Training on sovereign risk credit analysis, October 24

Reforming relationships between NPFs and AMCs may render the latter less useful

Pension savings and reserves market analysis

  • Asset management companies (AMCs) have no funds to cover market risks. An ability to cover clients’ losses (the so called “breakdown threshold”) for companies managing pension funds does not exceed 6-9% of the total value of pension assets under management. The Russian stock market volatility exceeds this “breakdown threshold” of most of the largest AMCs, regardless of whether the crisis years of 2008-2009 are taken into account or not.
  • Formalizing the securities safeguarding principle might reduce the number of AMCs. To date, this principle has not been defined by law and is treated arbitrarily by NPFs and AMCs. If it implies a physical safety of securities, NPFs would need AMCs much less than they do now, while formalizing it as a principle preserving the value of securities would increase market risks for AMCs and will require their recapitalization.
  • AMCs’ enlargement would negatively impact the stock market. These companies are important elements of any developed financial market and a reduction in the number of professional market participants should further squeeze liquidity on stock exchanges.

Stock market volatility exceeds AMCs’ “breakdown threshold”

The “breakdown threshold” implies capital adequacy of an AMC needed to cover its obligations before trustors in case of negative revaluation of pension savings and/or pension reserves under management.

By ACRA’s estimates, the real “breakdown threshold” for most of AMCs involved in managing pension savings and/or reserves (excluding liabilities to other trustors, such as insurance companies, endowment funds, unit holders, etc.) equals to 6-9% of pension assets value under their management (Figure 1).

Even ruling out credit risk and market liquidity risk and taking into account only market risks, stress testing of assets that make up pension savings and reserves, has shown that negative revaluation of pension assets at the end of the management period will not exceed 5%, in which case seven out of ten AMCs listed in Table 2 will be able to compensate losses. Their number will drop to just three, if negative revaluation reaches 10%, while a 20% barrier proved to be insurmountable for all largest players on the Russian collective investments market.

Figure 1. AMCs with capital adequacy sufficient to cover pension assets negative revaluation depending on latter’s amount

Source: ACRA estimates

That said, the Russian stock market is prone to much stronger fluctuations during the year, which potentially can make the aforementioned negative scenario reality. Conducting its research ACRA has analyzed volatility of various pension savings indices at Moscow exchange for time ranges 2008-2015 and 2010-2015 in order to eliminate the effect of the crisis and post-crisis years (Table 1).

Table 1. Volatility of pension savings indices at Moscow exchange

Source: Moscow Exchange, ACRA estimates

Volatility of the indices suggests that the negative scenario is statistically probable. If it is realized, the majority of AMCs will not be able to fulfill their obligations pertaining to the minimal guaranteed yield.

AMCs are unable to fulfill their minimal guaranteed yield obligations in full

Minimal guaranteed yield is understood as guarantees and obligations assumed by an AMC before its key trustors regarding redemption of their losses and ensuring a certain yield in case of realization of a negative scenario on the stock market.

The Russian pension system is unique in terms of the role played by pension funds. Taken as a whole, the latter act as an accountant institution that distributes the returns from pension assets management to accounts of insured persons and/or investors, while being also responsible for the results of portfolio management, but not being able to manage investment risks.

The fact is that, according to the law, NPFs are obliged to invest pension savings and a greater part of pension reserves through AMCs, which in turn include a clause in trust agreements that shifts all credit and market risks that may jeopardize the value of assets under management back to trustors, i. e. the NPFs.

The key rationale for such practice lies in a systemic risk of the stock market and AMCs’ inability to cover losses with their own funds. As a result, almost any minimum yield guarantee poses an unfulfillable obligation, as AMCs’ own capital is incomparable with the amount of funds they manage.

In Table 2, ACRA presents a leverage analysis of the largest AMCs managing pension funds and reserves (excluding liabilities to the other trustors listed above).

Table 2. 10 largest AMCs in terms of pensions savings and reserves having contracts with the Pension Fund of the Russian Federation as of December 31, 2015

Source: Pension Fund of the Russian Federation, National Asset Managers League, ACRA estimates

Legal formalization of the securities safeguarding principle will change the collective investments market

Even if AMCs’ own funds are enough to cover losses incurred in the course of pension assets management, there is a legal problem of interpretation of the safeguarding principle applicable to securities entrusted by NPFs to AMCs, as the term “securities safeguarding principle” has not yet been defined by the law.

The situation is complicated by the fact that whatever position the stock market regulator sticks to, this will cause problems one side or another. If safeguarding implies a physical safety of securities, not of their value, then NPFs will find it more profitable to manage their assets on their own, i. e. no longer having the need to hire “irresponsible” AMCs, pension funds will be able to provide higher yields to accounts of insured persons and investors. On the other hand, if the law attributes the safeguarding principle to the value of securities, this would immediately raise the question of recapitalization of AMCs and, consequently, would pose a threat of a sharp squeeze of the trust management market.

According to ACRA, all of the above scenarios will end up with contraction of the Russian collective investments market, which in turn will ease competition between NPFs and AMCs and will negatively impact both, opportunities for end users to choose professional market participants (NPFs and AMCs) and the overall liquidity of securities traded on the Russian stock market.

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