A risk based model of pensions supervision The Argentine experience Gustavo Demarco Superintendencia de AFJP, Argentina

Regulatory frameworks 1. Draconian 2. Self regulation 3. Risk based (interactive)

Draconian regulation Several Contribution-Defined pension systems of Latin America have adopted rigid regulations, particularly in regard to investment rules. Examples: a) Portfolio structure b) Investments permitted / prohibitions c) Minimum returns

Risk based Supervision Optimal supervision strategy is not a general solution (independent of particular contexts) Supervision plans are flexible Resource allocation depends on the levels of risk determined

Supervision in Argentina Four stages: 1. Inflexible supervision plans 2. Flexible supervision plans, especially in regard to management risks 3. Flexible supervision plans in regard to portfolio investments 4. Towards more flexible regulations

Concept of risk Menace to the achievement of: a) Objectives of the Companies b) Laws and regulation Focus on the consequences that affect the rights of Pension Fund members

Sources of risk Capital Assets Management Earnings Liquidity

Interactive supervision Both Supervision Authority and companies have supervision plans There may be synergies between both levels of supervision Pragmatic approach to the concepts of regulation/self regulation Supervision Authority uses internal controls of companies as ‘first stage supervision’

Interactive supervision requires Explicit definition of key procedures and control plans of the companies Explicit rules replacing direct by risk-based selective supervision Compliance Officers

Roles of Supervision Authority Define clear rules of first stage supervision (= regulate) Concentrate efforts in the second stage of supervision

Regulator’s supervision plans Combination of direct and indirect controls Intensity and types of programs depend on the evaluation of risks associated to: –critical processes –companies

Supervision Plan Includes a pragmatic combination of programs: variable scope (universe/sample) variable frequency (daily, monthly, quarterly, etc) preventive/corrective First/second stage

Compliance Officer Appointed by the Board of Directors Responsible of preparation and follow up of the Internal Control Plan of the Company Independent of Management Informs results of controls to Board of Directors and Supervision Authority Responsible of follow up in case of corrective procedures

Internal Control Plans ICP provide useful information to evaluate the companies’ risks Risk evaluation provides information to define the structure of ICP

Management Evaluation : Risk Matrix Associates a risk indicator r(i,j) to every company “i” and process “j” r (i,j) depends of several variables, in relation to: a) relative position of the company in the market b) Organization and procedures c) Previous experience (results of second level supervision)

Risk Indicators R = I x P R : Risk indicator I : Impact P : Probability of occurrence

Processes Membership Individual accounts Investments Pension plans Claims / Assistance to clients

Uses of risk matrices Determine frequency of controls Determine size of statistical samples Allocate resources (given the level of budget constraints) Support disciplinary policy

Fines / Corrective measures Fines and corrective measures also depend on the level of risk There may be monetary or non monetary sanctions Graduation of measures depends on: a) relevance of actual or potential effects b) recurrence

Investment Evaluation Portfolio investment regulations include implicit definitions of the optimum return- risk combinations Risk is implicitly defined in terms of rigid maximum portfolio share for every financial asset Flexible risk patterns require more flexible investments regulations

Investments performance evaluation Return Risk A B1B1 B2B2 C

Sharpe Index Efficiency is measured by: S i = (R i - R f ) /  i R i : return of portfolio, R f : free risk rate  i : volatility

Risk Return A B C RfRf RARA RCRC RBRB BB AA CC

Value at risk (VAR) Calculates risk by standard statistical methods Measures the worst expected loss in a time interval under normal market conditions, and given a level of confidence

Value at risk (VAR) VAR produces variable results, associated with variable volatility Portfolio limits need flexibility VAR may be used by portfolio decision makers and by Supervision Authority

Uses of portfolio risk evaluation First stage = Given the present financial regulations scheme, evaluate management and allocate resources in flexible supervision programs (e.g. on site inspections) Second stage = Use risk indicators to define ‘regulatory ranks’ (i.e., more flexible portfolio structure, minimum capital, etc.)

Revision of financial regulations Portfolio structure Investments prohibited Minimum/maximum returns Minimum capital requirements

Conclusions - 1 The adoption of a risk based approach permits more flexible supervision plans The degree of self-regulation depends on the evaluation of the level of risk associated with programs and companies Minimum guidelines for the first stage supervision plan should be provided by Supervision Authority

Conclusions - 2 The shift to a risk based strategy proved to be easier in management evaluation Usual models of financial risk evaluation may be adopted, but transition is more complex Flexible Supervision plans may demand more flexible regulations.

Conclusions - 3 Regulatory issues of risk based financial regulations still need further discussion Lower level regulations may be implemented in the short term. Higher level regulations may be part of second phase pension reforms.