07/07/2010 Author: Julian Korek

Comment: Julian Korek

Finance is caught in the cross-hairs of politics: from a tsunami of regulation, to short-selling bans, to re-instating a revised Glass-Steagall act – the impact of politics on a portfolio can be significant. So to what extent should we seek to understand, measure, manage and mitigate political risk?

Consider this question from the perspective of BP, which is, arguably, a convenient villain for US President Barack Obama, who is in turn facing mid-term congressional elections in November and criticism of his own response to the disaster. How greatly have the political manoeuvres of both company and government dictated the prognosis for the UK’s largest corporation?

Since the Deepwater Horizon rig exploded, killing 11 men and starting potentially the biggest ecological disaster in US history, BP’s share price has fallen 40%, destroying close to £50bn of shareholder value.

BP has handled the politics of the disaster poorly, and the US has used this to its advantage. Although the US is its biggest market, BP appears to have run its US affairs from London since the disaster occurred. Its headquarters remain in the UK and it does not seem to have the right level of political influence in Washington to offset its exposure to the US. BP’s response to the crisis has been characterised by obfuscation and denial.

CEO Tony Hayward’s comment that “I want my life back” has become a rallying cry for opposition to a company Obama pointedly refers to as British Petroleum. November’s mid-term elections inevitably colour the US political process this year and BP appears dangerously exposed to its vagaries; its penalties and share price inevitably affected by the mass feeling of public outrage supported by the US President.

So should we consider political risk when we construct a portfolio and should we seek to manage political risk on an ongoing basis? The answer to this question is surely yes when the stakes are so high – BP is the top holding in nearly half of the UK’s equity income funds and its dividend accounts for as much as 15% of the total income from the FTSE 100.

The problem with assessing political risk is that it is not very easy to predict. A politician’s primary allegiance is to the voter not the markets. In this sense, they are not rational actors whose behaviour can be forecast. German Chancellor Angela Merkel’s ban on naked short selling was designed to impress domestic voters, not install market stability. The initial response from EU member states to the Greek debt crisis was to withhold talk of an EU-wide bailout to punish Greece for its financial profligacy. The outcome of this delay was that when policymakers finally succumbed, a considerably larger bail-out was needed to reassure the (by now very nervous) markets than was first anticipated. This might have been more expensive economically but the political cost of bailing out the Greeks at the first sign of trouble would have been far higher.

To put the asset management sector in sharper focus in this context, the directive on Alternative Investment Fund Managers (AIFM) is seen by many as a populist piece of legislation that does little to address the root causes of the financial crisis. The final text of the directive, which will be agreed by politicians working on behalf of their constituents, will have an enormous bearing on our sector. In this case, we do at least have an idea of what is coming as endless drafts are made and then re-drafted. The final outcome might not be known, but it won’t be a shock. The BP oil crisis, like Toyota’s brake fault scandal before it, has had greater impact owing to the fact that, to investors, it was unpredictable – political risk should not therefore be a selective practice. It will not do to consider political risk only in the most unstable countries or around politically uncertain times. It is a situation of part probability and part impact – the smaller the probability, the greater the impact.

In 2010, markets are fragile, confidence is ephemeral, and the outlook remains uncertain. Unprecedented and ongoing political intervention is the only thing keeping some markets from seizure. However, it is one thing to acknowledge political risk and another to manage it. Open questions include how to assess political risk, appropriate quantitative methods and mitigation of political risks. Most risk management teams count among their numbers PhDs in quantitative finance. How many include a PhD in politics? When we look at the risk in a portfolio, should we not consider the political risk too? In the case of BP, it is clear that this particular risk assessment should have been much higher on its agenda.

Julian Korek is a founding member of Kinetic Partners.