By Helen Roberts
In June 2008, Moody’s rated Lehman Brothers’ debt at A1-investment grade, and only a few months later the unthinkable happened, the investment giant went bankrupt. The ramifications of the banking collapse of 2008 would be felt for years if not decades to come.
Not since 1929 had the financial world witnessed anything like it and governments were forced to sink trillions of dollars in global financial systems to prevent them collapsing entirely.
Since the collapse of Lehman Brothers in 2008, we have seen a host of regulatory reforms aimed at making the financial system safer and more transparent. Many of the reforms such as Basel III have focused on the banking sector and the need for banks to increase the quality and quantity of capital they hold. Despite the plethora of financial reforms, however, many commentators suggest the structure of financial intermediation (how institutions connect with each other) is still far too complex and has obvious risks.
Pension funds are also placing risk management at the top of their agendas. Most pension schemes − other than those managed in-house − appoint investment managers to manage their assets. So pension funds should be clear their investment managers are following best practices in assessing, monitoring and reacting to counterparty risk.
The checklist for achieving this starts with a clear and detailed investment management agreement (IMA) and credit support documents outlining the parameters in terms of counterparty creditworthiness, concentration of counterparties and margin requirements. But the checklist doesn’t end there. Pension funds should be clear that their investment managers have a dedicated team and appropriate resources to review counterparty risk on a regular basis.
There should be a robust and dynamic process to assess counterparty creditworthiness and a transparent system whereby counterparties are assessed and approved. There also needs to be a system to measure and monitor the credit exposure to each counterparty risk, broken down by asset class, tools available to monitor aggregate positions, and a process to give clients timely feedback when aggregate positions become substantial.
For their part, pension schemes require a holistic approach to counterparty risk. They need to have systems and processes in place to monitor the scheme’s overall counterparty risk exposure across their investment managers. The information has to be readily available and accurate. The recent swathes of regulation may be well intentioned and aimed at reducing counterparty risk, but on their own may not be enough to prevent future credit events. The other major concern among pension schemes surrounds the extra costs involved in implementing the regulatory changes.
What is clear, however, is that to meet their fiduciary duties schemes need to ensure not only their investment managers have the processes and systems available but they too have these in place. And once in place be vigilant to ensure that best practices are followed when looking at counterparty risk.
Helen Roberts is investment policy lead at the National Association of Pension Funds
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