Risk Management Manual

Transcription

1 UNITED NATIONS JOINT STAFF PENSION FUND Investment Management Division Friday, January 22, 2010

2 Table of Contents I. Introduction... 9 II. Note by the Representative of the Secretary General... 9 III. Duties and Responsibilities of the Governing Bodies A. General Assembly B. United Nations Joint Staff Pension Board C. Secretary General D. Representative of the Secretary General E. Investments Committee F. Investment Management Division IV. Guiding Principles A. It is better to be approximately right than to be precisely wrong B. All policies, procedures and manuals shall be approved, should be considered living documents and should be reviewed periodically C. Separation of the front office, middle office and back office with independent risk oversight and internal audit oversight D. Organization structure should be clearly defined with clear roles and responsibilities and risk principles should be consistently applied E. Test disaster recovery and business continuity plan on the regular basis with sound understanding of the residual risks F. Manage model risks. All Risk Models have model risks G. Set proper risk appetite with the sound understanding of the asset liability structure H. Perform stress test and back tests I. All external counterparties shall be subject to periodic due diligence J. Independent review of the risk management controls by an external expert K. Translate the lessons learnt into new risk controls L. Risk Objectives Safety Profitability Convertibility Liquidity

3 5. Risk Tolerance V. Governance VI. Risk Management Controls A. Credit Risk Issuer Ratings Fitch Individual Bank Ratings Credit Risk Controls ) Monitor Bond and Short Term Investment Limits: ) Monitor Equity Debt Factor: ) Broker Screening B. Counterparty Risk Custodian / MRK ) Acquisition of the services: ) On going due diligence: ) Monitor Regulatory Capital and Economic Capital: ) Monitor CDS spread: ) Monitor individual bank rating: ) Monitor Assets under custody: ) Monitor failed trades: ) Operational Losses or Fraud ) Service Delivery: Brokers ) Brokerage Agreement Services ) Failed Trades: ) Monitor Commission ) Monitor Daily Trade Blotter: External Advisors ) Service Delivery External Managers (Small Cap, Alternative Investment) ) Service Delivery

4 2) Due Diligence ) Insurance Bond ) Compliance with the investment guidelines C. Market Risk Asset Allocation Controls ) Equity Strategic AA ) Equity Tactical AA ) Fixed Income Strategic AA ) Fixed Income Tactical AA ) Real Assets Strategic AA ) Real Assets Tactical AA ) Short Term Strategic AA ) Short Term Tactical AA ) Developing Country Investments ) Developing Country Total Investments Socially Responsible Investments and Global Compact ) Weapons: ) Tobacco ) Prohibited Investments (Internal & External Managers): ) Prohibited Shorts: ) Negative Cash Holdings: ) Countries (Internal & External Managers) w/tax Exceptions: Global Equity Portfolio ) Single Equity < 5% of total Equity ) 4.75% Limit Shares Outstanding ) SC Europe 2% Limit Shares Outstanding ) Convertible bonds < 10% issue: ) SC Europe Max Cap Euro 2B: ) SC Asia Max Cap Yen 300B: ) SC US (Jen & DFA) Max Cap USD 3B

5 8) SC Europe GIC Sector Concentration ) SC Asia GIC Sector Concentration: ) SC US (Jen & DFA) GIC Sector Concentration ) SC (Europe, Asia, US: Jen & DFA) Cash < 5% Account Global Fixed Income Portfolio ) Credit Rating Minimum A ) Issuer Limit 5% Corporate: ) Total Debt Corporate < 10%: ) Issuer Limit 15% Sovereign ) Total Debt Sovereign < 20%: Global Real Assets Portfolio ) Physical Buildings ) RE Investments < 25%: Global Short Term Portfolio ) Issuer Limit 5% Corporate: ) Total Debt Corporate < 10%: ) Maturity limit <365 days: Miscellaneous ) Risk Tolerance & Risk Oversight ) Excessive Churning ) Realized losses >25%, unrealized losses > 25% 50%: ) External Factors ) Standing UN Rules & Regulations: ) Departmental Cross Communication ) External and Internal Audit Effectiveness: ) Management Letter Response: ) Actuarial Estimates: ) Investment Research: ) Advisor Performance ) Monitor Market Value Parameters:

6 D. Liquidity Risk ) Duration Gap ) Capital Commitment for Alternative Investments ) Stress Test with the latest ALM study for Solvency: ) Market Liquidity: E. Operational Risk ) Test Business Continuity Plan: ) Test Disaster Recovery Plan: ) Lessons Learned: ) White Pages: ) Remote Work Plan: ) Trade Errors Monitoring: ) Ten Continuous Annual Leave Days: ) Cash Management: ) Accounting Standards Implementation: ) Internal and external Fraud, Conflict of Interest: ) Effectiveness and efficiency of Trading, Operations and Investment Controls: ) Succession Planning: ) IT Outsourcing Vendor performance evaluation : ) IT Change Management: ) Password Management: ) IMD Staff Travel: ) Maintaining distribution lists: F. Currency Risk G. Legal and Contract Risk ) Countries with Tax Exemptions: ) Contract Renewal: ) Contract Review: ) Contract Issue Management: ) Legal contracts review for foreign jurisdiction:

7 6) Proxy Voting Review: ) Ensure Sufficiency and Quality of External Legal Counsel: H. Political and Sovereign Risk ) Monitor Sovereign Rating: ) IC Committee Advisor Reports I. Reporting Risk ) Investment Performance Monitoring: ) GIPS Compliance Monitoring: ) Information Security, Privacy & Records retention: ) Minutes for important investment meetings: J. Reputational Risk ) Monitor Compliance with all the risk controls: ) Information Dissemination and One Voice: ) Proactive co operation with all audit bodies: ) Late Payments: ) Compliance with PD rules: ) Compliance with Personal trading and conflict of interest policy: ) Compliance with gift policy: ) Understanding the conflict of interest, gift policy: ) Trade distribution across brokers: ) Complete all the mandatory trainings: ) surveillance: VII. Appendix A. Due Diligence Process for Hedge Fund Managers Investment Strategy review The Fund Structure Review Performance Review Risk assessment Administrative Review Legal Review

8 7. Reference Checks B. Gift & Entertainment Policy Gifts Entertainment Offers of Hospitality Questions

9 I. Introduction 1) The Regulations of the United Nations Joint Staff Pension Fund provide that the investment of the assets of the Fund will be decided upon by the Secretary General. The Secretary General has delegated the responsibility for overseeing this task to a senior United Nations official, designated as the Representative of the Secretary General for the Investments of the United Nations Joint Staff Pension Fund (RSG). The Secretary General's representative is assisted by the Investment Management Division (IMD). 2) The original procedures were published in January 1990 and amended periodically. In , a major review was undertaken to reflect the changes in the procedures that have taken place over the years. The procedures were updated in January 2006 to further update the 2005 version. 3) The Current Investment manual is updated in December 2009 for the purposes of clarity, organization and to accommodate various recommendations from the OIOS. II. Note by the Representative of the Secretary General 1) At the 54 th session of the Pension Board, the Investment Management Division (IMD) was requested to develop a comprehensive investment policy and present it to the Investment Committee for their comments following the results of the asset liability management (ALM) study undertaken last year and presented to the Pension Board during the same session. 2) The proposed investment policy was presented at the 196 th Investments Committee on 5 May IMD has incorporated all the recommendations made by the Committee. 3) The proposed investment policy reflects the Fund s strategic purpose of funding liabilities and details the primary investment goal, asset classes, performance objective, benchmarks, portfolio strategy, investment style, risk management and strategic asset allocation target. 4) The strategic asset allocation, the most critical element of the investment policy decision that will impact the long term risk adjusted performance of the Fund, is 60 per cent equities, 31 percent fixed income, 6 per cent real assets and 3 per cent short term investments as decided by the Representative of the Secretary General for the investments of the Fund at the 54 th session. 5) Risk tolerance thresholds that set an acknowledged and acceptable level of risk, the amount of loss that is tolerable in the pursuit of gain, will be implemented in the investment policy when the proper risk analytic tools to effectively evaluate and monitor the global portfolio are sourced. IMD is currently conducting a search for a portfolio risk analysis and performance attribution system. A risk model with a multi factor framework will identify the factors and securities to which risk is most sensitive and provide critical insights into the composition of the Fund portfolio risk and returns. 9

10 6) Risk budgeting is crucial to the investment process and will be detailed in the investment policy when the proper financial tools are available for implementation. The objective of risk budgeting is to create a systematic plan for the expenditure of risk and allocating what is the total risk that we are willing to incur to generate returns (risk tolerance), and measuring the risk allocated to each investment decision. The overall investment process can be improved by enforcing discipline, eliminating unintended or disproportionate bets, and balancing the risk and return of each investment decision. 7) The use of futures was discussed in the 195 th Investments Committee meeting and procedures, as requested during that meeting, were proposed in the 196 th Investments Committee meeting. The members of the Committee were of the opinion that such tools are basic and commonly used by pension funds to reduce the risk of adverse market moves. These tools will be implemented in accordance with best practices. 8) The existing proxy voting policies will be revised as part of the process of implementation of Responsible Investment. 9) Following an alternative investments study conducted by Mercer Investment Consulting Inc. in its report dated 30 th April 2008 and presented at the 196 th Investment Committee on 5 th May 2008, the report recommended material strategic asset allocation changes to lower the Fund s exposure to systematic risk and increase diversification. Amendments will be made to the strategic asset allocation once approval is granted from the Representative of the Secretary General and shall be then reflected in the investment policy. 10) The Pension Board may wish to take note of the Investment Policy provided in the annex to this note. 10

11 III. Duties and Responsibilities of the Governing Bodies A. General Assembly 1) The General Assembly at its first session in 1946 adopted a resolution whereby the fiduciary responsibility for the investment of the assets of the Fund was entrusted to the Secretary General of the United Nations. This fiduciary responsibility was further confirmed in 1948 when the General Assembly approved and adopted the Rules and Regulations of the United Nations Joint Staff Pension Fund. 2) The General Assembly may from time to time adopt resolutions on general investment policy as long as these resolutions are not conflicting with the fiduciary responsibility of the Secretary General. These resolutions for example have established that the investments of the Fund should abide with criteria of safety, profitability, liquidity and convertibility. All past General Assembly resolutions have confirmed the Secretary General s fiduciary responsibility which requires that all investment decisions taken must be in the best interests of the Fund. 3) In summary: a. The investment policies to be pursued by the Secretary General with respect to the investments of the Fund are established by the General Assembly of the United Nations. b. The texts of applicable General Assembly resolutions embodying UNJSPF investment policies shall be filed and updated by the Investment Management Division of the UNJSPF. c. The UNJSPF Pension Board and the Investments Committee shall assist the Secretary General in the formulation and implementation of the Fund s total plan risk and determine the Fund s tolerance for risk, taking into account future benefit obligations and contributions requirements. B. United Nations Joint Staff Pension Board 1) Article 4 of the Rules and Regulations of the Fund state that the Fund is administered by the United Nations Joint Staff Pension Board (UNJSPB), a staff pension committee for each member organization, and a secretariat to the Board and to each committee. 2) The United Nations Joint Staff Pension Board and the General Assembly may from time to time make observations and recommendations on broad investment policy. 3) The Pension Board shall review the investments of the Fund at its regular sessions with a view to rendering advice to the Secretary General on investment policies as to their adequacy and consistency with the Fund s goals and objectives. C. Secretary General 1) Article 19 of the Rules and Regulations of the Fund state that 11

12 a. The investment of the assets of the Fund shall be decided upon by the Secretary General after consultation with an Investments Committee and in light of observations and suggestions made from time to time by the Board on the investments policy. b. The Secretary General shall arrange for the maintenance of detailed accounts of all investments and other transactions relating to the Fund, which shall be open to examination by the Board. 2) In exercising his/her fiduciary responsibility, the Secretary General must ensure that all investment decisions are made in conformity with the Rules and Regulations of the Fund and in the best interest of the Fund. D. Representative of the Secretary General 1) The Secretary General has delegated the fiduciary responsibility for the investment of the Fund to a senior United Nations official who acts as the Representative of the Secretary General for the investments of the UNJSPF (RSG). 2) The RSG has the over all responsibility for the management of the investments of the assets of the Fund. On behalf of the Secretary General, the RSG is responsible for the approval of the investment policy, the strategic and tactical asset allocation and the appropriate investment strategy after consultation with the Investments Committee. The RSG oversees the implementation of investments decisions and ensures that the approved investment policy and assets allocation are followed. He/she is responsible for the reporting to the Pension Board, the ACABQ and the General Assembly on the performance of the Fund s investments. E. Investments Committee 1) In accordance with the relevant General Assembly Resolution and the Rules and Regulations of the Fund, the Secretary General in exercising his fiduciary duties consults with the United Nations Investments Committee (IC). The Committee advises the Secretary General and the RSG on long term investment policy, strategic and tactical asset allocation and investment strategy and on any matter related to the investments of the assets of the Fund that the members consider should be brought to the attention of the Secretary General or the RSG for appropriate action. The Committee meets on a quarterly basis to review the performance of the investments of the Fund, to discuss economic and market developments and to recommend long term and short term asset allocation. 2) The Investments Committee consists of nine members appointed by the Secretary General after consultation with the Pension Board and the Advisory Committee on Administrative and Budgetary Questions, subject to confirmation by the General Assembly. In addition to regular members, the Secretary General may appoint ad hoc members to serve in the Committee. 12

13 3) Pursuant to Article 19 (a) of the Regulations of the UNJSPF, the Investments Committee shall advise the Secretary General on long term investments. It shall also advise the Secretary General on overall investment guidelines and strategy. 4) In keeping with its terms of reference, the Investments Committee may also advise the Secretary General on any matter related to the investments of the assets of the Fund which the Committee is of the view should be brought to the attention of the Secretary General for appropriate action. 5) The Investments Committee normally meets four to five times a year, including one meeting annually held in conjunction with the session of the Pension Board and biennially with the Committee of Actuaries. The Investments Committee advises the Secretary General on the following matters: investment policy; asset allocation and strategy; while the long term guidelines provide the strategic asset allocation which is expected to generate investment returns with a risk level appropriate for the Fund s pension liability characteristics, the short term tactics reflect the direction in which each portfolio section should move under certain expectations; diversification by type of investment, currencies and economic sector; and other matters, which in the view of the Committee, should be brought to the attention of the Secretary General or on which the latter may deem the advice of the Committee desirable. 6) The Investments Committee reviews investment returns, small capitalization manager performance, diversification, and transactions of the Fund every quarter, as provided by IMD in its Bluebook and by the Institutional Investment Advisors. 7) The Committee s report shall be composed of the minutes of each meeting as prepared by the Secretary, reviewed by the Representative of the Secretary General, the Director and the participants. The report shall be reviewed and approved by the Committee at its next meeting. 8) The Secretary of the Investments Committee is appointed by the Director of IMD. The Secretary makes appropriate arrangements for the functioning of the meetings in consultation with the Director of IMD. The Secretary shall also oversee the travel arrangements for the members of the Committee attending scheduled meetings. The Secretary shall moreover ensure that only such reports as have been approved by the Investments Committee are released for distribution. 13

14 F. Investment Management Division 1) The staff of the Investment Management Division (IMD) assists the Secretary General and the RSG in the management of the investments of the assets of the UNJSPF. The staff of IMD is responsible for the day to day management of the Fund s assets. They implement the approved investment strategy and ensure that the portfolio conforms to the approved asset allocation. On a daily basis, the staff analyzes the financial markets, makes sales and purchase recommendations of securities and evaluates the returns achieved. IMD formulates investment strategies for a long term investment horizon and makes certain that the investments of the Fund conform to the approved policies and the Rules and Regulations of the Fund. The IMD ensure that performance and portfolio risk analyses reports are accurate and up to date and arranges for the maintenance of appropriate and accurate accounts on the Fund s investments. 14

15 IV. Guiding Principles A. It is better to be approximately right than to be precisely wrong. Risk management is highly quantitative in nature. All quantitative analysis should be firmly rooted in sound economic understanding. Commonsense should prevail and IMD shall question all quantitative conclusions if they seem counter intuitive and not seem be based on sound economic principles. B. All policies, procedures and manuals shall be approved, should be considered living documents and should be reviewed periodically. All policies and procedures should reflect the risk management objectives. The investment environment is fluid and that fluidity should reflect in periodic review of the procedures and policies. In addition, risk management policy and the investment policy should be reviewed every quarter to ensure IMD policies and processes take into account the latest market conditions. Changes in the policies should be internally debated, reviewed, and presented to the Investment Committee to see their guidance. All material changes shall be approved and be operational. C. Separation of the front office, middle office and back office with independent risk oversight and internal audit oversight The Risk and Compliance function should perform the independent oversight of all the processes of the front office, middle office and back office. Industry best practice of the separation of front office and back office should be followed to manage the operational risk. D. Organization structure should be clearly defined with clear roles and responsibilities and risk principles should be consistently applied. Risk controls should be consistently applied to all internal personnel and external counterparties. Exceptions should be noted, probed and root cause analysis should be performed. Reporting lines should be clearly defined with risk and compliance function to have direct access to the Representative of the Secretary General. Any changes in the roles and responsibilities shall be documented and communicated to the all affected parties. 15

16 E. Test disaster recovery and business continuity plan on the regular basis with sound understanding of the residual risks. Business continuity and disaster events are low frequency high impact incidences, the impact of which can be significant on the IMD. IMD should evaluate the disaster recovery and business continuity plans on the regular basis to ensure all material identified risks are identified and proper controls are placed. IMD should have a good understanding of the residual risks. IMD policies should ensure that all personnel understand their role in the event of disaster and have the equipment to function independently at an alternate location. F. Manage model risks. All Risk Models have model risks. All quantitative models are based on certain assumptions (normality of distribution etc). IMD should have good understanding of the limitations of the models and be conservative in terms of applying quantitative insights. G. Set proper risk appetite with the sound understanding of the asset liability structure Risk appetite cannot be properly set without the good understanding of the liability structure. IMD should be intimately involved in all Asset Liabilities studies, should have a sound understanding of the liability structure, currency exposure and set the risk appetite based on it. H. Perform stress test and back tests IMD should stress test and back test all the models. Stress test scenarios should be revisited a at least quarterly. IMD should also back test all the models. For example, if IMD is producing statistics based in 99 percent confidence intervals, it should back test to see that approximately one percent of the events are falling out of its confidence interval. Based on back testing, IMD may need to fine tune its models. I. All external counterparties shall be subject to periodic due diligence. IMD should exercise proper oversight to all the external counterparties (external fund managers, custodians, brokers etc) to ensure that counterparties have adequate risk controls and compliance functions are in place and their actions are not subjecting the IMD to undue risks. 16

17 J. Independent review of the risk management controls by an external expert IMD should evaluate the efficacy of its risk management function periodically by getting the risk management process and controls reviewed by an external expert. Feedback from the expert shall be reviewed and incorporated into the risk management function to strengthen the risk management process. K. Translate the lessons learnt into new risk controls The IMD should organize the lessons learnt sessions on a regular basis to understand what worked and what did not work. Processes should be improved based on the insights gained by the actual incidents and lessons should be translated into risk management controls. L. Risk Objectives The investment objectives of the Fund, which take into account observations and requests made by the General Assembly and the Pension Board, as reviewed and considered by the Investments Committee are: 1. Safety Safety is achieved by ensuring adequate asset class, geographic, currency, sector and industry diversification, by carefully researching and documenting investment recommendations and constantly reviewing the portfolio in order to take advantage of the unsynchronized economic cycles, market and currency movements. Asset classes are all subject to market risk; security is a relative term. 2. Profitability Profitability requires that each investment at the time of purchase be expected to earn a positive total return, taking into account potential risk, particularly market risk which is common to all securities of the same general class and commonly can be mitigated but not eliminated by diversification. 3. Convertibility Convertibility is the ability to readily convert investments into liquid currencies. Convertibility facilitates payments in local currencies. The Fiduciary responsibility to the Fund s participants mandates that due to the U.S. dollar based market valuation of the Fund, and the U.S. dollar based appraisal of its actuarial soundness, all investments should be readily and fully convertible into U.S. dollars. 17

18 4. Liquidity Liquidity is the ready marketability of the assets in recognized sound, stable and competitive exchanges or markets. Liquidity is required to ensure that the portfolio can be restructured in the shortest possible time in order to enhance total return and/or to minimize potential losses. In establishing liquidity requirements, the Investment Management Division ( IMD ) will take the following factors into consideration: (a) (b) (c) the need for liquidity to meet payroll requirements in an array of currencies the need for funds to take advantage of investment opportunities as they arise the need for funds required for projected cash flows The emphasis on liquidity shall be an investment consideration based on the expected changes in the funding of short term liabilities. Managing liquidity to meet the Fund s requirements will be met by structuring the investment portfolio to maintain a sufficient allocation of funds in highly liquid securities. IMD will consider an acceptable range of illiquidity to generate a higher return from the approved asset classes. It is noted that there may be attractive investment opportunities which require longterm commitments from the Fund. The Fund may invest in longer term asset classes, such as alternative investments 1, with the concurrence of the RSG. 5. Risk Tolerance Under Development: Risk tolerance will be established using input from the most recent ALM study, historical and projected performance and holdings based risk attribution data collected for a year from the risk system. The Risk tolerance will be multi dimensional in nature. It address the downside risk using tolerance based on Value at Risk (VaR) and active management tolerance based on Tracking Error. The Risk Tolerance will be the primary input in setting up the risk budget for various investment managers. 1 Real assets and alternative investments have limited liquidity 18

19 V. Governance Risk & Compliance Governance a b c 1 Create/Update/Approve Investment policy and guidelines Create/Update/Approve Operations Guidelines Create/Update/Approve Advisor evaluation guidelines Investments, Risk, IC Operations, Risk Investments g h Advisors produce research based on IMS request Advisors pro-actively send research based on IMS portfolio 3 Advisors Advisors k PM initiates research on an asset Receive Recommendation Determine appropriate portfolio weight PM PM PM p q Performs risk analytics on demand & on shedule Analyze portfolio characteristics and risk budgets 2 Risk Risk v w Produce Various Risk Reports Review Performance Reports Risk, Custodian Risk, PM d Create/Update/Approve Broker evaluation guidelines Investments Legend PM: Portfolio Managers IMD: Investment Management Division PD: Procurement Dept IC: Investment Committee m Initiate Trade PM Recommend Portfolio Adjustment Risk x Create Broker Performance evaluation Report PM, Compliance e Policy & Guidelines Review / Update Advisors services Review / Update Brokers Services IMD, PD IMD, PD n o Execute Trade Order File appropriate Documentation Operations, Brokers, it Operations, IT s Monitor Trade process Risk, Compliance Monitor Compliance with various policies Risk, Compliance, Audit u Review Compliance / performance / Broker / Advisor/ Operations Reports Risk, Compliance y z Create Advisor Performance Evaluation Report Produce compliance Reports PM, Compliance Risk, Compliance j l r t f 19

20 VI. Risk Management Controls A. Credit Risk 1. Issuer Ratings Short and long term Issuer Default Ratings (IDRs) may be assigned to entities for certain sectors, including Corporate, Financial Institution and Sovereign entities, which reflect the ability of an entity to meet financial commitments on a timely basis. Similar to other ratings, these are drawn from the International Long term and Short term ratings scales and are identified as IDRs. A short term Issuer Default Rating (SIDR) is based on the liquidity profile of the rated entity and relates to the ongoing capacity to meet financial obligations with a relatively short time horizon (less than 13 months, except for public finance where short term ratings may be assigned up to a three year horizon, in line with industry standards). The long term IDR is assigned to issuers and counterparties, reflecting their ability to meet all of their most senior financial obligations on a timely basis over the term of the obligation. The long term IDR, therefore, is effectively a benchmark probability of default rating. Credit Risk Moody's* Standard & Poor's** Fitch** INVESTMENT GRADE Highest quality Aaa AAA AAA High quality (very strong) Aa AA AA Upper medium grade (strong) A A A Medium grade Baa BBB BBB NON INVESTMENT GRADE Lower medium grade (somewhat speculative) Ba BB BB Low grade (speculative) B B B Poor quality (may default) Caa CCC CCC Most speculative Ca CC CC No interest being paid or bankruptcy petition filed C C C In default C D D Source: The Bond Market Association * The ratings from Aa to Ca by Moody s may be modified by the addition of a 1,2 or 3 to show relative standing within the category. 20

21 ** The ratings from AA to CC by Standard and Poor s and Fitch may be modified by the addition of a plus or minus sign to show relative standing within the category. 2. Fitch Individual Bank Ratings Individual Ratings are assigned only to banks. These ratings, which are internationally comparable, attempt to assess how a bank would be viewed if it were entirely independent and could not rely on external support. These ratings are designed to assess a bank's exposure to, appetite for, and management of risk, and thus represent our view on the likelihood that it would run into significant difficulties such that it would require support. The principal factors used to analyze and evaluate the bank and determine these ratings include: profitability and balance sheet integrity (including capitalization), franchise, management, operating environment, and prospects. Finally, consistency is an important consideration, as is a bank's size (in terms of equity capital) and diversification (in terms of involvement in a variety of activities in different economic and geographical sectors). A denotes: A very strong bank. Characteristics may include outstanding profitability and balance sheet integrity, franchise, management, operating environment or prospects. B denotes: A strong bank. There are no major concerns regarding the bank. Characteristics may include strong profitability and balance sheet integrity, franchise, management, operating environment or prospects. C denotes: An adequate bank, which, however, possesses one or more troublesome aspects. There may be some concerns regarding its profitability and balance sheet integrity, franchise, management, operating environment or prospects. D denotes: A bank, which has weaknesses of internal and/or external origin. There are concerns regarding its profitability and balance sheet integrity, franchise, management, operating environment or prospects. Banks in emerging markets are necessarily faced with a greater number of potential deficiencies of external origin. E denotes: A bank with very serious problems, which either requires or is likely to require external support. F denotes: A bank that has either defaulted or, in Fitch s opinion, would have defaulted if it had not received external support. Examples of such support include state or local government support, (deposit) insurance funds; acquisition by some other corporate entity or an injection of new funds from its shareholders or equivalent. Notes: Gradations may be used among the five ratings: i.e. A/B, B/C, C/D, and D/E. 21

22 1) The Credit Policy was introduced in May 2008 to ensure the proper mechanisms are implemented to assess the creditworthiness of counterparties and to manage risk through quality management by creating credit limits for investments. 2) The Credit Policy was first approved by the Investments Committee during the 196 th meeting on 5 th May ) Credit risk is defined as the potential that a borrower or counterparty will fail to meet its obligations in accordance with agreed terms resulting in a loss. The risk of a trading partner not fulfilling its obligations to another in a timely manner is a risk that all obligors face. Ensuring adequate control over credit risk and effective credit risk management is critical to the long term success of investment managers. 4) Credit risk management should address the following important areas: a. Approving and maintaining appropriate credit exposure measurement standards; b. Establishing limits for amounts and concentrations of credit risk, monitoring and implementing a review process for credit exposure and; c. Ensuring adequate controls over credit risk. To manage the credit risk at Investment Management Division of UNJSPF, the following internal controls have been implemented to ensure the safety of the Fund s assets and to minimize exposure to counterparties. 3. Credit Risk Controls 1) Monitor Bond and Short Term Investment Limits: Bond holdings must comply with fixed income investment guidelines outlined in Investment Policies and Procedures. Exception report shall be generated for the holdings which do not meet the guidelines. All outstanding breaches are reported to the IMD Director and the Investment team. for Post Trade compliance and Charles River for Pre Trade Compliance. Evidence: Breach report and memo to the investment team Action: a. Memo to the Investment team and the Director. b. Investments in bonds that violate the limits stated are monitored by the Investment Officer to determine the best opportunity for exiting the position at the best available price for long term ratings that are downgraded to Standard and Poor s BBB, Moody s Baa2 and Fitch IBCA BBB or below. c. Investments in bonds that violate the issue and total bond portion of the fund limits stated are monitored by the Investment Officer to determine the best opportunity for reducing the position at the best available price to bring the position back to acceptable limits. d. Investments in short term investments that violate the limits stated are monitored by the Investment Officer to determine the best opportunity for exiting the position 22

23 at the best available price for ratings that are downgraded to Standard and Poor s BBB, Moody s Baa2 and Fitch IBCA BBB or below. 2) Monitor Equity Debt Factor: The following ratios are utilized to assess the long term solvency of equity securities and signal weakness in financial strength regarding the cost of debts and its impact on the company s potential increase in default risk. (a) Debt to Capital Ratio = Total Debt (LT + ST) / Total Debt + Shareholders Equity (b) Debt to Equity Ratio = Total Debt (LT + ST) / Total Equity No formal limits, however, Investment Officers will monitor the capital structure with such indicators as they deem appropriate. Northern Trust Compliance reports and Thompson Portfolio Analytics generate security equity debt factors and these figures are reviewed on a periodic basis. & Thompson Portfolio Analytics Evidence: Equity Debt Report Action: Report to the Investment team and the Director. 3) Broker Screening: a. The selection of brokers used for sales and purchases for the UNJSPF ( Investment Manager ) is evaluated based on the Fitch Individual bank credit ratings; a leading global rating agency committed to providing the world s credit markets with valued and insightful independent credit research. b. Individual ratings are assigned only to banks and attempt to assess how a bank would be viewed if it were entirely independent and could not rely on external support. The ratings are designed to assess a bank s exposure to, appetite for, and management of risk, and thus represent the rating agency s view on the likelihood that it would run into significant difficulties. c. Principal factors used to evaluate banks include profitability and balance sheet integrity (including capitalization), franchise, management, operating environment, consistency, size and diversification. d. The minimum individual bank credit rating of B/C and minimum of US $5 billion in assets is preferred by UNJSPF for banks utilized for bond and equity trades. B rating denotes a strong bank with no major concerns and a C rating represents an adequate bank. e. The minimum individual bank credit rating of B is preferred by UNJSPF for banks utilized for short term investments. f. A review of the Fitch individual bank ratings is performed periodically (Quarterly). Proper consideration and proactive measures are made based on the following rating actions: 23

24 i. New ratings: A new rating has been assigned. ii. Upgrades: The rating has been raised in the scale. iii. Downgrades: The rating has been lowered in the scale. iv. Rating Watch On: The issue or issuer has been placed on active rating watch status. v. Change: The rating has been changed or modified due to a revision in methodology. vi. Revision Rating: The rating has been modified, usually as a result of the introduction of a new scale. vii. Withdrawn: The rating has been removed and is no longer maintained by Fitch. viii. Affirmed: The rating has been reviewed and no change has been deemed necessary. Evidence: a. The Statement of Financial Condition, Independent Auditors Report and Consolidated Financial Statement are reviewed in lieu of the Fitch IBCA ratings when available. b. The above reports are prepared in accordance with accounting principles generally accepted in the United States or International Financial Reporting Standards (IFRS) which are published by the International Accounting Standards Board (IASB) and International Public Sector Accounting Standards (IPSAS). c. The standards and accounting principles sometimes require the company to make estimates and assumptions regarding the valuations of certain financial instruments, the outcome of litigation, tax and other matters. Action: Broker Exception Process. Possible elimination from the preferred list. B. Counterparty Risk IMD engages various counterparties for investment related services. IMD counterparty exposure is non trivial and must be managed effectively. IMD has exposure to following types of counterparties. a. Custodian / MRK Service Providers b. External Small cap Managers c. External Investment Advisors d. Brokers e. Alternative Asset Management Firms f. BC/DR service provider g. Risk Analytics, Portfolio Accounting Service Providers h. Various contractors 1. Custodian / MRK 24

25 1) Acquisition of the services: All services must be acquired through the procurement mandated RFP process. RFP process should be two phased approach with on site due diligence visit by Risk Group.. Evidence: Memo of scores for technical evaluation, due diligence scores. Frequency: Need basis Action: Risk team provides a short listed candidate to the PD which meets the investment and risk requirement. 2) On going due diligence: Risk team should perform on site visit for custodian at least once a year. Scope of the visit is to see the operations, evaluate BC/DR process, infrastructure, face to face meeting with various managers. Risk & Compliance Team should also visit at least one sub custodian in different region once a year to evaluate the custodian sub custodian relationship, and sub custodian quality. Evidence: Due Diligence evaluation report. Frequency: At least once a year Action: If risk team discovers sub optimal process then, advice the IMD and PD to open discussion with the custodian for the explanation and remediation plan. If risk team discovers sub optimal process with the sub custodian, then it should engage custodian to remediate IMD concerns with the sub custodian. 3) Monitor Regulatory Capital and Economic Capital: Risk team should maintain rolling RCAP and ECAP ratio for last five years and create a base line capital ratio. If the capital ratio goes down 25% of the base line, then it must initiate the discussion with the custodian about its financial health. If RCAP ratio goes down below 10%, IMD need to initiate the emergency discussion with the custodian possibly transferring the assets to another custodian. Evidence: Rolling five year RCAP and ECAP ratio Action: Possible transfer of assets 4) Monitor CDS spread: Maintain five year rolling CDS spread. If CDS spread moves up by 2 standard deviation, IMD should engage in immediate discussion with the custodian management probing the financial health of the firm. If the CDS spread event is in conjunction of credit rating downgrade and falling RCAP ratio below 10%, IMD should initiate the transfer of assets to alternate custodian. Evidence: Rolling five year CDS spread. Frequency: Monthly Action: Possible transfer of assets. 5) Monitor individual bank rating: if the Individual Bank Rating drops, initiate discussion with the custodian management. If the Individual Bank Rating drops below C, then prepare to transfer the assets to alternate custodian. 25

26 Evidence: five year history of individual bank rating Frequency: Monthly Action: Possible transfer of assets. 6) Monitor Assets under custody: Keep history of rolling five year assets under custody. If the assets under custody drops more than 25%, initiate discussion with the custodian management. If the drop in assets under custody is accompanied with widening CDS spread or drop in individual bank rating or declining capital ratio, then prepare to transfer assets to alternate custodian. Evidence: Rolling five year history of assets under custody Action: Possible transfer of assets. 7) Monitor failed trades: Review the list of failed trades every quarter. If a particular region is experiencing uptrend in failed trades, then initiate discussion with custodian and possibly conduct an on site due diligence for custodian or sub custodian in the region where there is upward trend in failed trades. Evidence: Quarterly list of failed trades Action: Possible on site due diligence visit 8) Operational Losses or Fraud: Review the insurance contract which the custodian carries at least twice a year. If the insurance is dropped or reduced, immediate discussion needs to be started. If the custodian fails to produce the insurance contract within 30 days, initiate the process to transfer assets to alternate custodian. Evidence: Copy of insurance contract. Frequency: Semi Annually Action: Possible transfer of assets. 9) Service Delivery: Review all the issues from the custodians and MRK and prepare the evaluation form evaluating their compliance with the SLAs. Evidence: Evaluation Form. Frequency: Semi Annually Action: Discussion with the management to remediate the identified issues. 2. Brokers 1) Brokerage Agreement Services: 26

27 a. A Brokerage Agreement is a legally binding exchange of agreement and an effective communication tool for creating a common understanding between the UNJSPF and brokers regarding services, expectations, responsibilities, liabilities and priorities. b. Objectives of a Brokerage Agreement: i. To open the lines of communication between the parties and identify the terms and conditions of the agreement; ii. To help avoid or alleviate disputes by providing a shared understanding of needs and priorities. iii. To serve as a living document that both parties can review. If, during its term, the parties hereto should mutually agree to modify, amend or alter the provisions of the Agreement, in any respect, any such changes shall be effective only if in writing and executed by the authorized representatives of the parties. c. The brokerage agreement will further set forth the following: i. Responsibilities of both parties such as, but not limited to, compensation (i.e. commission), services provided (i.e. research), and indemnification. ii. It will also specify recourse if either party fails to honour one or more provisions of the contract by referring to the Settlement of Dispute clause which will stipulate how service related disagreements will be resolved. d. The liability for potential overdraft charges and delivery failure of assets is easily assigned based on the outlined responsibilities of both parties in the brokerage agreement. The brokerage agreement will serve to limit the liabilities of the UNJSPF. Evaluate the broker performance based on the SLA terms Evidence: Evaluation Form. Frequency: Semi Annually Action: Discussion with the management to remediate the identified issues. The broker list is updated periodically. Exceptions for brokers who do not meet the minimum criteria are made on a case by case basis by the Director of Investment Management Division. 2) Failed Trades: Get list of failed trades from the custodian and review if there are too many failed trades in a particular market or with a particular broker. Investigate the reason for failed trades. Evidence: Failed trades spreadsheet. Action: Ranking of the broker, revoking the exception process if in place, discussion with the custodian management to probe the reasons behind increasing failed trades. Possible elimination from the preferred list. 27

28 3) Monitor Commission: a. A review of the total commission dollars per asset class and region is performed monthly. b. A detailed review of the total broker dollars allocated and percentage of total commissions is performed on a quarterly basis. Broker commissions are aggregated across asset classes to assess the top allocations to brokers in percentage and dollar terms. Evidence: commission spreadsheet. Frequency: Monthly, Quarterly Action: Possible elimination from the preferred list. 4) Monitor Daily Trade Blotter: Daily trade blotter contains relevant information about all the trades executed the previous day. It has Trade date, the security traded, shares traded, trade price, executing broker and total commission. The compliance team will monitor the trade blotter to ensure all the trades meet the investment policy and that trades are distributed among brokers and trade commission. Evidence: Trade Blotter spreadsheet. Frequency: Daily Action: Discussion with the portfolio manager if compliance officer notices irregular pattern. 3. External Advisors 1) Service Delivery: Evaluate the advisor performance based on the SLA terms Evidence: Evaluation Form. Frequency: Semi Annually Action: Discussion with the management to remediate the identified issues. 4. External Managers (Small Cap, Alternative Investment) 1) Service Delivery: Evaluate the advisor performance based on the SLA terms Evidence: Evaluation Form. Frequency: Semi Annually Action: Discussion with the management to remediate the identified issues. 2) Due Diligence: All external managers have to undergo due diligence meeting at least twice a year. At least one of the meetings has to be on site visit by the risk team. Evidence: Due Diligence Report Frequency: Semi Annually 28

29 Action: Discussion with the management to remediate the identified issues. Possible termination of the contract. 3) Insurance Bond: All external managers must produce the insurance bond during the due diligence meeting, which should be equal to the what was in the contract with the IMD Evidence: Due Diligence Report Frequency: Semi Annually Action: Discussion with the management to remediate the identified issues. Possible termination of the contract. 4) Compliance with the investment guidelines: All external managers must comply with the investment guidelines in their respective asset class. Breaches will be noted and will need to be explained., Compliance Analyst Evidence: Breach report Action: Discussion with the management to remediate the identified issues. Possible termination of the contract. C. Market Risk 1. Asset Allocation Controls 1) Equity Strategic AA Upper Bound = 67%, Lower Bound = 53% Evidence: Compliance Analyst Report Action: Discussion with the portfolio managers to remediate the identified issues. 2) Equity Tactical AA : Input Investment Committee results for tactical Equity AA. Set range at 100 bps equal to + 50 bps upper and lower bound of range. Evidence: Compliance Analyst Report Action: Discussion with the portfolio managers to remediate the identified issues. 3) Fixed Income Strategic AA : Upper Bound =38%, Lower Bound = 24% Evidence: Compliance Analyst Report Action: Discussion with the portfolio managers to remediate the identified issues. 29