TaxTMI 
TaxTMI 
Risk Management System
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....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 practices followed by some / most of mutual funds in India. It may be mentioned that th....
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....atisfied. 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 DISTRIBUTION * VII. OTHER BUSINESS RISKS * APPENDIX A: FINAL RECOMMENDATIONS AS APPROVED BY THE AMFI BOARD ON 3 JULY 2002 * I. INTRODUCTION Risk management can ....
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.... 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 and should include: • Investment Policy, including Risk Philosophy (existing industry practice) • Operating Procedures (existing industry practice) • Compliance Manual (existing industry practice) • Code of Conduct (existing industry practice) • Disaster Recovery and Business Contingency Pl....
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.... 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 from fund management and should report to the Chief Executive Officer of the AMC. The function could be carried out in a number of ways: • As 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. III. FUND MANAGEMENT Policies and Procedures Existing Industry Practice ....
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....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 performance and positions with regard to the objectives of the schemes • researching and reviewing counterparties and debt issuers with regard to credit risk. • The front office (fund management) and back office functions must be segregated. Recommended Best Practice • The Mutual Fund should ideally have segregated research, portfolio management and dealing teams in the front office. To be Mandated by SEBI • The risk management function should be responsible for risk measurement, management and monitoring. Specific Risk Management Measures for Fund Management Risks Impact Risk Management Measures • Volatility in performance • Inconsistent or low returns leading to loss of investor confidence. • Erosion of assets under management leading to loss of revenue. â€....
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....or best execution. Independent verification procedures for all deals should be established. Rates and prices for verification should be obtained from independent sources. • "Back to back" transactions in debt securities of associates or associate companies (as defined in the SEBI (Mutual Funds) Regulations, 1996 • Internal deals between schemes or portfolios • Investments in securities issued by associates; purchases of securities owned by associates; sales of securities to associates. • Joint ventures with associates Existing Industry Practice • All SEBI regulations regarding restrictions on associate transactions and investments as well as requirements for disclosure must be adhered to. • All SEBI regulations regarding the execution of the deal at the market price and the documentation of justification for the inter-scheme deal must be adhered to. • The inter-scheme deal should be independently verified by Compliance. • Style drift and portfolio concentration • Inconsistent / low returns vis-à-vis similar schemes in the market leading to l....
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....ake suitable in-principle arrangements in advance for borrowing to deal with unexpected redemptions, in order to avoid delays and difficulties in resorting to borrowing when the need arises. The borrowing should not exceed SEBI limits of 20% of net assets under management. • Credit risk • The issuer may default on principal / interest • Defaults may lead to low investor confidence and hence erosion of assets under management. Existing Industry Practice • The Investment Committee should research and review issuers with regard to credit risk. • The Mutual Fund must adhere to all SEBI restrictions regarding investments in rated and unrated debt securities. • The Investment Committee should monitor the ratings of all debt issuers that the Mutual Fund has invested in. IV. OPERATIONS RISKS Policies and Procedures To be mandated by SEBI • The Mutual Fund must buy insurance cover against third party losses arising from errors and omissions. Third party liabilities refer to liabilities arising out of financial loss to investors or any other third party, incurred due t....
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....ecurity functionality such as locking of trade data • Integrated reporting across the Mutual Fund. Existing Industry Practice • The Mutual Fund should ensure that the fund accounting systems used (in-house or by the fund accountant to whom this activity has been outsourced) facilitate: • • Validation of NAV calculations • Automated and manual price feeds • Identification of missing prices • Flagging of price variances beyond pre-established tolerance levels. Organisation Existing Industry Practice • The Mutual Fund should segregate duties to ensure that an independent person or department carries out matching of trade confirmations. • The Mutual Fund should appoint a Valuation Committee which meets periodically to review valuation policies. Specific Risk Management Measures for Operations 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-comp....
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....The Mutual Fund should should ensure that the fund accounting systems used (in-house or by the fund accountant to whom this activity has been outsourced) facilitate: • • validation of NAV calculations • automated and manual price feeds • identification of missing prices • flagging of price variances beyond pre-established tolerance levels. • The Mutual Fund 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 r....
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.... have appropriate business contingency plans in place. • 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-à-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 procedures with regard to: • • matching of cash receipts to issue of units and cash payments to redemption of unit....
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....ment 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 (OCR), intelligent character recognition (ICR) and the use of pre-filled forms. • The R&T system should facilitate maker-checker authorizations. • The R&T system should facilitate reconciliation of cash and units. • The Mutual Fund should establish controls for alternate channels of distribution such as the telephone and Internet, if used. For transactions carried out over the telephone, call scripts should include confirmations of transaction details. Transactions via the Internet will transfer the responsibility of data entry and its accuracy to....
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....sp; Risks Impact Risk Management Measures • New product development • Non-compliance with regulations, loss of market reputation and poor customer service leading to loss of investor confidence. Existing Industry Practice • A new scheme should adhere to all required SEBI regulations which require every new scheme to be approved by the Trustees and the Board of Directors, and the offer document to be reviewed by SEBI. • The Mutual Fund should have a new product process in place. • All new schemes have to obtain clearance of the compliance officer and the regulator before they are launched. • Comprehensive market research should be undertaken by the Mutual Fund before the launching of a new product in order to assess the product's viability in the market. • The launch of a new product should have close involvement of the R&T agent and the IT teams, to enable evaluation of all infrastructure for its capacity to handle unexpectedly large volumes generated by a new scheme. Contingency arrangements should be made to handle overflow volumes. • Selling and distribution ....
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....Business Risks Risks Impact Risk Management Measures • Critical knowledge loss • Poor performance of the Mutual Fund in the market vis-à-vis other mutual funds. Existing Industry Practice • The Mutual Fund should have documented HR policies and procedures addressing issues such as attracting and retaining key skilled staff. Incentives such as stock options, performance bonuses and competitive salaries should be considered. • The Mutual Fund should have well documented policies and procedures. • The HR plan should aim to identify and build a second line for key positions. • The HR plan should also cover holiday planning in case of key employees going on leave. • Skills shortage • Low growth and poor performance vis-à-vis other mutual funds in the market. • Lack of knowledgeable personnel in the organisation leading to a lackluster or negative image of the Mutual Fund in the market. Existing Industry Practice • The Mutual Fund should have a training plan for employees to update their existing skills and equip them wit....
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.... • The Mutual Fund should periodically review the arrangement with the R&T agent and the custodian, and also survey other service providers in the market. APPENDIX A: FINAL RECOMMENDATIONS AS APPROVED BY THE AMFI BOARD ON 3 JULY 2002 PART 1: RECOMMENDATIONS TO BE MANDATED BY SEBI • Risk Management Function We recommend that all funds should have an independent risk management function. 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 • Othe....
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....separate cover for errors and omissions. PART 2: RECOMMENDATIONS TO BE ISSUED AS BEST PRACTICE GUIDELINES BY AMFI These are recommended best practice measures that should be adopted as the industry matures and the operations of individual players grow in size and complexity. • Liquidity Risks Funds should make suitable in-principle arrangements in advance for borrowing to deal with unexpected redemptions, in order to avoid delays and difficulties in resorting to borrowing when the need arises. • Use of Risk Measurement Tools in Portfolio Management Mutual Funds should consider using one or more of the following portfolio management tools for risk measurement, in keeping with international trends. These tools should be used to manage risks more effectively, and should be capable of carrying out the following analytics: • Quantification of exposure using measures such as Value at Risk (VaR), duration, and tracking error • Risk adjusted performance measurement using Sharpe Ratios, Treynor Measures and Sortino Ratios • Risk benchmarking, i.e. the exposure arising between the act....