in the attitudes of many ordinarysavers, who see the financial crisis asconfirming their prejudice that invest-ing and gambling are virtually identi-cal risks in “casino capitalism”.

This fear of risk means many retailinvestors fail to act in their own bestinterests and exhibit behaviour atodds with their stated goals.

An analysis by State Street, the USfinancial services group, in 2012 foundthat two-fifths of retail investors saidthey wanted to become “more aggres-sive” in preparing for retirement. But30 per cent said that their largest allo-cation in 10 years’ time would still bein cash.

Worryingly, nearly two-thirds ofretail investors also rated their finan-cial sophistication as “advanced”, aBond-like display of confidence thatsuggests unrealistic expectationsabout their likelihood of success.

Suzanne Duncan, global head ofresearch for the State Street Centerfor Applied Research says financialindustry participants should developmeasures of “personal” performanceto help clients achieve their goals.

Barclays has developed a proprie-

tary “financial personality assess-ment” that allows it to tailor advice toclients. Greg Davies, head of behav-ioural finance at Barclays, says inves-tors want the best returns possiblerelative to the anxiety, discomfort andstress they have to endure.

A reluctance to get involved, drivenby fear of making mistakes (loss aver-sion), is the “default” state in thecycle of emotions experienced byinvestors, Mr Davies says.

Since losses loom larger than gainsin investors’ minds, some choose toleave large amounts of cash sittingidle, an “immensely expensive wayto sleep better at night” when a mod-erate risk multi-asset portfolio candeliver returns of 4 to 5 per centannually over the long term, says MrDavies.

But while short-term fluctuations instock markets can lead to losses, long-term returns measured over 10 yearsfor the MSCI World index only brieflyturned negative in the worst period ofthe financial crisis.

Barclays has carried out more than40,000 interviews as part of its FPAprogramme and Mr Davies says differ-ences between gender, age and cul-ture in financial personalities tend tobe smaller than often presumed.

Asian investors are widely assumedto be more risk-tolerant, but this isnot true of Japanese investors who

share a more “European” attitude torisk, says Mr Davies, adding that it isvital to avoid providing advice basedon stereotypical assessments.

Barclays’ approach combines threemeasures of risk attitude. Scores forfinancial expertise, belief in skill, andwillingness to delegate build a frame-work to help clients remain commit-ted to a long-term strategy.

Mr Davies says it was notable thatscores for delegation and belief inskill dropped in the aftermath of the2007-08 crisis, as confidence in finan-cial institutions weakened.

Those scores have now recovered,while measures of risk tolerance haveremained extremely stable in spite ofthe volatility seen in financial mar-kets over the past five years.

Yogi Dewan, chief executive of Has-sium Asset Management, tells clientsto take risks in areas they understandbest, usually the sector in which theycreated their wealth, rather than infinancial markets.

Wealthy families tend to be overlysensitive to short-term geopoliticalevents, so Hassium spends time edu-cating clients to think more broadlyand more long-term.

Mr Dewan says that preservation ofcapital, rather than pursuing growth,is the first priority of wealthy clientswho generally feel losses much moreacutely than gains.

Need to balance caution and will to winInvestment But excessive timidity can turn out to be an expensive way of sleeping better, writes Chris Flood

Face off: not allinvestors have aJames Bond­styleappetite for risk

Alamy

Closing aprofitabletrade is oftenaccompaniedby a rush of‘feel good’hormones

Risk Management

As part of the automaticenrolment of manyemployees into new UKworkplace pensionschemes, individuals willsoon have to decide ontheir appetite for risk.

Companies are startingto consider how to helpemployees determine whatlevel is appropriate forthem.

The emerging bestpractice is for employers tounderstand theiremployees’ objectives,tailor available investmentoptions, personaliseemployee communicationsto guide them into theright funds, and thenmonitor individuals’progress against theobjectives.

To help guide employeesappropriately, it isessential to understandtheir wants and needs.It is impossible to achievethis on an individual basis,but it can be done forgroups by means ofsegmentation.

For example, theobjective of a group of lowpaid employees may be fortheir income in retirementto be about two-thirds oftheir working income,including the statepension.

Categorising staff bydemographics, investmentunderstanding, and level ofengagement helps identifygroups with similar risktolerance.

The next stage is tobuild on the understandingof each segment of theworkforce and tailorinvestment options to meettheir objectives.

There is a balancebetween taking enoughrisk to allow the assets togrow sufficiently toproduce adequateretirement income andbehavioural traits such asloss aversion.

Employees typically needthe long-term growthpotential – in excess ofinflation and annuityprices – that is generallyassociated with equities orsimilar volatileinvestments.

However, employees cannow receive instantupdates of their savingsbalances and are dismayedby big falls in asset values.

High growth investmentsare the ones that are proneto suffer short-term falls.Seeing the value of thesavings balance decline,employees may decide toswitch to less volatileinvestments such as cashor stop contributingaltogether.

Both are likely to have adevastating impact on theirretirement income.

Investment optionsshould look to manageshort-term declines toavoid this situation byspreading funds between avariety of assets classes.Longer term more illiquidassets can sit alongsideequities to providediversification and thepotential for long-termgrowth.

KPMG hasbeen working

with a number of providersto develop suitable funds.The downside is that theseinvestments tend to berelatively expensive.

It is likely thatorganisations will containsome people who have theunderstanding to maketheir own investmentchoices. Their needs can bemet by having a simplifiedrange of options that offersa spread of outcomes andliquidity.

But it is important toavoid the “paralysis ofchoice” that has besetmany investment platformproviders.

Having designed asuitable range ofinvestment funds for eachsegment of the workforce,the next step is toengage with them andguide them through theoptions.

Technology allows forcommunication to betailored to each individual.For example, informationregarding pension limitsshould only be sent tothose with high salaries,long service or large fundvalues.

Providing relevantinformation, communicatedin a manner suitable forthe employee segment in

question, enhancesengagement and actionfrom scheme members.

In this way, employeescan be guided into anappropriate investmentoption. It is important thatemployees participate inthe decision, rather than“defaulting” into apreselected option.

People are more likely tounderstand the decisionthey have made and stickwith it, even if fund valuesshould fall. Guidingemployees also allows theright funds to be put infront of them.

Reporting of performanceshould be framed relativeto an employee’s long-termgoals, rather than justshowing short-termmovements.

This personalisedreporting can alsoencourage a member toincrease contributions orset a more realisticretirement age, should itemerge that they areunlikely to meet theirobjective.

The writer is head ofinvestment advisoryat KPMG

UK employeesprepare forauto enrolmentPensionsPATRICK McCOY

Two years ago, Europeanbusinesses were worryingabout whether the eurowould survive. Today, a big-ger problem for many ofthem is its strength.

With the single currencyat its highest level sincemid-2011 on a trade-weighted measure, politi-cians are warning thatadverse exchange ratescould stall the eurozone’sfragile recovery.

While the euro’s riseagainst the dollar has beenfairly moderate, turmoil inemerging currencies has

stung many multinationals– which had bet heavily ongrowth in emerging econo-mies in recent years to com-pensate for the lack ofactivity in their home mar-kets, but now find them-selves exposed to swings ofas much as 20 per centbetween the worst-hit localcurrencies and the resur-gent euro.

“The most obvious [con-cern for 2014] is volatility inexchange rates,” says Car-los Ghosn, chief executiveof Renault, which suffered a€600m loss from emergingmarket currency weaknesslast year.

Adidas, whose euro-denominated revenues werehit last year by a slide inthe Argentine peso and Bra-zilian real, warned thismonth that it would sufferfrom weakness in the rou-ble, with political risk

afflicting a region where itleads rivals.

Siemens, the German con-glomerate, Electrolux, La-farge and Pernod Ricardhave also reported a nega-tive impact from exchangerate movements.

In the UK, manufacturersface similar headwinds, assterling has risen almost 10per cent in trade-weightedterms over the past year.

The reason this is provingso problematic is that mul-tinationals – while accus-tomed to hedging againstmovements in major cur-rencies – have tended not tohedge exchange rate risk inemerging markets that nowaccount for a growing pro-portion of revenues.

Treasurers find it expen-sive and at times impossibleto protect against fluctua-tions in volatile and rela-tively illiquid currencies

that may lack developedderivatives markets.

“If a company is goinginto an emerging market,it’s a very big risk and thecurrency is a huge compo-nent of that,” says MartinO’Donovan, deputy policyand technical director atthe Association of Corpo-rate Treasurers.

He adds: “Many peopledecide to run that risk aspart of the hazards of beingin that country.”

He believes treasurershad an inherent bias tounder-hedge, because over-shooting in the other direc-tion would make them seemto be speculating on curren-cies – and “that is deemedless acceptable”.

Moreover, the recent sell-offs in emerging marketcurrencies followed a cou-ple of years of very low vol-atility in the euro-dollar

exchange rate, the one thatusually matters most forcorporate hedging strate-gies. This has temptedmany companies to cuthedge ratios.

Now, however, corporatesales executives are report-

ing a surge in demand forprotection against emergingmarket currency risk.

Fabrice Famery, head ofEuropean corporate ratesand foreign exchange atBNP Paribas, says thatcompanies were able to

absorb the first bout of tur-bulence in emerging mar-kets, last July and August,but a second sell-off earlythis year had prompted a“significant increase” in thenumber seeking to hedgecurrency risk.

“It puts clients in adilemma, because if theyhedge a currency with highcarry long term, it’s veryexpensive for them,” hesays.

BNP Paribas has beenexploring ways to offer “dis-continuous” hedges – onesthat can be interrupted – asa way round the problem,as well as suggestinggreater use of options –which are more expensivebut “could make sense ifyou’re a bit late in hedginga currency that has alreadymoved”.

Much smaller companiesare also trying to assess

and mitigate their currencyexposure, says TonyCrivelli, head of globalhedging strategy at WesternUnion Business Solutions.Its UK business handled 15per cent more forward pay-ments for small and medi-um-sized companies in thesecond half of 2013 that inthe first half.

Wherever possible, how-ever, multinationals wouldseek to create “natural”hedges – aiming to haveproduction costs in thesame currency as revenues,for example, or raising localcurrency debt.

A survey published lastyear by the Bank for Inter-national Settlements, theBasel-based organisationthat serves as a bank forcentral banks, notes a long-term decline in non-financial customers’ hedg-ing needs, partly because of

the stability of major cur-rency pairs, but also drivenby multinationals’ growingsophistication in managingcurrency exposures, central-ising corporate treasuryfunctions, so positions canbe netted off internally.

That would also suit theinstinct of many executivesto steer clear of financialmarkets. “I’ve spoke to anumber of corporates abouthedging and they’re a veryconservative bunch,” saysJane Foley, a currencystrategist at Rabobank.“There is a perception thatderivative instruments areby their nature very riskyand there is a reluctance bysome boards to usethem . . . If there was aperiod of low volatility, itwould seem likely thatmany boards would see thatas an excuse not to[hedge].”

Europe’s leaders warn currency volatility could harm the recoveryCurrencies

The euro’s strengthposes problems forbusiness, reportsDelphine Strauss

Companies findthemselvesexposed to swingsof as much as20 per cent

Long­term goals:Patrick McCoy

Exuberance

Reluctance

DenialExcitement

Optimism

Panic

Fear

Despondency

Desperation

Capitulation

Reluctance

Depression

Apathy

Indifference

Long- and short-term investment returnsCycle of investor emotions

Source: Barclays

Returns on MSCI World index (%)

1980 82 84 86 88 90 92 94 96 98 2000 02 04 06 08 10 12 14

-60

-40

-20

0

20

40

6010-year returns, annualised1-year returns

It is importantto avoid the‘paralysis of choice’that has besetsome providers

FINANCIAL TIMES MONDAY MARCH 17 2014 ★ 3

Risk Management

Kidnap and ransom are anincreasing threat for busi-nesses operating in danger-ous parts of the world.

Commonly cited as con-tributory factors are suchdiverse elements as popula-tion growth, the spread ofmilitancy backed by theavailability of heavy weap-onry, and the creation of akidnap chain along which aperson can be readily sold.

In a briefing on his com-pany’s website, PeterDobbs, a kidnap, ransomand piracy underwriter atCatlin Group in London,notes that kidnap insurancewas introduced after theabduction of the baby sonof aviator Charles Lind-bergh in the US in 1932brought to wide attentionthe possibility of kidnap-ping valuable individualsfor financial gain.

Today, there are an esti-mated 30,000 to 40,000 kid-naps a year, but many gounreported, making a moreaccurate figure difficult todetermine, says Mr Dobbs.

Of these, only a small per-centage of victims areinsured in any way againstthe risk – insurance doesnot necessarily just coverransom reimbursement butalso other expenses that fre-quently total far more thanany ransom payment.

Kidnap is constantlyevolving around the world,he adds. New hotspots posegreater levels of risk to

businesses operating withinthem.

Many companies seek toexpand into developingcountries, but doing sooften entails significantrisk.

One area that looks set tosee operational risksincrease radically is theSahel region of sub-SaharanAfrica. It comprises areas ofthe Gambia, Senegal, Mau-ritania, Mali, Burkina Faso,Algeria, Niger, Nigeria,Cameroon, Chad, Sudan,South Sudan and Eritrea.

The region’s instabilityhas recently spread southto the Central AfricanRepublic and may extendfurther.

Al-Qaeda affiliates areincreasingly adopting kid-nap-for-ransom as a financ-ing method as much as apolitical strategy, says Alex-ander Evans, New York-based co-ordinator of theUN’s al-Qaeda-Taliban mon-itoring team.

He says: “The evidenceincludes: an uptick in kid-naps and ransom incomefor al-Qaeda affiliates in theSahel and Yemen in recentyears; released al-Qaedacorrespondence; and post-ings on al-Qaeda-inspiredinternet forums.”

However, other informedobservers caution againstoverstating the terrorist ele-ment. Pushed hard on thepoint, one insider estimatesthe split of kidnap for ran-som as 90 per cent criminal,10 per cent terrorist.

“And that is being gener-ous to the terrorists,” headds.

Indigenous rich peopleare considered more vulner-able to kidnap because ofthe greater predictability oftheir daily routine. Foreign-

ers can be prized because ofthe perceived larger ransomthey might fetch, but can beawkwardly high mainte-nance and attract publicitythat a terrorist organisationmight relish but would beanathema to criminals.

Returning to his dissec-tion of Africa, Mr Dobbsnotes that since the fall ofthe Gaddafi regime inLibya, large numbers ofstockpiled weapons arethought to have made theirway into the traditionallynomadic Sahel region.

The French governmenthas stationed troops in thearea in an attempt to con-tain the problem, but, hesays, the next decade could

see significant activity.With many boasting sig-

nificant energy reserves,these nations have provedpopular with oil and gascompanies. This environ-ment has in turn spurredthe growth of specialist pro-viders of advisory and secu-rity services.

Terra Firma Risk Man-agement, identifies fourelements to the business:Prevention, Preparedness,Response and Recovery.

Steve McCann, a providerof security advice and on-the-ground services to non-governmental organisationsand humanitarian groups,divides security measuresinto three broad categories:

acceptance, deterrence, andprotection.

Acceptance is built onexplaining to local commu-nities the context of anorganisation and its individ-ual missions.

Deterrence is based onthe deployment of armedguards.

Protection involves proce-dural moves such as imposi-tion by an organisation of acurfew on its staff (in Dar-fur generally fixed at sun-set) and the erection ofphysical barriers againstperceived threats.

Each has its advantagesand disadvantages, explainsMr McCann, co-founder ofthe SaferEdge consultancy –motto: not all ‘security’makes you safer.

A bandit determined torob would probably not beinfluenced by the accept-ance approach although itcan offer a degree of protec-tion if influential figures ina community in effectendorse an organisationand its activities.

Deterrence, by contrast,can contain within it theseeds of its own failure; themore people who knowabout planned movementsthe more potential there isfor leaks of information.Taking the barbed wireroute delivers instant insu-lation, mutual misunder-standing and local suspi-cion, he believes.

“There is no substitutefor having on your side peo-ple who are of the commu-nity and know the space,the culture and the stake-holders,” he says.

“They will know how tointroduce you and yourwork so you are understoodand the vast majority ofthreats can be neutralised.”

New hotspotsincreaseconcernsKidnap and ransom

About 30,000 to40,000 abductionsoccur every year,Brian Bollen learns

‘There is nosubstitute forhaving on your sidepeople who are ofthe community’

Rising markets and revivingeconomies have contributedto the most optimistic busi-ness climate in the westsince the collapse of Leh-

man Brothers in September, 2008. But,just as economic risk has declined, sopolitical risk is on the rise.

The Ukrainian upheavals have cre-ated the worst crisis in relationsbetween Russia and the west since theend of the cold war.

The US and the European Union aretalking about imposing economicsanctions on Russia. The initial meas-ures involved are likely to be limited,but the risks of a tit-for-tat escalationare high – and will be making bigwestern investors in Russia, such asBP, very nervous.

Russia provides a good case-study ofthe two sorts of political risk thatinvestors have to consider: the macroand the micro. Macro political risksinvolve large-scale changes – either inthe form of internal upheaval or inter-national conflict – which can seri-ously destabilise the business environ-ment. Micro political risk takes in thesort of events that do not necessarilymake world headlines – a change of

ministers, a capricious presidentialdecision, an unexpected court ruling.

In its prospectus for a share offeringin London in 2006, Rosneft, a largeRussian oil company, had statedfrankly: “Crime and corruption couldcreate a difficult business climate inRussia.” Now, investors also have tofactor in the risk of an internationalpolitical crisis.

Julian Macey-Dare, who heads theinternational political risk businessfor Marsh, a global insurance broker,says that the classic definitions ofpolitical risk centre round the threatsof war, or the expropriation of assets.

However, Mr Macey-Dare notes thatthe nature of the political risks thatbusinesses are worrying about isbroadening, both in terms of the kindof assets that need protecting, and thekind of markets that are deemedrisky.

The common assumption is stillthat the riskiest political environ-ments are found in emerging marketsand that it is physical assets – such asa mine or a factory – that are most atrisk of destruction, or confiscation.

Increasingly, however, it is just aslikely to be a non-physical asset –

such as a licence to operate, or a debt-holding – that can be placed at risk byan unexpected political change.

Political risks are also no longerconfined to emerging markets. On thecontrary, the threat of politicalupheaval in Europe is still one of themain macro political risks facing theworld.

At the moment, investors generallyseem to assume that the worst of theeurozone crisis is over. The return ofconfidence is reflected in the fact thatcountries such as Italy and Spain cannow borrow at lower interest rates.Private-equity investors are also onthe prowl in Europe. However, it isentirely possible that political eventsover the next year will reignite theeuro-crisis.

Two things in particular needwatching. The first is the likelihood ofa surge in votes for populist andanti-EU parties in the elections for theEuropean Parliament in May. If, forexample, the far-right National Fronttops the polls in France – a result thatis entirely possible – mainstream poli-ticians will face a crisis of confidencethat could transmit to the markets. Ifthe far left wins in Greece, the spectre

of a Greek default on its debt couldalso re-emerge.

The political situation in Italy –which owns the fourth-largest debtstock of any nation in the world – alsoremains fragile. Many businesspeopleare hoping that Matteo Renzi, theenergetic new prime minister, willforce through much-needed reforms.But the Italian political and social sys-tem has defeated many reformers inthe past. And, if Mr Renzi also fails, asense of political crisis would returnto Italy.

The year has also seen a revivedawareness of the fragility of emergingmarkets, with a particular focus onpolitical risk. Put simply, those mar-kets that look most risky are alsooften those with the most troubledpolitical environment.

So, in Latin America, the currentoptimism about Mexico is closely cor-related to the impressive politicalleadership of President Pena Nieto. Bycontrast, the decline in investor confi-dence about the prospects of Brazilhas coincided with the surge in streetprotests that threaten to peak, duringthe World Cup, later this year.

Turkey is also an emerging market

that is making investors nervous –and, once again, the threat of politicalupheaval is central to these concerns.

For the past decade, the country hasgrown rapidly and was widely per-ceived to be benefiting from thestrong and confident leadership ofprime minister, Recep TayyipErdogan. But he now faces multiplechallenges, including recurrent streetprotests in Istanbul, a corruptionprobe and a row with the powerful“Gulenist” movement, that has splitthe forces of political Islam.

Given Turkey’s dependence onshort-term capital, rising political tur-bulence could spell economic trouble.

In an ideal world, investors wouldbe able to make calm assessments ofthe circumstances of individual coun-tries, without necessarily leaping toconclusions about their neighbours.

In reality, a political upheaval inone country can lead to contagiousnervousness about an entire group ofnations, whether it is “emerging mar-kets” or the eurozone.

That is why political risk is likely tobe one of the main threats to theglobal economic recovery, over thecoming year.

Unrest in Europe raises concerns around the globePolitics Possible fresh upheaval in the eurozone could threaten recovery as much as turmoil in Ukraine and Turkey, writes Gideon Rachman

Trouble in one country canlead to contagiousnervousness about anentire group of nations

Crisis point: the EU and UShave drawn up sanctionsagainst Moscow EPA

Patrick JenkinsFinancial editor

Gideon RachmanChief foreign affairscommentator

Steve JohnsonDeputy editor of FTfm

Chris FloodFT correspondent

Gill PlimmerFT correspondent

Delphine StraussCurrencies correspondent

Patrick McCoyHead, investment advisorypension funds, KPMG

Rose JacobsFT contributor

Brian BollenFT contributor

Aban ContractorCommissioning editor

Andy MearsPicture editor

Steven BirdDesigner

Chris CampbellGraphics

For advertising details,contact Peter Cammidgeon +44 (0)20 7775 6321,or peter.cammidge@ft.com,

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4 ★ FINANCIAL TIMES MONDAY MARCH 17 2014

The title of the first panel ses-sion of the world’s biggestannual infrastructure confer-ence, held in Berlin thismonth, spoke to a top con-

cern among the industry’s profession-als: 45 minutes at 9.30am devoted to“bubble trouble”.

Granted, the title was adorned witha question mark. But the facts areundisputed, in the western world, atleast. Funding for infrastructure –where the government is almostalways the ultimate guarantor – hasyet to return to anything close to pre-recession levels, despite infrastruc-ture’s recognised multiplier effect inthe wider economy.

“You can underspend for a decadeor so before this stuff completely fallsapart, and in times of austerity it’stempting to do that,” says Paul Dav-ies, infrastructure partner at PwC, ofthe lack of deal flow.

Yet financing for such projects asairports, roads, water and energysystems is abundant, and availablefrom a range of sources: pensionfunds, sovereign wealth funds, evenbanks, although post-credit crisis capi-tal adequacy rules have curbed theirappetite.

That has meant that governmentsand private sellers are getting betterprices and investors accepting smallerreturns. Privatised UK airports arecurrently selling for 16-17 times earn-ings before interest, tax, depreciationand amortisation, compared with 12-13times a few years ago. That still palesin comparison with the 25-30 timesseen in 2007 . . . but then again, thatwas a bubble.

Nor does Michael McGhee, head oftransport at Global InfrastructurePartners, a $15bn fund, see the equa-tion changing in the near future.

“In Europe, in the current low inter-est rate environment, regulators [whooften determine what concession-holders can charge users of infrastruc-ture assets] are saying that means thereturns we’re allowed should bereduced. But if you want us to invest,you have to recognise that the natureof our return is that it comes fromlong-term assets, and interest ratesare eventually going to go up.”

The danger here for governmentsand their citizens, he argues, is thatcapital is mobile, and regulatory arbi-trage inevitable. Mr McGhee points toPortugal and Australia as among thecapital magnets, thanks to playing

their hand wisely. Lisbon, for exam-ple, sold a 50-year concession for 10Portuguese airports to the Frenchgroup Vinci last year, for about €3bn,or a little more than 11 times 2012Ebitda, but with long-term investmentrequirements built into the deal.

“If you can incentivise the ownersof the infrastructure to operate itmore efficiently, then that has a bigadvantage for consumers, and theeconomy as a whole,” he says.

Australia’s new government, mean-while, is actively courting infrastruc-ture investors with the aim ofrecycling capital. Both the federal andstate governments are selling off rela-tively low-risk assets with stablereturns, such as ports, and then usingthat money to fund riskier or lower-yielding – but necessary – projects,such as non-toll road upgrades.

That strategy, says Manish Gupta,head of Ernst & Young’s transportinfrastructure practice, takes advan-tage of a further twist to the currentoversupply of capital: the fact thatmuch of the money available is onlyavailable for developed assets.

In his view, the glut of financingconstitutes just one of three risksassociated with infrastructure invest-

ment. Political risk is another, includ-ing everything from neighbours resist-ing expansion of an airport to govern-ments nationalising assets.

Economic risks are the third dangerin Mr Gupta’s breakdown, and centreround the fact that most infrastruc-ture projects have long life cycles anddo not always mirror the wider econ-omy. Some airports, for example, sawtraffic decline by as much as 25 percent in 2008-09, compared with econo-mies that shrank by 5 per cent.

But economic risks can also includecapital controls – as instituted byCyprus last year – and, more prosai-cally, exchange rate risk.

For governments, citizens and busi-ness communities, the trick is to findthe right balance between spendingand saving. Too little spending, as theUS has seen over the past three or sodecades, results in crumbling assetswhich, aside from diminishing qualityof life, can also influence what MrGupta calls the “hygiene factor” in acompany’s decision of where to locate.

However, PwC’s Mr Davies ques-tions how much this influences indus-try. “The taxation regime and theease of doing business in a place willboth be much more important.”

And too much spending has its ownpitfalls, as demonstrated by the likesof Ireland, Spain or Japan. That iscertainly the risk the developingworld currently runs, particularly incountries where continued steep eco-nomic growth is far from a given.

This touches on a central questionthat Mr Davies believes has not beenproperly answered in any part of theworld: What is a sustainable level ofinfrastructure investment? In otherwords, what can citizens ultimatelyafford? For it is they who fund thevast majority of projects, through gen-eral tax, road tax, utility bills andmore.

From there, the task is for govern-ments to prioritise. The UK, with itsnational infrastructure plan, is doingthis relatively well, Mr Davies says.

Mr Gupta agrees: “There seems tobe a rational allocation.” But big sig-nature projects tend to dominate, withmore mundane but vital work some-times falling by the wayside.

And there is good reason that priori-tising might be difficult, says MrMcGhee: “What’s the priority? Every-thing. Name me a sector in the US orUK where we are actually over-invested.”

Serco is a case study inwhat happens when risksare not properly managed.

The outsourcing giant haslost its veteran chief execu-tive, seen millions ofpounds wiped off its shareprice and issued two profitwarnings in a turbulentyear that left it facing seri-ous reputational damageand in trouble with one ofits biggest clients – the Brit-ish government.

In January, the companywas told that it would beallowed again to take onfresh central governmentcontracts in the UK aftersix months in purdah.

Serco had been barredfrom being awarded workafter it was referred to theCity of London police formanipulating figures on aprison van escorting con-tract, and to the SeriousFraud Office for overcharg-ing on the electronic moni-toring of offenders.

The FTSE-listed companyremains closely watched byofficials in Britain. And thereputational damageinflicted will leave RupertSoames, who takes over aschief executive in June,with a tough job restoringits battered fortunes.

Serco employs 122,000staff in 30 countries, run-ning services including air-traffic control towers, pris-ons and hospitals.

But about a quarter of its£4.9bn annual revenuescome from work with theUK government, so thegroup has a strong incen-tive to improve its riskmanagement quickly.

In Serco’s case, thisinvolves a tighter watch onhundreds of contracts andmanagement staff, manyof whom may have trans-ferred from public sectoremployers.

Julian Birkinshaw, pro-fessor of strategy and entre-preneurship at LondonBusiness School, says thatcultures can take years tochange. However, there arealso clear things the com-pany can do.

“You can do all the con-tracting you like, but ulti-mately it comes down tothe moral fibre of the peo-ple involved in negotiatingand implementing the con-tract, and whether theyhonour the spirit of theagreement or the actualcontract,” he says.

“These people are beingasked to deliver on thinmargins and some compa-nies push a culture wheredoing things the right wayis the norm and in others,penny pinching and costsqueezing are condoned.”

A National Audit Officereport last year listed fiveseparate reviews into prob-lematic contracts run bySerco. Chief among these isan ongoing investigation bythe Serious Fraud Office forovercharging by millions ofpounds for electronic tag-ging of offenders, includingfor people who were dead.

A number of employees at

the company have also beenreferred to the City of Lon-don police after beingaccused of altering recordson the transport of prison-ers in London and thesoutheast.

It has in addition facedcriticism for its manage-ment of accommodation forasylum seekers, and overits running of an out-of-hours medical service inCornwall. Nevertheless,Serco has been keen to

demonstrate that it is tight-ening its processes.

In the wake of the revela-tions over electronic moni-toring, the company estab-lished a “crisis manage-ment” task force, withabout 60 staff, led by thechairman Alastair Lyons.

They helped PwC, theprofessional services firm,

carry out the electronictagging audit, trawlingthrough emails, and helpingto find any evidence ofoverbilling on other govern-ment contracts.

Serco appointed LordGold, a senior City lawyer,to conduct a review of itsbusiness practices. It hasalso brought in a variety ofother advisers, with Ernst& Young examining man-agement processes andidentifying why front-linestaff on electronic monitor-ing contracts, for example,decided to make a falserecord of information.

Ethical LeadershipGroup, a US company, isalso delivering a new codeof conduct and ethics,which has already beentaught to 1,300 staff andwill be transferred toemployees worldwide overthe next few years.

While an underlying shiftin business behaviour islikely to take time, Prof Bir-kinshaw says transforma-tion is possible.

“It seems clear that Sercoallowed a culture to prevailin which a little bit of shav-ing round the edges wasallowed,” he says.

“The chief executive hashis or her work cut out tochange that. There are twopathways: formalisationand personalisation.

“On the one hand, youcan create rules and proce-dures for checking up onstaff, and making surethings are done by thebook. But smart people canalways find a way aroundrules,” he adds.

Prof Birkinshaw says theother way is the personalapproach, where you getpeople to understand therationale for why theyshould do the right thing.

“Ultimately this is thebetter approach, but youare never going to get 100per cent take up. There willalways be some people whowant to rebel againstauthority,” he says.

“But you can get mostpeople wanting to do theright thing. Some combina-tion of the two models istherefore what I would usu-ally recommend.”

Serco pays high price for laxcontrols and poor cultureCompany profile

The group has itswork cut out torepair the damageto its reputation,writes Gill Plimmer

When state pensions wereintroduced in the UK in1909, the retirement agewas set at 70, a grand oldage that only a third of menthen aged 20 lived to see.Indeed, average male lifeexpectancy was just 48 andcritics complained workerswould spend their life con-tributing to a benefit theywould never receive.

Roll forward a little morethan a century and theretirement age has fallen tojust 65 for men and, until2018, will be lower still forwomen. Yet 80 per cent oftoday’s 20-year-olds areexpected to see their 70thbirthday, and life expect-ancy has risen to 78.5 formen and 82.4 for women,according to the OECD.

Moreover, life expectancyis still rising, by about 2.5years a decade.

This is an uplifting tale ofhuman progress, onerepeated, to a greater orlesser degree, worldwide.But there is downside; therising cost to governmentsand companies alike of pay-ing pensions and meetingretirees’ long-term healthand care needs.

Private sector companies,at least, are plotting anescape route from thismorass, although they willnot be out of the mire fordecades.

The vast majority of com-panies have closed theirdefined benefit (or final sal-ary) pension schemes tonew members, while manyhave also been closed tofurther accrual for existingmembers.

Instead, private sectorworkers are being funnelledinto defined contribution(money purchase) pensionschemes, where they bearthe “longevity risk” associ-ated with living to a ripe

old age, as well as invest-ment and interest rate riskfor good measure.

However, companies arestill on the hook for thepromises they have made todate, and rising longevity ismaking those promises evermore expensive.

According to David Blake,professor of pension eco-nomics at London’s CassBusiness School, companiesstarted to focus on the issuein 2006, when globalaccounting changes meantpension deficits had to berecognised on corporate bal-ance sheets.

But relatively few compa-nies have offloaded theirlongevity risk. There arethree main ways this can bedone: a pension buyout,where an insurer is paid totake the entire scheme onto its own books; a buy-in,where part of a scheme ispassed to an insurer; or alongevity swap, where justthe longevity risk isoffloaded.

There has been a reason-ably steady stream of buy-outs and buy-ins in the UK,but few elsewhere, prima-rily in the US and Canada.

One problem is cost.Scheme sponsors typicallyhave to pay an insurancecompany a premium of20-25 per cent over theaccounting value of theirliabilities in order to offloadthe risk.

And, although many in-surers are keen to take onlongevity risk, as it par-tially balances the mortal-ity risk they are exposed tofrom selling life assurance,their appetite is not limit-less.

Dan Mikulskis, co-head ofasset liability management

and investment strategy atRedington, a consultant,says: “The [insuranceindustry’s] capacity for thatkind of risk is never goingto be sufficient to absorb allthe corporate pension riskout there, but it does have arole to play in reducing lon-gevity risk for some funds.”

Prof Blake adds: “There isnow a massive concentra-tion of longevity risk with asmall number of insurers.”

He notes that investmentbanks, which had showninterest in entering themarket, have been put offby tighter regulation in thewake of the financial crisis.

The take-up for longevityswaps has been lower still,with UK companies havinghedged just £31bn of theirtotal liabilities, estimated at£1.16tn by the Pension Pro-tection Fund.

Mr Mikulskis says thatfor most schemes, longevityrisk is still relatively minor.It becomes more importanthowever when equity orinterest rate risk diminishas funding levels improve.

Governments are re-sponding to rising lifeexpectancy by raisingretirement ages. The OECDsays most of its memberstates will have retirementages of at least 67 by 2050, atypical rise of 3.5 years formen and 4.5 years forwomen. Yet it argues gov-ernments “need to do moreto encourage people to worklonger and save more”.

Prof Blake lauds two

recent developments in theUK as potential solutions.First, the advent of “auto-enrolment” will ensuremost of the 8m to 9m work-ers currently without pri-vate pension provision areenrolled in a scheme, unlessthey choose to opt out.

Second, the current gov-ernment has explicitly tiedrises in the pension age tomovements in life expect-ancy.

“The idea is that the statepension age will rise so thatevery generation spendstwo-thirds of their adult lifein work and one-third inretirement,” he says. “Wenow, for the first time, havea kind of measure of inter-generational equality.”

But other problemsremain. “The thing that wehaven’t really confronted islong-term care,” says ProfBlake. “I speak to a lot ofpeople in local governmentand they say the two thingsthat will overwhelm localauthorities are the cost ofadult social care – which isan uncontrolled item ofexpenditure in their budget– and their pension plans.

Mr Mikulskis sees littlescope for governments tooffload this healthcare-related risk.

“There are very few natu-ral hedges; [there is a]shortage of people totake the other side of thetrade,” he says. “To somedegree it’s part of govern-ments’ role to take on thisrisk.”

Funding oldpromises isproving costlyLongevity

Steve Johnson looksat the struggle tomeet pension needs

‘Serco allowed aculture to prevail inwhich a little bit ofshaving round theedges was allowed’

Age concern: most people will need to save more

Spending onbig projectsis a delicatebalancing act

Infrastructure Governments are the primarysource of funding but austerity measures havemade money very tight, reports Rose Jacobs

‘There is a massiveconcentration oflongevity risk witha small numberof insurers’

Project management: long leadtimes often make it difficult tomirror the wider economyDreamstime

‘What’s the priority?Everything’

Michael McGhee,Head of transport,

Global Infrastructure Partners

Risk Management

Serco revenue

Source: National Audit Office

2012-13 (£m)

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