WHAT FUND MANAGERS SHOULD BE ADDRESSING
Following the downgrade by Moody's of a number of major global banks, managers should urgently be addressing their funds' counterparty risk. There are few signs of the economic situation in Europe improving and, at the time of this writing, further downgrades had been announced for Italian banks with some German institutions under review.
Many fund managers and treasurers expect a minimum of single A credit status for counterparties, particularly in the derivatives markets. The downgrades mean that investment advisors and fund companies will have to consider either concentrating more deal flow with fewer names or revise their minimum counterparty creditworthiness requirement.
Guidelines written up prior to the financial crisis in 2008 may have to be revisited as there has been a sea change in the global financial landscape since then. The focus on counterparty risk has intensified since 2008, with emphasis placed on CDS spreads and bank credit ratings. Hence the concerns now being raised in the market by both investment managers and investors.
Indeed, investors consider the shrinking pool of A-rated banks which can act as derivative counterparties as a more pressing concern than the Libor rate-fixing scandal.1
Regulatory requirements
UCITS funds must comply with a minimum credit rating requirement for counterparties to OTC derivative transactions (in the case of firms which are not credit institutions) of A2 or equivalent or an implied A2 rating guaranteed by an A2 rated institution. For regulated credit institutions this does not apply and therefore will be less of a concern unless a minimum rating is stipulated in the prospectus of the fund.
There are currently no minimum creditworthiness requirements for Cayman funds' counterparties, however, such considerations may be enshrined in the risk management policies of individual fund companies. These policies will require urgent review by fund directors.
The role of the board
According to recommendations made by the CESR2, an "adequate" risk management process should be maintained at fund level, and its functioning determined according to the rules established by each investment company. The policy should be reviewed and revised on a regular basis by the board of directors.
The fund's board should be in a position to review and enforce where required breaches in the risk management policy. In particular, fund directors should at this stage be actively engaged in reviewing funds' counterparty risk policies vis-a-vis banks, and determining what changes are warranted. This is a critical period for fund boards to engage with investment managers to ensure an appropriate policy is in place that investors will be comfortable with. It is also a chance for boards to be re-visiting risk management documentation and operational procedures in relation to counterparties. Such a review should include:
- Roles and responsibilities within the risk management process
- Ensuring independence of the risk management function from the operating units
- Reviewing appropriate reporting lines to the board of directors
- Making sure procedures are in place regarding the possibility of further counterparty downgrades
Further considerations
Fund managers should also ensure that where revisions are being made to the risk management policy of funds, be they UCITS or non-UCITS, appropriate approvals are received at board level and proper reporting channels remain in place between the risk management function and the board of directors.
Conclusion
The current pace at which instruments and credit institutions' ratings are changing means that risk management policies may require more regular revisions, particularly as the counter party risk picture no longer resembles that of pre-2008. Wherever possible it is essential that such changes are carried out within the appropriate parameters laid down by the fund's memoranda or other constitutional documentation, and that changes are reported to and approved by boards.
While it is to be hoped that no further changes will be required, risk management documentation may need to include the possibility that further counterparty changes be required in the event of future downgrades, or some form of reaction to such changes needs to be detailed within the risk management documentation.
Footnotes
1. 'Counterparty risk trumps Libor fixing concerns for clients', International Financing Review, July 2012
2. Risk Management Principles for UCITS, The Committee of European Securities Regulators, CESR/09-178
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