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TMI BlogRisk Management SystemX X X X Extracts X X X X X X X X Extracts X X X X ..... t of Indo-US Financial Institutions Reforms and Expansion Project, has undertaken a detailed study on risk management practices followed by all the mutual funds. They have made certain recommendations to ensure a minimum standard of due diligence or risk management system for all the mutual funds in various areas of their operations like fund management, operations, customer service, marketing and distribution, disaster recovery and business contingency, etc. Operating Manual for Risk Management System AMFI and Pricewaterhouse Coopers have prepared an operating manual for risk management system for the mutual funds. A copy of the operating manual has been sent to you by e-mail and is also available on SEBI website under the Mutual Funds Section. The risk management practices in various areas of operations of mutual funds are covered in the operating manual under three categories: (i) Existing industry practices (ii) Practices to be followed on mandatory basis, and (iii) Best Practices to be followed by all mutual funds. Details are given below: (i) Existing Industry Practices: Under each head of risk area, the manual covers the exemplary ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ies has been implemented and whether Boards of AMCs and trustees are satisfied. 3. Review by Internal Auditors After full implementation of the risk management system, it shall be made a part of internal audit from April 1, 2003 onwards and the auditors shall check on a constant basis about the adequacy of risk management systems. Their reports shall be placed before the Boards of AMCs and trustees who shall make comments on the adequacy of systems in the quarterly and half-yearly compliance reports filed with SEBI. These guidelines are being issued in accordance with the provisions of Regulation 77 of the SEBI (Mutual Funds) Regulations, 1996. Yours faithfully, P.K. NAGPAL ANNEXURE OPERATING MANUAL FOR RISK MANAGEMENT FOR INDIAN MUTUAL FUNDS TABLE OF CONTENTS I. INTRODUCTION * II. RISK MANAGEMENT FRAMEWORK OVERVIEW * III. FUND MANAGEMENT * IV. OPERATIONS RISKS * V. CUSTOMER SERVICE * VI. MARKETING AND D ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... risk management framework described in this document covers all aspects of a Mutual Fund s operations. Risks have been broadly categorised into five areas: Fund Management Operations Customer Service Sales and Marketing Other Business Risks. Risk management measures have been described for each of these areas across three dimensions: policies and procedures, systems and organisation. Additionally, measures for specific risks in each area have also been described. 1. Policies and Procedures Risk management is most effective when it follows a top-down approach. In this approach, the senior management of the Mutual Fund is the main center of power and responsibility. Based on various factors like the risk appetite and business strategy of the organisation, the philosophy regarding risk should be developed. This philosophy should then be transmitted throughout the organisation in the form of concrete and detailed policies, procedures and guidelines. The policy and procedures documents should build a framework for the effective and efficient management of the fund an ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... the AMC the responsibility of the day-to-day execution of these policies. Risk Management Function (To be Mandated by SEBI) The Mutual Fund should have an independent risk management function consisting of one or more risk managers. This function will be responsible for identifying, evaluating or measuring all risks inherent in a mutual fund organisation, as well as establishing controls to mitigate such risks. The risks include: Fund Management : volatility in performance, style drift and portfolio concentration, interest rate movements, liquidity issues, credit risk Operations: deal errors, settlement problems, NAV and fund pricing errors, inaccurate financial reporting, fraud, failure of mission critical systems and infrastructure, obsolete systems Customer Service: errors in deal processing, other investor services, fraud Marketing and Distribution: new product development, selling and distribution Other Business Risks: critical knowledge loss, skills shortage, non-compliance, third party risks. The function should be separate ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... reaches e.g. whether investments have been made in permitted securities or limits on deal size, etc. have been exceeded automatic time-stamping of deals maker-checker authorisations exception reporting monitoring of outstanding confirmations, settlements and payments access controls and firewall decision support capabilities and portfolio modelling (e.g. scenario analysis, what-if analysis) risk-adjusted performance measurement (e.g., Value at Risk (VaR) analysis) reporting on target vs. actual portfolio. Organisation Existing Industry Practice The Mutual Fund should establish an Investment Committee. This committee will be responsible for : laying down the Mutual Fund s investment policy and philosophy with regard to different asset classes, sectors, counterparties, etc., as defined in the Investment Policy Manual reviewing ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... ctual managed portfolio and the benchmark portfolio Stress testing and back testing of exposure calculations.e.g., Sharpe s Ratio, Treynor Measures, beta, FAMA decomposition, VaR, etc). The mutual funds should consider using equity derivatives for hedging and rebalancing. Quality of investment research, facilities, people, procedures Existing Industry Practice The Mutual Fund should document the rationale for an investment decision as required by the SEBI regulations. Ideally, the Mutual Fund should have a dedicated research team. The Mutual Fund should hire qualified and experienced portfolio managers, research analysts and dealers with adequate experience in the industry. They should be provided continuous training to understand new products, skills, markets and sectors. The fund management and research teams should have access to research from multiple sources: both internal and external. ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... nd action plan for rebalancing the portfolio. Interest rate movements Inconsistent / low returns vis- -vis similar schemes in the market Existing Industry Practice The Mutual Fund should have daily profit-and-loss reporting at securities and portfolio levels to the Investment Committee. Recommended Best Practice The Mutual Fund should consider using interest rate derivatives to manage risk and rebalance portfolios. Liquidity issues Delays or inability to meet redemptions leading to non-compliance with SEBI regulations Low investor confidence leading to erosion of assets under management. Existing Industry Practice All SEBI regulations with regard to redemption periods for different scheme types must be adhered to. The Investment Committee should monitor the portfolio on a daily basis and periodically review it to tr ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... Funds with assets of less than ₹ 100 Cr may take insurance cover for an amount of less than ₹ 5 Cr as determined by their trustees. The premium for this cover may be paid for in accordance with SEBI regulations. Custodians must also buy separate insurance cover for errors and omissions. Existing Industry Practice The Mutual Fund should purchase insurance to cover first party losses. First party losses are those which impact the insured and include asset based losses (due to natural or unnatural disasters such as fire, flood, burglary, etc.) as well as financial or data losses. They also include losses due to acts of infidelity by employees of the insured and computer based crimes such as hacking or virus attacks that may impact the data of the Mutual Fund. Compliance should review all trading activities at frequent intervals. Operating procedures should lay down reconciliation activities and their frequency: End-of-day broker confirmations with records of deals End-of-day reconciliation of posit ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... Risks Impact Risk Management Measures Deal errors Incorrect execution of deals in terms of price, volume or asset class, potentially leading to failure of settlement, financial loss or non-compliance with regulations. Recommended Best Practice The back office system should be integrated with the front office system to facilitate: straight-through processing one-time capture of trade details maker-checker authorisations in-built checks and validations. Existing Industry Practice The Mutual Fund should not allow dealing through personal cell phones of dealers. The Mutual Fund should have recording facilities in the dealing room. Settlement problems Failure to provide securities or payment for securities leading to financial loss and/or reputatio ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... should carry out periodic compliance and audit checks on the NAV calculation methodology to ensure accuracy of calculations and their compliance with the regulatory requirements. Inaccurate financial reporting Non-compliance with regulations and loss of investor confidence on account of incorrect projection of financial health. Existing Industry Practice All financial reporting should be subject to audits by internal and external auditors as well as the compliance officer, at quarterly intervals. The Trustees should review all financial reporting to ensure transparency and accuracy. The Mutual Fund should ensure that adequate disclosure is made with regard to derivative transactions, off-balance sheet items and contingent liabilities. Fraud Non-compliance with regulations, financial loss, reputation loss. Existing Industry Practice The Mutual Fund shou ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... Obsolete systems Operational errors, delay in meeting regulatory requirements, inefficient processing of customer related processes. Existing Industry Practice The Mutual Fund should carry out a periodic systems audit to ensure required functionality vis- -vis products and regulatory requirements. The Mutual Fund should carry out periodic stress testing of systems to ensure the ability to process large volumes at acceptable speeds. The Mutual Fund should implement applications that are developed using open architecture in order to facilitate interfacing and integrating with other applications. V. CUSTOMER SERVICE Policies and Procedures Existing Industry Practice The Mutual Fund should define service levels with regard to investors and incorporate these in the service level agreements with the R T agent. The Mutual Fund should establish reconciliation procedure ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... sales and marketing database support of customer and account relationship data model in-built checks to ensure all statements are printed. The Mutual Fund should ideally establish electronic interfaces its with banking systems to allow for automatic instructions for payment and reconciliation. Specific Risk Management Measures for Customer Service Risks Impact Risk Management Measures Errors in deal processing Failure to correctly and timely process customer transactions leading to loss of investor confidence and non-compliance. Existing Industry Practice The Mutual Fund should establish procedures for accepting applications and sending out end-of-day confirmations for transactions. Procedures should include scanning of all customer applications. The Mutual Fund should also consider tools such as bar-coding, optical character recognition (O ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... All investor units should only be issued in dematerialized form. The Mutual Fund should conduct periodic audits of customer account set-up and credit checks on customer accounts to prevent the setting-up of fraudulent accounts. In instances where physical unit certificates are issued, the Mutual Fund should consider the use of bar coding, invisible ink or other tools to prevent the possibility of fraudulent certificates being redeemed. Recommended Best Practice Cash applications should not be permitted Redemptions should only be made to a bank account For any change in address request, the R T agent should confirm the change to both the old and new addresses . VI. MARKETING AND DISTRIBUTION Specific Risk Management Measures for Marketing and Distribution Risks Impact Risk Management Measures New product development Non-compliance with reg ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... VII. OTHER BUSINESS RISKS Policies and Procedures Existing Industry Practice The Mutual Fund should have documented Human Resources (HR) policies and procedures. The policies and procedures should address issues such as: attracting and retaining key skilled staff succession planning career development plan training plan to equip new employees with relevant skills and to update skills of existing employees; training could be delivered in-house or through external institutions. The Mutual Fund should have a well documented and comprehensive compliance manual as required by SEBI regulations, and an operations manual, which are accessible to all employees. Organisation Existing Industry Practice The Mutual Fund should have qualified HR and administration staff with a sound knowledge of HR. ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... Existing Industry Practice The compliance officer should adhere to all SEBI regulations with regard to the immediate reporting to SEBI of any instance of non-compliance by the Mutual Fund as well as periodic reporting to Trustees. The Mutual Fund should have a well documented and comprehensive compliance manual, as required by SEBI regulations. This manual should be accessible to all employees. All new employees should be made to undergo compliance training. Trustees should adhere to all SEBI regulations regarding their responsibilities. The Independent directors on the Mutual Fund Board and the Audit Committee should actively review functioning of the Mutual Fund. The Compliance Department of the Mutual Fund should be staffed with people having legal, regulatory, accounting and other required expertise. The compliance officer should have a direct reporting line to the Trustees. Recommended Best Practice Trustees should update themselves with the general and specific roles and res ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... an additional function of an existing employee of the AMC, e.g. the Compliance Officer or Internal Auditor; Through a Risk Management Committee; Outsourced to an external agency; or As the Trustees of the mutual fund may deem fit. A Risk Management Framework manual detailing the policies and procedures, systems, organisation controls and specific risk management measures for the above risks will be prepared by AMFI. The creation of such a function should be mandated by SEBI, with an implementation time frame of 3 months from the date of such mandate, or 1 st January 2003, whichever is later. Disaster Recovery and Business Contingency Plans All funds, and their Registrar and Transfer (R T) agents and custodians, should have an off-site back up facility and a Business Contingency Plan that is tested and evaluated on a regular basis. The business contingency plan should be comprehensive and should cover information technology, infrastructure and personnel requirements. Such a contingency plan should allow the AMC to perform, at the bare minimum, the critical function ..... X X X X Extracts X X X X X X X X Extracts X X X X ..... d Dealing Systems Funds should consider implementing integrated front and back office systems which will facilitate straight-through processing, thereby reducing the possibility of input errors at any stage in the investment, dealing and settlement process. More importantly, a front office system with a robust compliance module will facilitate pre-trade compliance checks, thereby reducing the possibility of regulatory or internal limits being breached. Dealing and Best Execution Currently, most players are too small to warrant a segregation of duties between fund managing and dealing. However, as the industry matures and volumes increase, this will be an area that should be looked at more closely, with a view to setting clear guidelines for best execution. Money Laundering In the absence of any money laundering regulation in India, funds should, at a minimum, adopt the following measures: Cash applications should not be permitted Redemptions should only be made to a bank account For any change in address request, the R T agent should confirm th ..... X X X X Extracts X X X X X X X X Extracts X X X X
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