Regulating and Monitoring Investment Risk: Application of the OECD Guidelines Juan Yermo Financial Affairs Division OECD

What do we mean by investment risk? What is the time horizon? Is there a liability (commitment, guarantee or target benefit)? Who is the risk bearer? Choice of risk measure will depend on these factors

Main risk measures Overall risk measures Volatility (standard deviation) Beta (market correlation) Downside risk measures Expected shortfall / expected tail loss Stress test Value-at-Risk Downside risk more relevant for DC pensions because of benefit target

Investment risk in DC pensions Long-term horizon, terminal wealth matters most Consumption matching requirement after retirement Some relevance of investment outcomes up until retirement Expected shortfall from targeted replacement rate

Drawbacks of VaR as a risk measure in DC pensions Short-term horizon (one day/month) It does not tell us anything about losses below VaR limit It does not tell us anything about the portfolio’s exposure to annuity rate risk To be useful for beneficiaries, VaR needs to be integrated into replacement rate model

Regulating investment risk Directly: Setting ceilings on risk measures Indirectly: Setting ceilings on portfolio allocations Self-regulation: Prudent person rule Regulatory approach depends critically on extent of market and regulator knowledge, competition, and redress

Drawbacks of quantitative rules Optimal asset allocation is a moving target Difficult to change (often set in law) Does not ensure diversification within limits Quantitative risk control measures can achieve same goals without these drawbacks

Recent reforms to quantitative rules Shares Shares Belgium: 65% - no limit (2002)Belgium: 65% - no limit (2002) Czech Rep.: 25% - no limit (2004)Czech Rep.: 25% - no limit (2004) Denmark: 50% - 70% (2001)Denmark: 50% - 70% (2001) Mexico: 0% - 15% (2005)Mexico: 0% - 15% (2005) Portugal: 50% - 55% (2002)Portugal: 50% - 55% (2002) Spain: 10% - 30% for unlisted (2003)Spain: 10% - 30% for unlisted (2003) Foreign investment Foreign investment Japan: 30% - no limit (1999)Japan: 30% - no limit (1999) Canada: 30% - no limit (2005)Canada: 30% - no limit (2005) Denmark: 5% - 10% for non-OECD (2005)Denmark: 5% - 10% for non-OECD (2005) Mexico: 0% - 20% (2005)Mexico: 0% - 20% (2005) Germany: no limit for Pensionsfonds (2002)Germany: no limit for Pensionsfonds (2002) Korea: 20% - 30% (2003)Korea: 20% - 30% (2003)

Limits on shares

Limits on foreign investment

The debate on foreign investment For: seven countries with largest capitalisation account for more than 80% of the world’s equity portfolio (OECD more than 90%) For: seven countries with largest capitalisation account for more than 80% of the world’s equity portfolio (OECD more than 90%) Against: difficulty of hedging exchange rate risk over long horizon, impact of capital outflows on exchange rate and BoP. Against: difficulty of hedging exchange rate risk over long horizon, impact of capital outflows on exchange rate and BoP. Trade-off diversification benefits and macroeconomic effects of foreign investment Trade-off diversification benefits and macroeconomic effects of foreign investment A gradual approach to relaxing the foreign investment limit seems judicious for emerging markets

”Prudent” quantitative limits Limits on % of portfolio invested in individual securities or issuers Limits on ownership concentration (if direct control not desirable) Limits on % of portfolio invested in non- transparent/illiquid instruments But can be left to self-regulation via the “prudent person rule”

OECD Guidelines on Pension Fund Investment Management Requires prudent person; allows some quantitative limits (e.g. self- investment) Includes “expert knowledge”, “duty of loyalty” and “due diligence” Written investment policy and risk control process Market value preferable