Financial Sector Assessment

The Regulation of Investment Regimes7

The means by which investment regimes, and thus asset allocation, related to public and private pensions are regulated will vary across and within countries (e. g., each individual U. S. state has its own investment regime). Regulatory (and tax) constraints on invest­ment behavior and national funding rules significantly influence pension fund strategies. For example, in the case of Chile,8 the pension sector is regulated by a highly complex investment regime, with limits by instruments, instrument characteristics, issuers, and issuer types. By comparison, the investment regime for pension funds in OECD countries is considered relatively much simpler.

OECD countries are typically classified in two groups, adhering to either the prudent man rule or the quantitative restrictions regime. The former states that pension funds should manage their portfolios as a prudent man, implying a proper diversification of the portfolio and few direct restrictions. The lack of restrictions is countered by a heavy reli­ance on the presence of competent and honest managers to ensure the implementation of relevant standards, as well as on the assurance of an adequate level of ability and integ­rity. This assurance requires the development of strict criteria comparable across firms or of legislating criteria regarding the expertise of fund managers. Prudent man rules also require that greater financial and legal responsibility be attached to any imprudent action by corporate officers. Such rules can vary across countries, sectors, and companies, but the OECD recommends a flexible general framework that can be applicable across borders.

A quantitative restrictions regime involves direct restrictions on the portfolio, both by instrument and user, including foreign asset and concentration limits. Despite variations across countries, general principles for the regulation of investment portfolios have been articulated by OECD (2000). The purpose of regulation is to ensure both the security and

the profitability of the funds invested. Basic principles of portfolio management focus on (and differentiate between) both assets and liabilities, especially asset-liability manage­ment (ensuring that liabilities are sufficiently covered by suitable assets). Another impor­tant principle is that they differentiate between each institution, thus taking a compre­hensive view of each institution’s structure and the range of risks to which it is exposed. Basic standards of portfolio management outlined by the OECD include the following:

• Diversification (between categories) and dispersion (within a given category) of assets

• Maturity matching (including a liquidity principle) of assets and liabilities

• Currency matching applied comprehensively (derivatives can be used in this regard)

• Pension assets invested primarily in long-term securities that provide for a prudent risk-return profile

• Schemes managed in a way that is consistent with the risk tolerance profile of stakeholders

Quantitative restrictions outlined by the OECD include the following:

• No minimum level of investment should be placed on the portfolio, except on an exceptional and temporary basis.

• Maximum levels of investment by category may be justified on prudential grounds, in which case it may be advisable to

- allow firms to exceed such conditions under certain circumstances,

- differentiate between maxima and allow ceilings to be exceeded on the basis of that differentiation, and

- take account of how such investments are valued and of the actual effect of that valuation.

• Investment in an asset must be limited to a proportion of the fund’s total portfolio and even restricted if that asset involves special risks.

• Certain categories of investments may need to be strictly limited (e. g., loans with­out appropriate guarantees, unquoted shares, and company shares that raise risks of conflict of interest).

• Limits should be placed on investments by insurance companies and pension funds in companies or on investments holding a large volume of such categories of assets.

• The use of financial derivatives as management instruments may be useful or effective if done prudently and in accordance with established rules that ensure consistency with appropriate risk management systems.

• Appropriate and compatible accounting methods may be set up so that informa­tion on investments is sufficiently transparent.