Why custodians should do your stress testing

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Thanks to APRA, the regulator for Australian super funds, the annual ‘health check’ traditionally performed by asset consultants may be a thing of the past. From next July, funds will be doing regular stress testing using new models developed by their custodians.

As part of a raft of new regulations designed to improve prudential standards among super funds, the Australian Prudential Regulatory Authority has issued the standard ‘SPS 530’ requiring trustees to oversee investment governance with a particular focus on liquidity management under various scenarios. In short, funds need to stress test their portfolios.

As with most APRA regulations, there is little prescriptive guidance under SPS 530. APRA does not attempt to predict the next black swan event, of course. But there is no guide, even, as to how trustees should report investment performance, such as: before or after tax?

The key requirement which trustees have started to work on in the past few weeks is: “There must be a liquidity management plan for each RSE (responsible superannuation entity – typically, the trustee board) and investment option, including appropriate stress testing scenarios.”

According to Marian Azer, an executive director and head of product for JP Morgan’s global fund services business, funds should be stress testing their portfolios on a more regular basis and if the APRA regulation prompts that, then that is a good thing.

Azer says the big risk for Australian funds is probably currency. The $A has a history of volatility. In 2008, for instance, many funds had to cover large positions when the $A slumped sharply.  Some funds had to sell their most liquid assets, at a less-than-ideal time, to cover their positions.  

JP Morgan is working on a new product designed to help Australian funds to more easily stress test their portfolios. The risk analytics tool is currently being used in Europe and the US and will be available in Australia in the new year.

Azer says JP Morgan can factor in a whole range of scenarios, whether based on historical events or futuristic occurrences.  “We can see, for all our clients, what would happen if the Aussie dollar fell to US60c or interest rates spiked or the share market tanked,” she says. “You can play around with a whole lot of factors.”

But she says it is important that trustees then consider what they should do in all those situations.  “The big drivers allowing funds to be able to look at this are data and technology. More and more data is being provided as information, which is usable, so the funds can see a snap shot of where they are.”

APRA’s main concern is that, in some instances, there were no set plans or policies in place to outline how funds would deal with the type of liquidity event caused by the sharp currency move or that they had not sufficiently stress tested their products.

This is supported by APRA’s research that touched on issues funds experienced during the financial crisis. APRA stated that a number of super funds faced liquidity issues during the GFC and were forced to seek regulatory relief.

Similarly, Babloo Sarin, vice president of investment analytics at State Street Global Services, says funds need to look at each of their investment options to see whether they have sufficient liquidity to cover various scenarios. They should also look at the correlations between asset classes in these situations. Sometimes, in a crisis, normal correlations do not apply.

And, something funds may never consider, for instance, is an extreme weather event.

“Look what happened in Japan after the tsunami,” Sarin says. “And what about terrorist attacks?”

State Street recently held a forum with its clients to discuss liquidity issues. The firm has a proprietorial analytical tool it calls ‘Truview’, which it offers to its Australian clients, which include the big funds SunSuper and QSuper.

Sarin notes that APRA regulations tend not to be prescriptive. He would like to see a clearer definition of liquidity to help funds in their deliberations.

Like Azer, he says the power is in the data, which is what custodians are good at providing.

“We ensure that it’s good quality going in and therefore good quality coming out. We differentiate ourselves in the quality of the data.”

Azer, a former senior consultant with Mercer Sentinel, says the annual health check typically performed on funds by their consultants will mot be made redundant by more regular stress testing. Health checks cover a lot of other ground, including asset allocation and manager reviews.

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