Liquidity and stress testing

6 min read

As promised in its 2021 Policy Priorities, APRA has released its draft revised prudential standard Investment Governance (SPS 530) for RSE licenses, and the outcomes of its review of unlisted asset valuations, as part of its report titled Findings from APRA’s superannuation thematic reviews. We discuss the key changes and findings relevant to superannuation investments teams, investment and valuation committees, and boards of RSE licensees.

Key takeaways

  • Liquidity management While the proposed changes will provide RSE licensees with more clarity on the specific content requirements for liquidity management plans, this isn’t a major rewrite, and won’t materially impact how RSE licensees categorise illiquid asset investments or quantitively limit their weighting towards illiquid investments.
  • Valuation processes for illiquid assets The proposed changes to the prudential standards elevate valuation governance frameworks from the status of guidance in Prudential Practice Guide SPG 531 – Valuation to a mandatory requirement in the draft prudential standard. As outlined in the findings of APRA’s thematic review of valuation processes, RSE licensees will be expected to critically evaluate their valuation practices and identify those requiring immediate improvement. This suggests that APRA expects valuation processes be reviewed and uplifted ahead of the proposed commencement of the revised SPS 530 on 1 January 2023.
  • Stress testing While RSE licensees will have to maintain their investment stress-testing programs, the program will need to be board approved and satisfy a prescriptive checklist of requirements proposed to be introduced into SPS 530.

Liquidity management practices, and the impact on illiquid and alternative investments

It wasn’t that long ago the debate surrounding illiquid asset investments by superannuation funds was filled with apocalyptic visions of the superannuation system facing a liquidity crisis, unable to cope with the dual pressure of severe market volatility experienced at the start of the COVD-19 pandemic and the introduction of the Federal Government’s early release scheme.

With that backdrop (and those dramatic prophesies failing to eventuate), APRA’s proposed changes to the liquidity management provisions of SPS 530 are modest. There remains a requirement to have a board-approved liquidity management plan covering each investment option. The content requirements of the liquidity management plan will be expanded to require:

  • the implementation of liquidity stress testing as part of the broader investment stress testing program (see below);
  • a clearer delineation of the roles and responsibilities of those involved in the management and oversight of liquidity risk (including the board, board committees and management); and
  • an outline of the information and key metrics to be reported to the board, relevant committees and senior management, to ensure adequate oversight of liquidity risk.

The board, relevant board committees and senior management will also be required to ensure that information (including the key metrics mentioned above) is periodically reviewed.

While the proposed changes will provide RSE licensees with more clarity on the specific content requirements of liquidity management plans, this isn’t a substantial rewrite. It won’t materially impact how RSE licensees categorise illiquid asset investments or quantitively limit their weighting towards illiquid investments. There are no signals in these proposed changes that suggest APRA will use the reforms to the prudential standards to shape the policy debate currently underway on the implications of capital concentration among superannuation funds over the next decade, or the increasing involvement of super funds in public M&A takeover activity.

Heightened regulation of valuation processes under SPS 530

While the proposed enhanced public disclosure of valuation of unlisted assets remains topical in the context of the Government’s finalisation of the portfolio holdings disclosure regime by superannuation funds, there had also been ongoing speculation about the measures that might be put in place by APRA to target valuation practices – in particular, those of illiquid assets. This is especially so given:

  • the impact that the valuation of illiquid assets can have on comparative investment option performance; and
  • the frequency of illiquid asset revaluations being undertaken by RSE licensees (particularly during periods of market volatility), and ensuing that valuations and unit prices are fair and reasonable as between the redeeming or switching member and other members.

The proposed changes to the prudential standards on investment governance will elevate the guidance on valuation policies in SPG 531 to a prudential requirement to have in place a valuation governance framework (which broadly reflects much of the guidance in SPG 531). Valuation governance frameworks will be required to include a board-approved valuation policy that outlines:

  • valuation methodologies for each asset class;
  • the circumstances in which external valuations will be required;
  • the frequency of valuations of investments, and the circumstances and triggers for an interim valuation outside of the determined frequency; and
  • the circumstances in which the RSE licensee will accept, reject or reassess valuations to ensure the valuations remain appropriate.

As with the changes to liquidity management practices, there’s also a focus on accountability for valuation processes and more specificity on internal valuation reporting requirements.

What are the implications for unlisted asset valuation processes arising from APRA’s thematic review?

In reviewing an RSE licensee’s current valuation governance policies against the draft prudential standard, it is worth considering the findings from APRA’s superannuation thematic review, which included unlisted asset valuations within its scope:

APRA’s findings
  • A lack of clear triggers for the consideration and imposition of valuation adjustments
  • The absence of formalised monitoring processes for valuation adjustments (including the transition from out-of-cycle to a normal valuation cycle)
  • No framework for the alteration of valuation adjustments
Recommendations for uplifting valuation governance framework
  • Adopt clear triggers that may automate more frequent investment committee meetings, and frequency of valuation reporting (such as daily or weekly instead of monthly or quarterly)
  • Ensure there is consistency in the framework for conducting revaluation processes across each asset class (consistent with the guidance in SPG 531)
  • Allow investment committees, management and the board to focus on reviewing and challenging valuation information, by putting in place valuation processes ahead of a crisis
  • Review how valuation discounts are determined and applied, and the circumstances in which reliance will be placed on information provided by independent valuers and / or fund managers
APRA’s findings
  • A lack of demonstrated board challenge or discussion of valuation decisions
  • Broad delegations to management on valuation matters was often without limits
  • Delegations that include conflicted reporting lines
Recommendations for uplifting valuation governance framework
  • The board should articulate how it will oversee and approve out-of-cycle valuations, including via delegation to the audit risk and compliance committees, investment committees or valuation committees
  • Review and define the triggers for the increased involvement of the board and its committees during periods of heightened market volatility
  • Consider whether there is adequate opportunity for the board and its committees to challenge management and external parties on valuations
APRA’s findings
  • RSE licensees failing to assess the appropriateness of valuations
  • Reliance on fund managers’ operational controls
  • Some RSE licensees failing to engage with fund managers promptly, potentially affecting member equity through delayed adoption of valuation adjustments
Recommendations for uplifting valuation governance framework
  • Ensure that the valuation framework covers not only the review process for the initial out-of-cycle valuation approval but a quantitative framework for reverting to normal valuation cycles
  • Formulate the process for proactive engagement with fund managers and asset consultants (including frequency of engagement)
  • Undertake robust ongoing due diligence for pooled and managed investments where an RSE licensee will be reliant on an externally produced valuation, and have no ability to comment or challenge the manager or sponsor’s valuation methodology
APRA’s findings
  • Lack of conflicts mitigation where investments teams with remuneration outcomes tied to investment performance play a key role in determining or influencing valuations
Recommendations for uplifting valuation governance framework
  • Prudential Practice Guide SPG 531 Valuation makes clear that valuation decisions and committees should occur independently of investment decision-makers
  • Ensure there are processes to mitigate the influence that investments teams can have on valuation processes

Following the significant equity market volatility experienced at the start of the COVID-19 pandemic, focus quickly shifted to the valuation practices of RSE licensees and their illiquid asset portfolios, drawing the attention of the House of Representatives Standing Committee on Economics. For those RSE licensees included in APRA’s thematic reviews, supervisors will monitor how they have responded to, and will continue to respond to, APRA’s specific findings, including formulating and improving their valuation governance frameworks.

Proposed changes to the rigour of investments stress testing

While RSE licensees will continue to need to have an investment stress-testing program in place, the proposed amendments to SPS 530 require it to be board approved with a prescriptive checklist of requirements introduced, including:

  • for each RSE licensee’s investment strategy, at a minimum, an annual assessment shall be undertaken to assess and confirm that adverse stress testing scenario ranges and targets remain appropriate;
  • annually (or more frequently) undertake an investment stress test and assess the performance of each investment option based on the actual asset allocation of each investment option;
  • articulate the roles and responsibilities of those (both internal and external) involved in the design, implementation, review, reporting and oversight of the investment stress testing (including the role of the board, relevant board committees and senior management);
  • documentation of the processes for the regular review of stress testing methodology and assumptions; and
  • detailing the circumstances that might lead to ad hoc investment stress testing, including triggers to indicate when ad hoc investment stress testing would be undertaken.

The results of the investment stress testing program will be required to be reviewed periodically by the board, relevant board committees, and senior management; and reflected in the RSE licensee’s investment governance framework.

What’s next?

We don’t expect APRA to release an updated SPG 530 and SPG 531 until consultation on the draft amendments to SPS 530 completes in 2022. The consultation process is open for five months, with APRA requesting written submissions by 16 February 2022.

APRA had also planned (in February 2021) for consultation on its prudential standard for outsourcing (SPS 231) to be released in the second half of 2021, but we now expect that to be delayed until the new year.

APRA intends that the revised prudential standard SPS 530 will commence on 1 January 2023.