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A call for sound investment practices and policies(includes related information on investment officer guidelines)

The alarm bells from the Orange County disaster have faded outside the beleaguered communities themselves, yet the problems highlighted as the cause of the disaster have not faded. Sound investment practices and policies are still as critically important as ever. In fact, highly publicized problems at Gibson Greetings, Barings and Daiwa Bank illustrate that the need for improved investment practices is not limited to the public sector. Indeed, if sophisticated financial players like Barings and Daiwa can fall victim to internal control problems, then governmental entities, whose primary business is not and should not be finance, may be even more at risk. Precisely because government's primary business is not finance, however, it must be even more careful than private enterprise.

The principles for sound investing are the same for government and private enterprise. Safety, liquidity and yield, in order, are the guiding principles for all investing. Private investors, whether individuals or financial conglomerates, however, can accept different risk parameters for each of these principles. Indeed, so can different parts of government. A pension fund, for instance, with a longer time horizon than an operating fund, may have more flexibility in satisfying its liquidity needs than the operating fund. As between the public and private sectors, however, government must set more conservative risk parameters.

Last December, after Orange County's problems came to light, the Treasury Department hosted a meeting between the President's Working Group on Financial Markets and various associations of state and local officials, including the National League of Cities, to discuss investment policies and practices of state and local governments. The Working Group and the associations agreed "to work together to promote sound investment policies and practices by state and local governments."

In the following months, some state and localities reviewed their investment practices, and some adopted new investment guidelines and controls. Various organizations, including the National League of Cities, promulgated suggested investment guidelines and offered to help governments review and prepare new guidelines and train personnel. These were all good steps, but they have not been widespread enough.

In October, the Treasury Department and the Securities and Exchange Commission announced a joint project to emphasize the seriousness with which we view state and local investment practices.

The members of the President's Working Group all agree that the state governments have the primary responsibility for ensuring prudent investment practices of the governmental units ultimately under their jurisdiction. All taxpayers and all levels of government, however, have an interest in promoting appropriate investment policies and practices.

Oversight entities have a special duty to ensure proper training of the investing and over-sight staff. Financial markets are too complex to be dealt with by those who are not prepared to do so.

For all those involved, information sharing must be key. Investment officers must share information with their oversight entities and auditors. Further, they must be prepared to answer questions, ensuring that they understand the complexities of investments. Oversight entities must demand information and demand that it be understandable. Concentration of information in one area means a lack of information in another area.

Internal controls, whether in private firms or government investment offices, depend on information sharing. An investment officer must be able and willing to explain investment decisions and must be accountable for those decisions. Oversight entities must also be accountable for investment decisions and must demand information on those decisions for which they are responsible.

These guidelines are easy to recite, but can be difficult to implement. There is, moreover, no one formula that is appropriate for the particular facts and circumstances of each fund.

There have been some federal initiatives in this area. Under the Government Securities Act Amendments of 1993, the National Association of Securities Dealers has proposed to extend its sales practice niles, including the suitability rule, to the sales of government securities. The SEC is in the process of seeking public comment on this proposal. Also, the bank regulatory agencies are hoping to propose a suitability rule soon for banks that sell Government securities.

Suitability rules, however, should not be used as a substitute for sound investment practices. It is the responsibility of investment officers to exercise their public trust to the best of their abilities. Governmental entities must be sure they have they have the expertise, either on staff or hired as advisors, to manage the government's funds.

The Working Group is also planning another meeting with the groups we met with last year to learn what various groups and jurisdictions have done and to get advice on what steps the federal government can take to encourage prudent investment practices.

While the particular facts and circumstances of each entity mean the specific steps it must take will probably differ from those of other entities, the guiding principles will always be the same. It would be a mistake, however, to focus on only one of those principles. Emphasizing safety, for example, to the exclusion of liquidity and yield, could cause unnecessary pain to the citizens, also. There is absolutely nothing wrong with reaching for extra yield, as long as the first two guiding principles, safety and liquidity, are also satisfied. Further, derivatives may not always be inappropriate. What is an appropriate investment for each fund has to be determined based on the particular facts and circumstances of that fund.

Investment officers, who live with these issues every day, are probably acutely aware of them. Oversight entities, however, who always have an overabundance of problems with which to deal, can have a tendency to ignore what is not in crisis. As Secretary of the Treasury Robert E. Rubin has said, "Implementing sound investment policies and practices must be a priority and monitoring them must be a continuing priority even in times when a crisis does not exist."

The risks of imprudent financial management are too great to ignore, even in good times. The federal government stands ready to help states and localities and the various associations prevent problems. It is a job that must be done.

RELATED ARTICLE: Guidelines For Investment Officers and Oversight Entities

Investment officers must:

* have defined investment objectives and criteria that are either created or approved by the officials or bodies to whom the investment officers are responsible;

* analyze their portfolios and each investment opportunity in light of the guiding principles of safety, liquidity and yield;

* understand each investment and how its risks and rewards relate to the rest of the portfolios;

* decline investment opportunities they do not understand or cannot value; and

* explain to the oversight entities the kinds of risks within their portfolios and how such risks fit within the investment objectives.

Oversight entities, for their parts, must:

* monitor how portfolios conform to investment objectives and criteria;

* understand the kinds of risks within portfolios and how such risks fit within the investment objectives;

* ensure that investment officers have adequate training and that the risks of each investment are understood by more than one investment officer (there are too many proverbial busses in America to depend on only one person);

* ensure that auditors, both internal and external, understand the kinds of risks within portfolios; and

* be ever-vigilant against pressuring investment officers to become profit centers. The primary duty is to protect the funds, not ease pressure on the budget.

John D. Hawke, Jr. is Under Secretary of the Treasury for Domestic Finance. Roger L. Anderson is a Senior Advisor in the Department of the Treasury.
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Author:Hawke, John D., Jr.; Anderson, Roger L.
Publication:Nation's Cities Weekly
Date:Nov 20, 1995
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