The AIJ Investment Advisors Incident and Risk Management

UEMURA Shuichi
Senior Fellow, RIETI

What caused the shock

The revelation this year that AIJ Investment Advisors was unable to account for the corporate pension fund assets it managed significantly shocked not only the pension funds that had commissioned the management of their assets to the investment management company, but also the entire Japanese society for the following reasons:

First, while fraud-like incidents relating to unlisted shares had been continuing, this very serious problem was brought about by an investment advisory company officially registered under the Financial Instruments and Exchange Law. Many might have associated this incident with the Olympus Corporation case as both incidents experienced huge losses known only to a handful of people and had been hidden for many years. The governance of asset management businesses needs to be revised, including the enhancement of administration and inspection systems and the establishment of checks and balances among related parties.

Second, while ensuring sustainability of public pensions under a low birthrate and an aging population was an important policy issue, this case exposed the fact that corporate pension funds, too, were under financial difficulties. Especially, it has been found that 40% of the employees' pension funds do not even have reserves necessary for their substitutional portions, the so-called "pension funds with assets below the substitutional portion" (according to materials published by Ministry of Health, Labour and Welfare). It is no wonder that people became concerned with this situation.

The details of the incident are being worked out by the authorities through efforts such as a compulsory investigation by the Securities and Exchange and Exchange Surveillance Commission. Nevertheless, the information reported by the media hitherto indicates its mysterious nature. Although the number of staff members at investment advisory companies in general is relatively small, the number of individuals who are said to have been involved in the problematic pension asset management is so small that it makes one wonder if anyone else was involved. What is even more mysterious is how such losses that wiped out most of the assets can be incurred. Regarding this point, it has been pointed out that derivatives transactions were involved.


The asset management firm apparently claimed being able to "perform even when the market is under adverse conditions." However, there are two possible reasons for suffering huge amounts of losses: (1) it took large positions in futures transactions (contrarian position, at that) with small amounts of margin money, and (2) it collected premiums by selling options. In either case, when expectations of future market movements turn out to be wrong, based on their "notional principal," losses drastically increase, which is a characteristic of derivatives trading. On the other hand, if the market moves as expected, based on its notional principal, profits drastically increase, or it will be able to earn steady profits on option premiums. This is what makes derivatives attractive. In the case of AIJ, its speculation turned out to be wrong, and its risk management (putting aside to what extent it had such a function) completely failed.

There have been repeated misconducts and crises of companies involving huge losses from derivatives transactions and the concealing of such losses. In 1995, Barings Bank of the UK collapsed due to unauthorized trading by Nick Leeson, an employee at its Singapore branch. In 1998, Long-Term Capital Management (LTCM), a hedge fund whose board members included two recipients of the Nobel Prize in Economics and who devised the Black-Scholes model, a formula to calculate the price of derivatives, collapsed in the midst of the Russian financial crisis. In 2001, Enron, a major energy company, collapsed due to its unlawful accounting practice involving derivatives. Also, during the financial crisis following the subprime loan problem, many financial institutions caused losses involving derivatives transactions. Especially, AIG, a major U.S. insurance company, was placed under government supervision in 2008 due to losses from securitized products and credit default swaps (CDS).

Then, what may (or may not) be the ultimate incident is the recent huge loss caused by a major U.S. financial institution, JPMorgan Chase. According to an emergency telephone interview on May 10, 2012 with its CEO, Jamie Dimon, the bank suffered a $2 billion loss as a result of failure with derivatives transactions conducted in order to hedge the overall risks of the bank. JPMorgan Chase had been known for its superior risk management skills and highly regarded for having suffered relatively small losses in the recent financial crisis whereas many financial institutions suffered significant ones. Among the dispirited financial industry, Dimon alone put up a good fight and led the argument against the introduction of the "Volcker Rule," which would restrict banks' proprietary trading (trading activities). The bank's failure, therefore, significantly disappointed the market, and its share price drastically fell after the announcement of this incident. The incident could best be described with the expression, "And you too, JPMorgan Chase?" Furthermore, its impact on future financial regulations, including the implementation of the Volcker Rule, is also said to be significant.

Basics are important for risk management

Going back to the AIJ Investment Advisors issue, there are some indications that both pension funds entrusting their funds for management and companies contributing the money to the pension funds overlooked the basics of risk management. As often observed in the failures of computer systems, if something is left to outside specialists, such as systems vendors and asset management companies, there awaits a trap in risk management. Entering into a discretionary investment contract does not eliminate the need for supervising the commissioned manager. The related parties to the incident should have been more alert and should have questioned how AIJ's high performance could be achieved under the recent market conditions.

Moreover, the principle of diversified investments?as exemplified by the expression, "Don't put all of your eggs in one basket"? is the very basic foundation of risk management. This should be kept in mind whether or not the rule under Article 39, Paragraph 15 of the Cabinet Order for Employee's Pension Fund (Avoidance of concentration into particular investment approaches) is non-binding. The "investment approaches" are not necessarily intended to mean the selection of investment management firms, but over-dependence on particular managers would in fact lead to the concentration of risks.

In the background of the overlooked basic foundation of risk management are the pension funds that possibly had become less sensitive to risks because of their desire to recover the shortage in their reserves. According to the behavioral economics theory put forward by the Economics Nobel Prize laureate, Daniel Kahneman, etc., people tend to become risk-tolerant in loss situations (prospect theory). This is similar to the idea of "turning things around with a home run" or "coming back from the brink." Judgments in such situations should be made with particular caution.

In response to the AIJ Investment Advisors' incident, the Ministry of Health, Labour and Welfare has organized the Expert Committee on Asset Management and Financial Administration of Employees' Pension Fund Etc. to discuss the system of the employees' pension itself and many other issues and to prepare its report with a target of June. While its outcome is anticipated, there apparently is a need to respond to a much more basic issue?the problem of the Japanese society as a whole on how to compensate for the lack of basic financial knowledge and risk awareness.

May 22, 2012

May 22, 2012

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