SEBI brings a Revised Risk Management Framework for Mutual Funds

SEBI brings a Revised Risk Management Framework for Mutual Funds

The capital market regulator, i.e., the Securities Exchange Board of India (SEBI) has released a revised risk management framework in order to protect the investors’ interests and ensure that mutual funds provide high-quality service. It has revised the set of rules and guidelines for the risk management framework for mutual funds. The new regulations come in place of the previous guidelines issued earlier in September 2002.

The mutual fund industry in India has grown rapidly, owing primarily to retail investors’ interest in systematic investment plans, which allow for the regular investment of a fixed amount in schemes. According to the Association of Mutual Funds in India (AMFI), assets managed by India’s mutual fund houses increased to around 36 trillion rupees ($487.72 billion) in August from nearly 28 trillion rupees a year earlier.

After the Mutual Funds Advisory Committee (MFAC) reviewed the risk management framework for mutual funds, the regulator incorporated the panel’s recommendations into the new risk management framework (RMF).

The revised framework for risk management is issued a month after the market regulator banned Kotak Mahindra Asset Management, one of the country’s biggest mutual fund managers, from launching any fixed maturity plans (FMPs) for a period of six months and fined it for violating the rules.

Franklin Templeton was also barred from launching any new debt plans in India for two years in June after SEBI identified “severe lapses and violations” at the firm when it opted to stop numerous programmes/schemes suddenly. Franklin has filed an appeal but has agreed not to launch any new debt funds for the time being.

Date of implementation

The new RMF will be implemented on January 1, 2022. Mutual fund houses, on the other hand, are permitted to comply with the new RMF prior to that date.

Why was the review of RMF needed?

The review was compelled on account of significant changes in the mutual fund industry and the financial markets in general, including innovation of products, investment in newer asset classes, distribution landscape, technological evolution, investor penetration, and awareness, and an increase in risk factors, among other things.

The overall objective of the revised RMF is to manage key risks involved in the operations of mutual funds by providing a set of guidelines, principles, standards, and policies to be followed by AMCs and their members of the management.

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New risk management framework for mutual funds requires dedicated risk officers

The new SEBI Risk Management Framework (RMF) defines the term “risk management” as an independent and distinct function of an asset management firm. According to SEBI, the asset management firm should appoint a dedicated risk officer for each risk, such as an investment risk, compliance risk, operational risk, and cyber security risk. In addition to these officials, each asset management firm should also employ a chief risk officer (CRO) in its office.

SEBI further stresses that the risk management framework aims to clearly define the roles and responsibilities of the risk personnel and to also make them available on the fund house’s website. Though the Chief Risk Officer[1], along with the management, is responsible for overall risk, the board of AMC, as well as trustees, should also be held accountable for the same. Both the AMC and the trustees should have separate Risk Management Committees (RMCs) for this purpose.

These committees will conduct annual reviews of the risk management framework at both the AMC and scheme levels. The CRO should be included in the RMCs. The RMCs will report to the Board of AMCs and trustees, respectively, and will also suggest or recommend any long-term risk management solutions, both at the AMC and scheme levels.

Thus, the risk management framework outlines the policies, procedures, roles, and risk management responsibilities of the management, AMC board, & trustees of the board. In particular, SEBI has come forward by defining the set of roles and responsibilities of the board of AMC, trustees of the board, chief executive officer (CEO), chief risk officer (CRO), chief investment officer (CIO), the role of other chief experience officers (CXOs) and fund managers.

The SEBI circular also states that there needs to be a clear distinction between the roles and responsibilities of the respective CXOs and the CRO. The CRO or the risk management function of the CRO cannot be entrusted with regular or day-to-day operations, which will be the responsibility of the respective CXOs.

In addition, the AMC should keep a risk metric for each mutual fund scheme. The risk metric should include each type of key risk, such as investment risk, liquidity risk, credit risk, and so on, as well as the path to maintaining the desired risk level. Wherever applicable, the metric may include an assessment of risk levels in relation to an appropriate benchmark.

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The RMCs should assemble together on a regular basis, i.e., minimum once every quarter to assess various risks, including risk metrics, at both the scheme and AMC levels, and to assist the board of AMCs and trustees in carrying out their responsibilities in this regard.

Elements, characteristics, and objectives of RMF

According to the SEBI’s circular, wherever applicable, the elements of RMF have been divided into two parts: mandatory elements and recommendatory elements. The ‘mandatory elements’ are those that should be incorporated by AMCs and the ‘recommendatory elements’ address other leading industry practices that can be considered for implementation by AMCs, to the extent relevant to them.

A roadmap for the implementation of the new risk management framework (RMF) has been requested from the fund houses. A self-assessment of their risk management framework is also required on the part of the fund houses. They then are required to submit a report to SEBI.

Moreover, the AMC should conduct an annual review of the RMF compliance, according to the circular. In other words, compliance with the framework should be checked annually by the AMC, and review reports must be given to the AMC’s board of directors and trustees for their consideration and, if necessary, appropriate directions.

SEBI has stated that the risk management framework should include the following features, among others:

  • At both the operational and strategic levels, it should be a key component of the mutual fund’s processes and governance framework.
  • It should be tailored to the risk profile of both the AMC and the scheme.
  • It should concentrate on potential risks and take steps to mitigate and control them.
  • It should be dynamic and adaptable enough to recognize new risks as they arise and to account for those risks that no longer exist.

SEBI further emphasized that the RMF of mutual funds must cover four areas: governance and organization, risk identification and management, risk measurement and management, and the reporting of risks and related information.

SEBI has released a set of questions, which asset management companies can use to identify risks. Some of these include:

  • What are the different types of risks faced by the AMC/ mutual fund?
  • What is the probability of the occurrence of each of the identified risks?
  • What is the potential impact of primary risk events, in terms of financial loss, reputation loss, impact on investors/ unitholders, and regulatory action?
  • What are the emerging or new risks?
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The objectives of the risk management framework should help the management and the board of directors of both AMC and trustees in ensuring the following:

  • To demonstrate very high standards of due diligence in the daily management
  • To promote proactive management and early identification of all potential risks
  • To assign and to increase accountability and responsibility in the organization
  • To manage risk within the tolerance limits as defined in the risk management framework

The role of all chief experience officers in asset management companies, in respect of the management of risks in mutual funds, is clearly defined in the new RMF. It also included guidelines for identifying, measuring, and managing risks. The RMF has provided comprehensive guidelines – both mandatory and recommendatory – for the above-mentioned key risks to which the mutual fund is exposed.

The revised RMF, given by SEBI, also stated that risks associated with managing the distribution channels and processes around commission pay-outs must be monitored. The AMC will also be held liable for any mis-selling done by those involved in the sales of mutual fund schemes, such as distributors, according to the circular. All salespeople and distributors must be NISM-certified, and mutual funds must conduct a detailed analysis to see if there is any mis-selling at the AMC level.

In nutshell

The risk management framework was first introduced in September 2002 by SEBI. But that has not stopped some mutual fund companies from taking excessive or unnecessary risks. It remains to be seen whether SEBI’s revision of the risk management framework will deter such mutual fund houses/ schemes from taking their investors’ interests for granted.

Risk management is an important factor in determining how well a scheme performs over time. Some high-quality mutual fund houses/ managers have been paying attention to this more closely than others, rewarding their investors as a result. Instead of focusing solely on quantitative parameters, as an investor, you should seek out mutual fund houses and schemes that employ prudent investment practices and employ a robust risk management system.

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