Www.consar.gob.mx FIAP International Seminar Supervision and Risk Control Santiago de Chile, May 2006

www.consar.gob.mx

FIAP International Seminar Supervision and Risk Control

Santiago de Chile, May 2006

2

• Introduction

• Description of supervision in Mexico

• Objectives, accomplishments and costs of supervision in Mexico

• Other supervision alternatives

• Conclusions

CONTENTS

3

The Retirement Savings System (Sistema de Ahorro para el Retiro, SAR) in Mexico has peculiar characteristics, which determine System objectives, supervision and practices

Because of the above, it is necessary to prevent excessive risk taking in investment portfolios.

• The minimum pension guaranteed by the State involves a fiscal liability.

GOVT.GUARANTEE

SOCIALLY SENSITIVEPURPOSE

• The social purpose of resources makes it a relevant and interesting matter for Mexican Society and Government.

FINANCIALASSETRELEVANCE

• For many workers it is their only financial asset.

FORCEDSAVINGS

• It is a forced savings system; this implies an important trust relationship for participants.

System Characteristics:

4

Rendimiento

Riesgo

Límite

Riesgo

Lí

Rendimiento

Riesgo

Límite

Portafolios óptimos

Sub -óptimos

Rendimiento

Riesgo

Límite

Portafolios óptimos

Sub -óptimos

The Supervisor must define the maximum risk level (not an easy task)

On the basis of the above, the work of the Supervisor is to establish an Investment Regime that extends the efficient frontier.

While the task of Pension Funds Administrators is to place their portfolio close to these

Supervisor Administrator

The chosen portfolio will depends on client characteristics (trust responsibility)

5

There are two approaches to investment supervision

Prudent Man Rule Investment Boxes

Advantages

• Potentially the best way to supervise investments

• May accelerate the professionalization of administrators

• May stimulate fast market development

• Resolve agency problems• Alternatives to limit exposure

to underdeveloped markets• Used when investors do not

use enough market discipline• A very specialized agent

conducts the supervision

Disadvan-tages

• Conditions for proper system operation do not always exist

• The benefits of committing fraud may exceed costs

• Young systems administrators have less incentive to protect their reputation

• Agency problems may prevail

• May introduce important distortions into portfolios and, therefore, on returns

• In some cases, they do not control risks effectively

• May increase other existing inefficiencies

• Does not take into account diversity in investor preferences

6

The supervisory schemes for pensions in Latin America are based on portfolio limitations

• An important part of the diversity in said schemes responds to the different contexts that they were created for, which reflect different priorities to resolve market failures and to take care of minimum social commitments.

• However, supervision must be constantly reviewed to guarentee that it is an effective tool for risk control imposing the least possible cost in terms of efficiency. This is even more important in the light of:

−The evolution of local financial markets,

−Increased specialization of Pension Funds Administrators,

−A wider offer of financial asset types and

−A more mature Pensions System

7

• Introductionscription of supervision in Mexico



• Conclusions

CONTENTS

8

In order to supervise investments and control risks, the Authority uses two tools:

Investment Regime

It is necessary to prevent ,via supervision, excessive or uncontrolled market, credit and liquidity risk taking, and also prevent the generation of conflicts of interest.

Prudent Man Rule

It is necessary to generate basic skills in the management of investments and operational and legal risks; and also to induce the best international practices and reduce disparities in Pension Fund Administrators’ (AFORES) skills.Before opening an Investment Regime, it was necessary to make

sure that AFORES had a proper institutional infrastructure to manage investments and risks.

Tools:

9

CONTENTS

• Introduction


• Evolution of the Investment Regime

• Prudent Man Rule Supervision



• Conclusions

10

Since the start of the system there have been amendments to the Investment Regime to open up more investment alternatives and provide better risk control tools

• Investment limits for each issuer were eliminated (a minimum of 65% in Government Bonds) and credit rating limits were also introduced.

New issuers

Limits for each issuer were eliminated

New currencies were allowed

New risk control mechanisms

Main changes in 2002-2003

• Use of derivatives allowed.

• Portfolio risk measure: VaR.

• Instruments in foreign currencies allowed:

• Quasi Governmental, Municipal Governments and State Governments.

Gov. PesosDollar

+ YenEuro

Private Pesos+ YenEuro

Dollar

11

The high growth rate of SAR was a factor to once again make changes to the RI in 2004, in order to promote greater investment diversification.

Changes made to the Investment Regime in 2004-2006

New instruments

New markets

• Variable income through stock indexes

• International markets

Contribute in a greater degree to

improve returns

Their main contribution is to

lower country risk

12

SB1: Worker over 56 years of age, and also those who choose it.SB2: Only for workers under 56 years of age.

In addition, the SIEFORES family was extended to two funds under a life cycle concept.

Fund One (SB1) has a more conservative RI, which restricts stock market investments and has a lower risk level. Fund Two (SB2) may invest in Stock Inedexes.

There are already two funds having a differentiated risk level

r

r

r

Renta VariableRenta Variable

ValoresValoresExtranjerosExtranjeros

Renta FijaRenta Fija

Fondo A

Renta VariableRenta Variable



Fondo A

VaR0.6%

SB2

SB1



SB1



SB1

1.0%

13

CONTENTS

• Introduction


• Evolution of the Investment Regime

• Prudent Man Rule Supervision



• Conclusions

14

•Have a Risk Committee in place.

•Create an Independent Unit to Measure Risks.

•Have models and methodologies to measure and control risks.

•Follow the best operational risk practices.

•Have an Investments Committe in place.

•Have automated systems for investment operation, settlement and recording (Front-Back).

•Personnel must be trained.

•Set up mechanisms to have access to the best market prices.

•Have a Code of Ethics forbidding the use of Siefore information for personal benefit.

Risk Supervision Investment Supervision

The prudent man rule supervision is based on the best international practices, and was designed in agreement with the needs and characteristics of the System

The creation of an investment and risk supervision infrastructure has taken time and required the Authority’s initiative.

15

CONTENIDO

• Introduction

• Introduction



• Portfolio Evolution

• Analysis of Efficient Frontiers

• Analysis of VaR


• Conclusions

16

Retirement savings show a substantial increase and already represent 12.2% of GDP

Ahorro para el Retiro en México (miles de millones de pesos)

17.7 26.6

30.4

35.2

42.3 54.4

55.2

40.0

55.1 57.864.7

76.3

95.3 96.6

11.012.1 12.2

4.25.1

5.7 6.16.9 7.0

10.59.6

8.7

7.0

3.1

-

20

40

60

80

100

2000 2001 2002 2003 2004 2005 Abr-06

mile

s de

mill

ones

de

dóla

res

0

2

4

6

8

10

12

14

Porce

nta

je d

el P

IB

RCV, ISSSTE y AV en Afores ViviendaSAR 92 Ahorro como % del PIBRCV y AV como porcentaje del PIB

US $

6065707580859095

100

ene-0

0abr-

00

jul-

00

oct

-00

ene-0

1abr-

01

jul-

01

oct

-01

ene-0

2abr-

02

jul-

02

oct

-02

ene-0

3

abr-

03

jul-

03

oct

-03

ene-0

4abr-

04

jul-

04

oct

-04

ene-0

5abr-

05

jul-

05

oct

-05

ene-0

6abr-

06

The changes to the RI of SIEFORES have resulted in a systematic reduction in Government securities holdings. This tendency has accelerated.

Investments in Government securities(% of net assets)

Source: CONSAR

73.8%

If the Investment Regime had not been opened, concentration in Government securities would reach 84.5%

New Investment Regime is effective

Start of Variable Income and

International Debt investments

18

Investment portfolios already show a profile substantially different from earlier dates.

Source: CONSAR

89.8%

82.3%78.2%

73.9%

7.8%

13.2%

13.1%

11.6%

2.4%4.5%

5.0%

3.7%

7.2%

1.3%3.7% 2.3%

70%

75%

80%

85%

90%

95%

100%

Gubernamental Corporativa y paraestatales Instituciones Financieras

RV Internacional RV Nacional Deuda Internacional

Fund 1 Fund 2

Dec-01 Dec-03Apr-06

SingleFund

SingleFund

19

Inversion en Renta Variable y Deuda Internacional(en millones de dólares)

481 562 595 696 6949001,032

3,2373,338

668.811.6%

294

519.939.6%

3,691.363.9%

1

558.342.5%

234.517.9%

1,415.224.5%

--

-

1,000

2,000

3,000

4,000

5,000

6,000

7,000

31/0

8/20

05

07/0

9/20

05

14/0

9/20

05

21/0

9/20

05

28/0

9/20

05

05/1

0/20

05

12/1

0/20

05

19/1

0/20

05

26/1

0/20

05

02/1

1/20

05

09/1

1/20

05

16/1

1/20

05

23/1

1/20

05

30/1

1/20

05

07/1

2/20

05

14/1

2/20

05

21/1

2/20

05

28/1

2/20

05

04/0

1/20

06

11/0

1/20

06

18/0

1/20

06

25/0

1/20

06

01/0

2/20

06

08/0

2/20

06

15/0

2/20

06

22/0

2/20

06

01/0

3/20

06

08/0

3/20

06

14/0

3/20

06

22/0

3/20

06

28/0

3/20

06

05/0

4/20

06

12/0

4/20

06

19/0

4/20

06

28/0

4/20

05

Mill

on

es d

e d

óla

res

Deuda Extranjera

Renta Var. Extranjera

Renta Var. Nacional

5,775.4100%

Portfolio diversification with international securities and capital markets explains a significant part of recent changes

RV: 4,360.1DI: 1,415.3

Total: 5,775.4

10.1% of

Net Assets

The investment horizon has also expanded

Weighted Average Term

Source: CONSAR

*Excludes AFORES having less than 1 year in operation

Days

-

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

5,000

Ab

r-00

Jul-

00

Oct-

00

En

e-0

1

Ab

r-01

Jul-

01

Oct-

01

En

e-0

2

Ab

r-02

Jul-

02

Oct-

02

En

e-0

3

Ab

r-03

Jul-

03

Oct-

03

En

e-0

4

Ab

r-04

Jul-

04

Oct-

04

En

e-0

5

Ab

r-05

Jul-

05

Oct-

05

En

e-0

6

Ab

r-06

AAverage Maximum Minimum

21

The foregoing effects translate into a higher Diversification Index

0

1

2

3

4

5

6

7

8

9

10

1998 1999 2000 2001 2002 2003 2004 Oct-05 Nov-05 Dic-05 Ene-06 Feb-06 Mar-06 Abr-06

Average Maximum Minimum

Diversification Index

* The Index is high for portfolios with a larger number of asset types and a lower concentration among asset types

** Excludes AFORES having less than 1 year of history, including Afore IXE

Source: CONSAR End of April 2006 figures

Banamex

Bancomer

Inbursa

ING

Profuturo

Banorte

HSBC

Principal

Santander

XXI

Actinver

Azteca

Invercap

IXE

Metlife

9.0%

10.0%

11.0%

12.0%

13.0%

14.0%

15.0%

16.0%

17.0%

18.0%

0.00 0.10 0.20 0.30 0.40 0.50 0.60Non Governmental %

Re

turn

(1

2 m

on

ths

)

Bett

er

Retu

rn

Greater Diversification

Largest 5 AFORES measured by managed resources

Next 5 AFORES measured by managed resources

Smallest 5 AFORES measured by managed resources

The AFORES showing a lower concentration in Government titles (more diversification) get a better return

23

CONTENTS

• Introduction


• Objectives, accomplishments and costs of

supervision in Mexico



• Analysis of VaR


• Conclusions

Efficient frontiers have progressed with RI liberalization (reduction of boxes and new alternatives)

*Chart with current data and assuming the investment regimes of 2001, 2002, 2003, 2004 and 2005.

8%

10%

12%

14%

16%

18%

20%

22%

0.0% 0.1% 0.2% 0.3% 0.4%Parametric VaR

Ret

urn

s

1997200120042006

Returns of RI liberalization

between 2004 and 2006

The effects of RI on the efficient frontier are evident: a greater liberalization, larger potential returns.

Returns of RI liberalization between 1997 and 2006, for the maximum risk limit of

1997

25

The year 2005 shows an increased diversity and greater returns over 1997.

Investment portfolios in 2005 get greater returns than the efficient frontier portfolios in 1997, which would not be feasible without RI liberalization.

The chances of obtaining greater returns have become realized, as shown the location of investment portfolios in respect of the efficient frontiers

Allowing more investment opportunities contributes to portfolio differentiation (reduces distortions)

Efficient Frontiers

0%

5%

10%

15%

20%

25%

0.0% 0.5% 1.0% 1.5% 2.0%

Parametric VaR

Ret

urn

s

FE - 1997 FE - 2005 1997 2005

26

Some portfolios reflect that SIEFORES took advantage of the so-called “free lunch”, because they improved their returns with no risk increase

5%

7%

9%

11%

13%

15%

17%

19%

21%

0.00% 0.10% 0.20% 0.30% 0.40%

VaR Paramétrico

Ren

dim

ien

tos

Banamex

XXI

Actinver

Principal

Banorte

Bancomer

The portfolios of SIEFORES are far away from the efficient frontier because the current investment regime was enacted a short time ago

Average return increase:

181 base points

27

CONTENIDO

• Introduction





• Analysis of VaR


• Conclusions

28

Boxes do not provide an adequate control of absolute risk because they do not consider the correlations among assets nor the exposure to volatility of instruments

The VaR seeks, contrary to investment boxes, to control the maximum risk of portfolios

Eficacia del VaR para controlar los riesgos

R

VaR Limits and Boxes

18%

20%

22%

24%

26%

28%

30%

0.00% 0.40% 0.80% 1.20% 1.60%

VaR Paramétrico

Rend

imien

tos

1999

2006

18%

20%

22%

24%

26%

28%

30%

0.00% 0.20% 0.40% 0.60% 0.80% 1.00% 1.20% 1.40% 1.60%

VaR Paramétrico

Rend

imie

ntos

1999

2006

Boxes only

30

The control of global portfolio risk may limit returns.

However, the VaR has some disadvantages

Returns

In general, a longer investment term has a higher risk and, therefore, limits the investment horizon.

Term

In order not to exceed the VaR limit, Administrators make similar operations when confronted with particular market conditions.

Herd behavior

When the market is volatile, Administrators invest in less sensitive instruments.

Procycliceffects

31

VaR instruments used jointly with box limits may generate larger efficiency losses than the use of only one of these restriction types.

VaR

Free Lunch

al nivel de VaRregulatorio

Free Lunchcon bajo riesgo

Pérdida de Eficiencia de los cajones

Free Lunchpotencial si no existiera el VaRregulatorio

Pérdida de eficiencia por el VaR y los cajones

VaR

Free Lunch

al nivel de VaRregulatorio

Free Lunchcon bajo riesgo

Pérdida de Eficiencia de los cajones

Free Lunchpotencial si no existiera el VaRregulatorio

Pérdida de eficiencia por el VaR y los cajones

When a box limit is relaxed and the maximum VaR is kept constant, it creates a “free lunch” that is less than the one that would be created if the VaR was also relaxed.

Risk

Retu

rns

32

• Introduction




• Conclusions

CONTENTS

33

ADVANTAGES

DISADVANTAGES

• Does not limit the efficient frontier

• Provides a guarantee of a minimum relative return

• Does not necessarily help to control investment risk

• Creates potential incentives for portfolio emulation, or even, for Administrators to show a herd behavior

• Does not limit derivatives leverage

As a risk control measure, complementing boxes, it is feasible to establish return ranges. This tool also helps to guarantee minimum returns.

Return ranges define the minimum and maximum return that Administrators may obtain without the obligation to make provisions or repay them into the Fund. Ranges are defined as an interval around the average industry returns (36 months).

34

Return ranges are not effective global risk control tools. That is, they do not operate to limit portfolio losses to a selected percentage level (in a horizon and with a confidence level)

6%

8%

10%

12%

14%

16%

18%

0.00% 0.20% 0.40% 0.60% 0.80% 1.00% 1.20%VaR

Ren

dim

ient

o

6%

8%

10%

12%

14%

16%

18%

0.00% 0.20% 0.40% 0.60% 0.80% 1.00% 1.20%

VaR

Ren

dim

ien

to

Banda de riesgo

However, when Pension Funds Administrators are efficient, the ranges may be a relative risk control indicator, in respect of the reference defined by the range

When Administrators depart from the efficient frontier, ranges do not control portfolio relative risk either.

35

The Chilean case considers five funds with minimum and maximum limits to Variable Income investment. Fund A may invest the largest percentage of its resources (80%) in stock, while Fund E may not invest in these assets

More Investment in Variable

Income

Less Investmen

t in Variable Income

Efficient Frontiers for Chilean multiple funds

0%5%

10%15%20%25%30%35%40%

0.00% 1.00% 2.00% 3.00% 4.00% 5.00%Parametric VaR

Ret

urn

Fund A

Fund B

Fund C

Fund D

Fund E

Although limits were introduced to differentiate portfolios (differentiated risk options), this brings about inefficiencies for some risk levels

Efficiency losses because of boxes

36

• Introduction




• Conclusions

CONTENTS

www.consar.gob.mx

FIAP International Seminar Supervision and Risk Control

Santiago - Chile, May 2006

Documents

Www.consar.gob.mx FIAP International Seminar Supervision and Risk Control Santiago de Chile, May 2006