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Legendary investor Benjamin Graham once said, “The essence of investment management is the management of risks, not the management of returns." The closure of six Franklin Templeton (FT) schemes last year is, at its core, a failure of risk management, as illustrated in the Securities and Exchange Board of India’s (Sebi’s) recent order. But were these deficiencies specific to one firm, or are there broader lessons for the fund industry?

The issues are manifold. Some failures are straightforward, including an operational risk failure that led FT to conduct a transaction with an entity barred by Sebi, and a failure to adjust the valuation of instruments from issuers facing financing difficulties. Other issues are more nuanced, such as running schemes in a similar manner (with overlapping holdings), thereby violating Sebi’s categorization rules in spirit, if not the letter. The broader question is whether some of the risk management issues are specific to one firm or systemic. While regulations can outline valuation principles and provide some guidelines, it cannot account for every scenario; the valuation agencies have a critical role to play here.

FT’s handling of issuers facing financial difficulties has parallels with banking, and points to a systemic issue. India moved from a bank-led intermediation of credit to a mutual fund-led one in recent years. Earlier, when faced with financial difficulties, banks resorted to evergreening of bad loans; FT evergreened by not exercising its put options, which would have forced repayment on issuers and a possible default.

In the case of banks, the decision to extend-and-pretend was based on a desire to avoid recognizing bad loans that would have impacted their capital adequacy ratios; in FT’s case, it was a desire to avoid protracted bankruptcy proceedings in the National Company Law Tribunal, with a possibility of steep haircuts. Sebi recently tackled the valuation aspect of non-exercise of put options (by forcing valuation agencies to not consider remaining put options in their valuation), but the credit risk aspect is more important, and non-exercise must also trigger a credit rating review.

There has been a flurry of rulemaking in risk management. The Circular on Product Labelling in MF schemes (Riskometer) released last year recognizes the fact that in stressed markets, liquidity risks may override market and credit risks in terms of importance. The recent rules around providing disclosures across both duration (one year and less, three years and less, and any duration) and credit spectrum (three levels) are useful and disabuse the notion that low-duration funds have necessarily low risks. Lastly, the new rules set additional limits on residual maturity. However, these rules must be complemented by oversight over valuation and risk management, with penalties for misleading practices.

The recent requirements for stress testing provide an opportunity to strengthen the ability of debt mutual funds in managing risk appropriately in the best interests of investors. However, to be effective, the methodology and assumptions behind stress-testing models must have a reasonable basis, and not merely be an arbitrary percentage or haircut. Second, where the stress-testing guidelines are provided by an industry association or a third-party provider, mutual funds must complement the scenarios with their own alternative methodologies; the biggest risk in stress-testing models is the risk of a single industry-wide view.

All said, the purpose of risk management is not to reduce risks. The purpose is to understand and communicate the risks clearly so that all stakeholders, from risk management professionals, boards of asset management firms, portfolio managers to investors, have the same understanding about the risks of the product, and that there is no mismatch in expectations.

The learnings from FT have moved the risk management regulations forward, but it is important not to wait for the next crisis to discover their shortcomings.

Sivananth Ramachandran, CFA, is director-capital markets policy, India, CFA Institute.

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