Franklin Templeton Case Highlights the Need to Improve Industry Risk Management Practices
This is the final article in a series of three that explores the issues arising from the fallout of the scheme closures of Franklin Templeton’s Indian arm. The first and second articles can be accessed here and here.
Legendary investor Benjamin Graham once said, “the essence of investment management is the management of risks, not the management of returns.” The closure of the six Franklin Templeton (FT) schemes last year is, at its core, a failure of risk management, as amply illustrated in the Securities and Exchange Board of India’s (SEBI) recent order. But were these deficiencies specific to one firm, or can we take broader lessons for the Indian 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, like running schemes in a similar manner (with overlapping holdings) and thereby violating SEBI’s categorization rules in spirit, if not the letter. In addition, it’s clear that the calculation of Macaulay duration (a measure of the interest rate risk) did not have an adequate and reasonable basis, because FT and its valuation agencies did not account for the conditions in the term sheets, which were favorable to issuers. As a result, the duration of the six schemes was grossly underestimated.
The broader question is whether these risk management issues are specific to one firm or systemic. The poor business judgment that led to the closure of the schemes was perhaps specific; FT took a lot of exposure to promoter entities that depended on the cash flows of their investee companies. Even if these exposures were secured by the shares of the investee companies, during a crisis, both the promoters’ ability to pay and the value of the collateral would deteriorate, exposing investors to a downward spiral. It’s not clear whether the issue with the duration calculation was prevalent across the industry. Although regulations can outline valuation principles and provide some guidelines, they 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. In recent years, India has moved from a bank-led intermediation of credit, to a mutual fund-led one. Earlier, when faced with financial difficulties, banks resorted to evergreening bad loans; FT evergreened by not exercising its put options, which would have forced repayment on issuers and a possible default. In the banks’ case, the decision to extend-and-pretend was based on a desire to avoid recognizing bad loans that would have affected their capital adequacy ratios. In FT’s case, it was a desire to avoid protracted bankruptcy proceedings in the National Company Law Tribunal (NCLT), with a possibility of steep haircuts. SEBI recently tackled the valuation aspect of nonexercise of put options (by forcing valuation agencies to not consider remaining put options in their valuation), but the credit risk aspect is more important. Nonexercise, however, also must trigger a credit rating review.
We have seen a flurry of rulemaking in risk management. The Circular on Product Labelling in Mutual Fund schemes (Risk-o-meter) 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 short-duration funds have necessarily low risks. Last, the new rules set additional limits on residual maturity, which is a more straightforward concept than duration; for example, for schemes with a duration of less than one year, the residual maturity of instruments shall be less than three years. These rules, however, must be complemented with oversight over valuation and risk management, accompanied by penalties for misleading practices.
The recent requirements for stress testing provide an opportunity to strengthen the ability of debt mutual funds to manage risk appropriately in the best interests of investors. 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, in cases in which the stress-testing guidelines are provided by an industry association or a third-party provider, mutual funds must complement the scenarios with their 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, including risk management professionals, boards of asset management firms, portfolio managers, and investors, have the same understanding about the risks of the product and to ensure that expectations are not mismatched. What we have learned from FT has moved the risk management regulations forward, but it is important not to wait for the next crisis to discover its shortcomings.
This article first appeared in Livemint.
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