Introduction

Investments can be an important part of a financial institution’s assets and a considerable source of its income. However, investments can also lead to significant losses potentially affecting an institution’s financial soundness and even cause major liquidity problems. Moreover, various factors, including the complexity of some financial arrangements, the unpredictability of economic conditions, as well as future market volatilityA measure of the variability of the price of an asset., can also make it more difficult to measure investment risks.

In order to protect consumers of financial products and services, it is therefore essential that financial institutions follow sound and prudent investment management practices.

This guidelineA document that describes the steps that financial institutions can take to satisfy their legal obligation to follow sound and prudent management practices and sound commercial practices. sets out the AMF’s expectations for investment management by financial institutions. The AMF is empowered by the various sector-based statutes it administersInsurers Act, CQLR., c. A-32.1, section 463; Deposit institution and deposit protection Act, CQLR, c. I-13.2.2, section 42.2; Act respecting financial services cooperatives, CQLR, c. C-67.3, s. 565.1; Trust companies and savings companies Act, CQLR, c. S-29.02, section 254. to give financial institutions guidelines that may pertain to any sound and prudent management practicesA financial institution’s management practices ensuring good governance and compliance with the laws governing its activities, in particular, the assurance that the financial institution will maintain adequate assets to meet its liabilities as and when they become due and adequate capital to ensure its sustainability. .

The AMF’s expectations are based on core principles and guidance issued by international organizations, including the Basel Committee on Banking Supervision and the International Association of Insurance Supervisors.Basel Committee on Banking Supervision. Supervisory Guidance for Assessing Banks’ Financial Instrument Fair Value Practices, April 2009. International Association of Insurance Supervisors. ICP 15 Investment, October 2011. They also draw on lessons learned from past experience with the financial markets.

1. Sound and prudent investment management

Sound and prudent investment management requires an effective and efficient framework. As such, a financial institution should adopt practices that include clearly defining the roles and responsibilities of board members and senior managementThe group of individuals responsible for managing a financial institution on a day-to-day basis in accordance with the strategies and policies set by the board of directors. as well as developing a strategy supported by a policyA set of general principles adopted by a financial institution for conducting its activities in a given area. and proceduresA set series of tasks to be performed. It is generally the result of imperatives that cannot be negotiated by the individual who applies it. .

As part of a dynamic and evolving management approach, an institution should implement mechanisms enabling it to proactively and prospectively monitor and control its investments on both, individual investment and aggregate portfolio basis.

For the purposes of this guidelineA document that describes the steps that financial institutions can take to satisfy their legal obligation to follow sound and prudent management practices and sound commercial practices. , a financial institution’s investments generally refer to deposits, securitiesAn interest in or charge on property taken by a creditor or guarantor to secure the payment or performance of an obligation. and derivatives. They may also be referred to as instruments, debt securities or financial instrumentA contract that gives rise to a financial asset or a financial liability.s.Under the sector-based statutes applicable to financial institutions, investments may be made in other ways, including by way of hypothecary loans, claims secured by hypothec or income-producing properties.

2. General framework for investment management

2.1 Roles and responsibilities of the board of directorsReferences to the board of directors may include a board committee established, for example, to examine specific issues.

In addition to the roles and responsibilities described in the Governance Guideline and the Integrated Risk Management Guideline, the roles and responsibilities of the board of directorsA body of elected or appointed individuals ultimately responsible for the governance and oversight of a financial institution. with regard to a financial institution’s investment management should primarily be as follows:

• review and approve the investment strategy and ensure that it is implemented;

• review and approve the investment policy while ensuring that senior management reviews the policy periodically and as needed;

• ensure that investments are managed by competent and experienced persons of integrityThe quality that an individual has of being honest and having strong moral principles that he or she refuses to change. It is demonstrated through the individual’s actions and through the conduct of the his or her personal and professional business. who are compensated in a way that avoids potential incentivesUsed in its broad sense, it may includes bonuses, commissions, salaries, premiums and fees in compensation programs, and other benefits from sales contests, promotions, perks or gifts. for excessive risk-taking;

• monitor any irregular or problematic activity, transaction or situation.

2.2 Roles and responsibilities of senior management

Other than the roles and responsibilities described in the Governance Guideline and the Integrated Risk Management Guideline, the roles and responsibilities of senior management with regard to a financial institution’s investment management should primarily be as follows:

• develop and implement the investment strategy;

• develop the institution’s investment policy, recommend it to the board of directorsA body of elected or appointed individuals ultimately responsible for the governance and oversight of a financial institution. and ensure its application;

• oversee the implementation of procedures relating to the various investment activities, particularly for compliance with authorizations, restrictions, prohibitions and limits;

• periodically analyze and assess the risk-return trade-off for investments on an individual investment and aggregate portfolio basis and report to the board regularly and at the board’s request;

• ensure that the institution has independent valuation data, particularly when over-the-counter derivatives are used; in the absence of such capability, the institution should use the services of a specialized dealer;

• ensure that they are provided with the relevant information regarding the nature of the institution’s involvement in derivatives activities and the related risks.

2.3 Strategy, policy and procedures

Strategy

A financial institution’s investment strategy should be supported by the operational objectives, plans, organizational structure and appropriate control measures.

In general, the investment strategy should allow the institution to:

• develop a policy and implement the procedures necessary for the institution to achieve sound investment management;

• aim for a risk/return balance based, in particular, on its business lines and its risk appetiteThe aggregate level and types of risk a financial institution is willing to assume to achieve its strategic objectives and business plan. . To this end, the institution should regularly determine and revise its investment risk toleranceRisk tolerance sets boundaries on the level of risks a financial institution is prepared to accept based on its risk appetite. levels based on its objectives.

An institution should take the following into consideration when developing an investment strategy:

• the scope of investment risks, including market riskThe risk of losses arising from movements in market values of assets and liabilities due to changes in market factors, such as interest rates, credit spreads, equity prices, foreign exchange rates and commodity prices. , credit risk, liquidity risk and operational risk;

• its capital requirements.

The investment strategy should be reviewed regularly and as needed, particularly in light of changes in the capital markets, the development of new financial products and the institution’s commitments to clients.

Policy

An institution’s investment policyInsurers Act, CQLR., c. A-32.1, sections 82 and 83; Deposit institution and deposit protection Act, CQLR, c. I-13.2.2, sections 28.29 and 28.30; Act respecting financial services cooperatives, CQLR., c. C-67.3, sections 468,469 and 470; Trust companies and savings companies Act, CQLR, c. S-29.02, sections 65 et 66. should establish the principal parameters within which the institution should manage its investment activities. The policy should be sufficiently supported to ensure effective management, particularly in respect of situations where the risk is considered high.

Consistent with the investment strategy developed by the institution, its investment policy should generally address the following elements:

• types and characteristics of the investments;

• expected returns and the purpose of the investments, such as liquidity, matchingInvolves co-ordinating cash inflows and outflows of on- and off-balance sheet assets and liabilities whose maturity or interest rate repricing dates correspond to a given period. , pledging of collateral, hedgingA technique used to protect the income generated by a financial institution by reducing its exposure to market risk by establishing symmetrical positions. Usually, a gain or loss arising from mismatching can be offset by a hedging gain or loss. and trading;

• investment concentration limits;

• investment decision criteria, standards and other parameters. If necessary, an institution could establish:

  • investment authorization levels within its organizational structure and any conditions related thereto;

  • restrictions or prohibitions on the acquisition of certain investments deemed to involve greater risk or issued or guaranteed in connection with transactions between affiliated legal persons or associates.

• choice of dealers, advisers and representatives as well as their remuneration methods; Remuneration incentivesUsed in its broad sense, it may includes bonuses, commissions, salaries, premiums and fees in compensation programs, and other benefits from sales contests, promotions, perks or gifts. should not conflict with the achievement of the institution’s objectives.

• processes relating to intra-group management of investment activities;

• procedures for analyzing and evaluating investments when deciding to make an investment and when carrying out a transaction;

• monitoring and control of investments.

Procedures

Investment management procedures should allow an institution to properly manage its investment activities with respect to investment acquisitions or disposals. Investment decisions should be based on analyses and valuations that take into account, in particular, the institution’s investment risk tolerance levels and expected returns. They should also be supported by full documentation.

Risks

Before making an investment, a financial institution should understand the source, scope and types of risks associated with an investment activity. Accordingly, adequate procedures should be implemented so as to manage investment risks, while giving consideration to the interrelationships and interdependencies between the risks to which the institution is exposed. Adequate methods should also be used to measure the institution’s risk exposure and establish techniques for mitigating risks.

The institution should consider various internal and external factors that are likely to affect these risks, i.e., its risk tolerance levels, but also its objectives, the general economic climate, interest rates, and legal and regulatory requirements.

The financial institution should also measure and monitor its risk at both the transaction and portfolio levels to the appropriate time horizon. Furthermore, reporting mechanisms should be established so that the risks encountered are clearly communicated, known and understood by all parties within the institution that are involved in its investment activities.

Analysis and valuation

An institution should determine the value of its investments in an objective manner and ensure that the information used to do so is reliable. It should do this using valuation models, as necessary, establish a comparative basis for determining values and, where applicable, avoid basing its decisions solely on ratings as the sole factor in valuing its investments.

Investment analysis tools should be established based, in particular, on the following elements:

• nature, characteristics and liquidity of the investments;

• degree of exposure to various risks for each type of investment and for the investment portfolio as a whole, particularly in light of concentration limits.

The institution should remain prudent with respect to any analysis conducted by rating agencies. Ideally, it should obtain ratings from at least two agencies. As well, it should ensure that the ratings are reliable, particularly where market conditions are unfavourable.

2.4 Intra-group management

Investment concentration riskRefers to an exposure with the potential to produce losses large enough to threaten a financial institution’s financial health or ability to maintain its core operations. and the potential effect of contagion are the principal elements justifying a comprehensive and coherent investment management approach at the group level.

Accordingly, investment procedures should, if applicable, be set up for the institution and the entities in the group, including a security fund created at the request of a federation for the member credit unions, or a guarantee fund of which a federation and its mutual insurance associations are members. These procedures should cover certain situations that could entail greater risks for one or more entities within the group or for the group as a whole. For example:

• where a financial institution and one or more of the entities in the group act both as investor and lender with respect to the same person outside the group;

• in a potential conflict of interest situation where investments are made by one institution (or one of the entities in the group) in a company related to an officer or a member of senior management or the board of directorsA body of elected or appointed individuals ultimately responsible for the governance and oversight of a financial institution. of another institution (or another entity) forming part of the group.

Moreover, where a financial institution outsources its investment management to a specialized entity within the group or to an outside service provider, the AMF believes the institution maintains responsibility for ensuring that the risks related to its investments are managed in a sound and prudent manner. The Outsourcing Risk Management GuidelineAutorité des marchés financiers. Outsourcing Risk Management Guideline sets out the AMF’s expectations in this regard in greater detail.

3. Monitoring and control of investments

3.1 Investment portfolio practices

A financial institution should establish management practices to properly monitor and control its investments both on an individual investment and an aggregate portfolio basis.

The institution should therefore have a clear understanding of its investments and properly monitor changes in risk and return for its portfolio. It should also ensure that its investment portfolio is diversified, concentration limits are adhered to, and key risks are taken into consideration—in particular, market riskThe risk of losses arising from movements in market values of assets and liabilities due to changes in market factors, such as interest rates, credit spreads, equity prices, foreign exchange rates and commodity prices. , credit risk and liquidity risk.

Risk-return relationship

Uncertainties resulting from major market fluctuations, investment categories becoming illiquid or information reliability concerns are some of the factors that may give rise to key questions regarding the risk-return relationship of investments.

The institution should analyze and assess its portfolio, regularly and as needed, to ensure the risk-return relationship of the investments making up the portfolio. Consequently, it should ensure that the investments and the positions taken with respect them meet its objectives and are in line with its investment risk toleranceRisk tolerance sets boundaries on the level of risks a financial institution is prepared to accept based on its risk appetite. levels. As well, the institution should be able to draw on reliable and efficient information systems for such purpose.

As necessary and when certain headwinds emerge, the institution should analyze and reassess certain investments and estimate their impact on the institution’s bottom line.

The selection of investments should be adjusted and thorough monitoring should be conducted as necessary, particularly when material discrepancies arise with respect to actual versus expected returns or a significant change takes place regarding the risk associated with one or more investments. Furthermore, large investments should be valued by an independent expert when necessary, particularly with respect to illiquid assetsAn asset that cannot easily be converted to cash and that therefore cannot be sold quickly without losing some of its value. .

Diversification, concentration limits and other risks

An investment portfolio is diversified primarily to mitigate investment risks. Concentration limits should therefore be setAutorité des marchés financiers. Integrated Risk Management Guideline. and should cover all the institution’s exposures, primarily with respect to issuers and counterpartiesAn entity that takes the opposite side of a financial contract or a transaction. . These limits could be expressed in relation to the following parameters, among others:

• types of investments and their attributes (including risk-return relationship, maturities, whether they are mortgage backed or secured by claimsA financial asset that has a counterpart liability. , rank in the event of winding-up, dividend policy, conversion features). For example, more restrictive limits might be placed on some types of complex investments, such as certain derivatives.

• liquidity and transferability of the securitiesAn interest in or charge on property taken by a creditor or guarantor to secure the payment or performance of an obligation. ;

• geographic zones and industry sectors, particularly with respect to foreign securities;

• counterparties, such as public issuers, private issuers, affiliated legal persons and associates of a director and the institution;

• foreign currencies.

An institution should be able to measure its market risk exposure across its entire portfolio and across risk factors (particularly interest rates, equities and currencies).

The general areas of credit risk in which a financial institution is prepared to engage should be identified in its investment policy. In addition, the type of credit activity, type of collateral or real estate, and types of borrowers on which the financial institution may focus should be specified in its investment policy.

Special attention should be given to embedded transactions of credit risk, such as credit derivatives, whose value depends on exogenous factors. Financial institutions that engage in the use of instruments such as derivatives should take into consideration that counterparty exposures could change depending on the mark-to-market value of the underlying financial instrumentA contract that gives rise to a financial asset or a financial liability.. Effective measures of potential future exposure are therefore essential for the establishment of meaningful limits. In addition, credit risk of investment activities should be coordinated with credit risk of other activities of the financial institution.

As for liquidity risk management, a financial institution should structure its assets in such a way so that it has enough cash and marketable securities to cover its financial obligations.

3.2 Scenario analysis and stress testing

Economic conditions and market volatilityA measure of the variability of the price of an asset. can influence the value of a financial institution’s investments at any time.

As part of a dynamic and evolving management approach, an institution should consider various assumptions and design scenarios and carry out stress testing in order to assess the impact of adverse market conditions on its investments, while taking into consideration the risks tied to investments such as interest rate riskRefers to the exposure of a financial institution to adverse movements in interest rates. , liquidity risk, foreign exchange risk, credit risk and counterpartyAn entity that takes the opposite side of a financial contract or a transaction. risk.

Scenario analysis and stress testing should be discussed among the board of directorsA body of elected or appointed individuals ultimately responsible for the governance and oversight of a financial institution. , senior management and staff assigned to managing the institution’s investments. They should also be supported by appropriate documentation.

Once it has identified any vulnerabilities that could have an impact on the financial institution, actions could be considered with respect to investment management such as:

• using hedgingA technique used to protect the income generated by a financial institution by reducing its exposure to market risk by establishing symmetrical positions. Usually, a gain or loss arising from mismatching can be offset by a hedging gain or loss. strategies to mitigate its risk exposure;

• adjusting its investment policy, particularly with respect to concentration limits;

• strengthening the control and monitoring mechanisms for certain large investments or those considered more vulnerable to risk.

3.3 Internal controlFor more details regarding internal controls, see the Governance Guideline.

In order to achieve effective and efficient investment management, a financial institution should establish internal control mechanisms to ensure that investments comply with the institution’s policy and procedures and with legal and regulatory requirements.

When establishing those mechanisms, the institution should, in particular, ensure that front office, back office, middle office and risk management functions remain independent of one another.

Internal investment controls should cover matters such as:

• concentration limits;

• valuation and recording of investments in accordance with Canadian generally accepted accounting principles. Special attention should be given to investments used for arbitrage, trading and hedgingA technique used to protect the income generated by a financial institution by reducing its exposure to market risk by establishing symmetrical positions. Usually, a gain or loss arising from mismatching can be offset by a hedging gain or loss. purposes.

• responsibilities of depositaries and the terms and conditions of custodial arrangements;

• cash flows generated through investments such as income, repurchases and redemptions at maturity;

• disclosure and publication of relevant and reliable information regarding investments, for both internal and external purposes.

Internal control deficiencies and breaches significantly affecting investment compliance should be noted and reported to senior management and the board of directorsA body of elected or appointed individuals ultimately responsible for the governance and oversight of a financial institution. . Appropriate follow-up should be performed and necessary measures should be taken in a timely manner. With this in mind, a financial institution should have its investment risk management processes independently assessed on a regular basis. The results should be communicated directly to the board of directors, its audit committee or senior management according to their materiality.