RISK MANAGEMENT FOR CENTRAL BANK FOREIGN RESERVES RISK MANAGEMENT FOR CENTRAL BANK FOREIGN RESERVESEUROPEAN CENTRAL BANK EDITORS: CARLOS BERNADELL, PIERRE CARDON, JOACHIM COCHE, FRANCIS X. DIEBOLD AND SIMONE MANGANELLI RISK MANAGEMENT FOR CENTRAL BANK FOREIGN RESERVES EDITORS: CARLOS BERNADELL, PIERRE CARDON, JOACHIM COCHE, FRANCIS X. DIEBOLD AND SIMONE MANGANELLI Published by: © European Central Bank, May 2004 Address Kaiserstrasse 29 60311 Frankfurt am Main Germany Postal address Postfach 16 03 19 60066 Frankfurt am Main Germany Telephone +49 69 1344 0 Internet http://www.ecb.int Fax +49 69 1344 6000 Telex 411 144 ecb d This publication is also available as an e-book to be downloaded from the ECB’s website. The views expressed in this publication do not necessarily reflect those of the European Central Bank. No responsibility for them should be attributed to the ECB or to any of the other institutions with which the authors are affiliated. All rights reserved by the authors. Editors: Carlos Bernadell (ECB), Pierre Cardon (BIS), Joachim Coche (ECB), Francis X. Diebold (University of Pennsylvania) and Simone Manganelli (ECB) Typeset and printed by: Kern & Birner GmbH + Co. ISBN 92-9181-497-0 (print) ISBN 92-9181-498-9 (online) Table of Contents Foreword by Gertrude Tumpel-Gugerell 5 Introduction by Carlos Bernadell (ECB), Pierre Cardon (BIS), Joachim Coche (ECB), Francis X. Diebold (University of Pennsylvania) and Simone Manganelli (ECB) 7 1 GENERAL FRAMEWORK AND STRATEGIES 1 Strategic asset allocation for foreign exchange reserves by Pierre Cardon (BIS) and Joachim Coche (ECB) 13 2 Thoughts on investment guidelines for institutions with special liquidity and capital preservation requirements by Bluford H. Putnam (Bayesian Edge Technology & Solutions, Ltd.) 29 3 A framework for strategic foreign reserves risk management by Stijn Claessens (University of Amsterdam) and Jerome Kreuser (The RisKontrol Group GmbH) 47 4 Asset allocation for central banks: optimally combining liquidity, duration, currency and non-government risk by Stephen J. Fisher and Min C. Lie (JP Morgan Fleming Asset Management) 75 5 Reaching for yield: selected issues for reserves managers by Eli M. Remolona (BIS) and Martijn A. Schriijvers (De Nederlandsche Bank) 97 6 The risk of diversification by Peter Ferket and Machiel Zwanenburg (Robeco Asset Management) 107 7 Currency reserve management by dual benchmark optimisation by Andreas Gintschel and Bernd Scherer (Deutsche Asset Management) 137 2 SPECIFICS OF RISK MEASUREMENT AND MANAGEMENT 8 Risk systems in central bank reserves management by Mark Dwyer (DST International) and John Nugée (State Street Global Advisors) 151 9 Corporate bonds in central bank reserves portfolios: a strategic asset allocation perspective by Roberts L. Grava (Latvijas Banka) 167 10 Setting counterparty credit limits for the reserves portfolio by Srichander Ramaswamy (BIS) 181 11 Multi-factor risk analysis of bond portfolios by Lev Dynkin and Jay Hyman (Lehman Brothers) 201 12 Managing market risks: a balance sheet approach by Bert Boertje and Han van der Hoorn (De Nederlandsche Bank) 223 13 Ex post risk attribution in a value-at-risk framework by Eugen Puschkarski (Oesterreichische Nationalbank) 233 14 Ruin theory revisited: stochastic models for operational risks by Paul Embrechts (ETHZ), Roger Kaufmann (ETHZ) and Gennady Samorodnitsky (Cornell University) 243 4 Contents 3 CASE STUDIES 15 Risk management practices at the ECB by Ciarán Rogers (ECB) 265 16 Management of currency distribution and duration by Karel Bauer, Michal Koblas, Ladislav Mochan and Jan Schmidt (C v eská národní banka) 275 17 Foreign reserves risk management in Hong Kong by Clement Ho (Hong Kong Monetary Authority) 291 18 Performance attribution analysis – a homemade solution by Alojz Simicak and Michal Zajac (Národná banka Slovenska) 305 19 Performance attribution for fixed income portfolios in Central Bank of Brazil international reserves management by Antonio Francisco de Almeida da Silva Junior (Central Bank of Brazil) 315 20 Management of the international reserve liquidity portfolio by David Delgado Ruiz, Pedro Martínez Somoza, Eneira Osorio Yánez and Reinaldo Pabón Chwoschtschinsky (Central Bank of Venezuela) 331 21 Determining neutral duration in the Bank of Israel’s dollar portfolio by Janet Assouline (Bank of Israel) 343 List of contributors 361 Foreword Risk management is a key element of sound corporate governance in any financial institution, including central banks. In particular, central banks, in performing their policy tasks, are exposed to a variety of financial and non-financial risks, which they may want to manage. One such key risk concerns foreign reserves, because central banks’ main activity, namely ensuring price stability, needs to be backed by an adequate financial position. Efficient management of foreign exchange reserves is vital if a central bank’s credibility is to be maintained. For many central banks, a significant part of the financial risks inherent in their balance sheet arises from foreign reserve assets. Successful foreign reserves management ensures that the capacity to intervene in the foreign exchange markets exists when needed, while simultaneously minimising the costs of holding reserves. Risk management of foreign reserves contributes to these objectives by strategically managing and controlling the exposure to financial and operational risks. Undoubtedly, foreign reserves risk management can benefit from methodologies and tools applied in the private asset management industry, as well as from developments of leading firms in competitive markets. However, the motivation for a volume addressing risk management from a central bank’s point of view is that not all private sector concepts are directly applicable to foreign reserves management. Central banks are idiosyncratic investors, because policy objectives induce specific portfolio management objectives and constraints and prescribe a generally prudent attitude towards market, credit and liquidity risk. Foreign reserves management deviates in terms of the investment universe, available risk budgets, investment horizons, management of liquidity risk, and the role and scope of active portfolio management. This volume gathers valuable contributions by academics and practitioners that reflect the specific nature of central bank reserves management. The contributions highlight the important role risk management plays in the continuous validation and improvement of central banks’ investment processes. Traditionally, reserves were mainly invested in liquid sovereign bonds. A changing investment universe makes it possible or even requires holdings to be more diversified. While observing liquidity and other policy requirements, highly-rated non-government instruments are added to the investment universe. These developments change the role of risk management: beyond a pure risk control perspective, proactive risk management must on a strategic level be involved when transforming policy requirements into strategic investment decisions. Despite a broadened investment universe, holding foreign reserves implies opportunity costs, as investments must necessarily deviate from a broadly diversified market portfolio. In recent years, many central banks have started using active management to further minimise these costs. Strategies and methods applied in the private asset management industry have therefore found their way into reserves management. These developments should go hand-in- hand with a further strengthening of risk management functions. This volume contributes to the development of methodologies and best practices in a changing environment for reserves management. In so doing, it strengthens the belief that risk management functions in central banks need comprehensive mandates to assure an efficient allocation of resources, development of sound governance structures, improved accountability, and a culture of risk awareness across all operational activities. Gertrude Tumpel-Gugerell Member of the Executive Board of the European Central Bank 6 Introduction Introduction Carlos Bernadell (ECB), Pierre Cardon (BIS), Joachim Coche (ECB), Francis X. Diebold (University of Pennsylvania), and Simone Manganelli (ECB) The management of foreign exchange reserves is an important task undertaken by central banks. Depending on the design of exchange rate arrangements and the requirements of monetary policy, foreign reserve assets may serve a variety of purposes, ranging from exchange rate management to external debt management. Hence central banks’ efficient management of foreign reserves is vital if they are to fulfil their mandates comprehensively. In particular, efficient allocation and management of foreign reserves will promote the liquidity needed to fulfil policy mandates while at the same time minimising the costs of holding reserves. Central bank foreign reserves risk management can contribute to these objectives by managing and controlling the exposure to financial and operational risks. In recent years, many central banks have expanded their risk control units into comprehensive risk management functions, beneficially independent to some extent from the bank’s risk-taking activities, and supporting decisions at all stages of the foreign reserves investment process. In addition to supporting traditional control functions such as compliance monitoring, foreign reserves risk management can contribute to the translation of policy goals into specific and efficient strategic asset allocations that focus not only on risk, but also on return. Indeed, it is precisely the risk-return interface, and the tension that arises for central banks navigating that interface, that motivate this volume. On the one hand, it is probably socially wasteful for a central bank to hold only sovereign bonds, accepting their relatively low risk- free return, which suggests the desirability of more aggressive central bank investment strategies. On the other hand, central banks are unique institutions with very particular mandates, which suggests that naively importing private sector asset management strategies may be misguided. So, then, what should a central bank do? In this volume, we attempt to progress toward an answer. Our approach contains three components, corresponding to the volume’s three parts: (I) General Framework and Strategies, (II) Specifics of Risk Measurement and Management, and (III) Case Studies. Part I sets the stage in broad terms, suggesting and evaluating various alternatives, and making it clear that an appropriate framework must respect the unique aspects of central banking environments, characterised by a high degree of risk aversion and institutional constraints. Part II contains a variety of rather more technical contributions focusing on risk measurement and optimisation of the risk-return trade-off as appropriate for central banks. Finally, Part III contains descriptions of current practice at a variety of central banks worldwide, which are designed to provide context and perspective. Part I, General Framework and Strategies, begins with Cardon and Coche, who stress the importance of good corporate governance and a sound organisational design. Their paper views strategic asset allocation as a three-step process. First, an appropriate organisational design should be developed to ensure a smooth implementation of daily reserves risk management. The paper argues for a three-tier governance structure, with clearly distinguished and segregated strategic asset allocation, tactical asset allocation, and actual portfolio management responsibilities. Second, the general policy and institutional requirements should be translated into specific, precise and quantifiable investment guidelines. Finally, these investment guidelines should be transformed into an optimal long- term risk-return profile. 8 Introduction Putnam dwells on the second step of the process described by Cardon and Coche. He argues that for central bank foreign risk management, it is crucial to understand the interplay between investment objectives and investment guidelines. A thorough examination of the commonly-employed investment guidelines may uncover the existence of strategies that actually work against the complex long-term investment objectives of central banks. In concrete terms, he suggests addressing the trade-off between short-term and long-term needs by dividing the foreign reserves portfolio into two sections: “liquid” and “liquidity- challenged”. This would permit the central bank to withstand sudden shocks to the market environment, while at the same time earning liquidity, complexity and volatility premia which are typically only available to long-term investors. The remaining five contributions in Part I provide different examples of how central banks’ investment guidelines can be embedded in a well-structured mathematical framework. Claessens and Kreuser suggest a numerical approach in order to solve a dynamic stochastic optimisation model that incorporates both macro aspects of policy objectives (e.g. monetary policy needs and foreign exchange management) and micro elements (e.g. the definition of portfolio benchmarks and the evaluation of investment managers). Fisher and Lie criticise risk management strategies based on exogenous ad hoc restrictions of the investment universe. This typical asset allocation process generally leads to overconstrained portfolios and to significant efficiency losses. They suggest an asset allocation framework that maximises portfolio returns, given a risk target and subject to constraints on liquidity, credit quality and currency allocations. Remolona and Schrijvers examine three alternative strategies. The first focuses on duration, the second on default risk and corporate bonds, and the third on higher-yielding currencies. They find that the trade-off between risk and return as measured by the Sharpe ratio points to a recommended duration of not longer than two years. In the case of corporate bonds, the key issue is how to achieve a proper diversification, given the significant asymmetries that characterise the distribution of these portfolio returns. For higher-yielding currencies, empirical evidence suggests that yield differentials are generally not offset, but rather reinforced, by currency movements. Ferket and Zwanenburg quantify the risk and return characteristics of some of the most popular asset classes in the private asset management industry (long-term and global government bonds, investment-grade credits, high-yield bonds and equities), which they then compare to those of a cash benchmark – the lowest risk portfolio. Their empirical results suggest several diversification strategies that may have attractive risk-return trade-offs for central banks. Scherer and Gintschel look at currency allocation. The literature focuses on two problems – wealth preservation and liquidity preservation – that are typically solved separately. Rather than following each approach in isolation, the authors model the currency allocation decision as a multi-objective optimisation problem, making explicit the trade-off between the two objectives, and incorporating political constraints into the decision-making process. Part II of the volume, Specifics of Risk Measurement and Management, contains contributions that deal with more technical aspects of the risk management process. Nugee and Dwyer introduce the concept of “whole enterprise” risk management. They first describe risk management from a narrow financial risk control perspective. Then, they examine the typical financial risks faced by a central bank, and critically review the traditional risk methodologies in use. In the second part of the paper, they argue in favour of a wider framework of risk management and corporate governance for the entire central bank, Introduction 9 incorporating aspects of legal, operational and reputational risks in addition to the common financial risks. The papers by Grava and by Ramaswamy discuss issues related to diversification towards corporate bonds and measurement of credit risk. Given the current environment – characterised by low- yield, highly-rated government bonds – managers of official foreign exchange reserves have started to consider higher-yielding alternative instruments. The overall message is that the potential inclusion of higher-yielding securities in a central bank reserves portfolio should not be discarded a priori, provided that the related risks are properly measured and managed. Grava studies the effects of adding corporate securities to reserves portfolios. He considers only highly-rated investment-grade bonds, on the grounds that investment in lower-rated securities might require specialised skills and resources not typically available at a central bank. The main finding is that adding spread risk leads to better risk-return profiles than increasing portfolio duration. Moreover, a long-term passive allocation to credit sectors, coupled with the ability to tolerate short-term underperformance, generates significantly higher returns in the long run. Ramaswamy provides a framework to implement an internal credit risk model for reserves management in a central bank. The model uses as input only publicly available information, thereby providing a good compromise between accuracy and simplicity. The paper also provides indicative values for the credit risk model parameters required for quantifying credit risk. The next three papers deal with market risk. Dynkin and Hyman describe the Lehman Brothers market risk model. This is a multi-factor model, with the factor loadings rather than the factors viewed as observables. The paper illustrates the advantages of such a methodology and provides a good overview of its usefulness for risk management. Bortje and van der Hoorn present a balance sheet approach to managing market risk. The paper distinguishes two dimensions along which the financial strength of a central bank can be measured: its profit-generating capacity, and its ability to absorb losses. A central bank’s profitability can be gauged from the profit and loss account. Under simplifying assumptions about exchange rates and yield curves, the paper argues that profitability is largely driven by the size of the monetary base, the interest rate level, and operating costs. On the other hand, the ability to absorb losses is found by comparing the potential loss (as measured by the Value-at-Risk of the portfolio) with the total amount of reserves. The composition of the balance sheet is subsequently optimised within a constrained maximisation framework. Puschkarski develops a general procedure for decomposing time variation in portfolio Value-at-Risk from one reporting period to the next. This decomposition occurs across three main dimensions: time, market developments, and changes in portfolio allocation. A fourth element, taking into account the interaction between these three dimensions, is also described. Such analysis will help managers to set and monitor risk limits, and to understand how and why they are occasionally breached. Finally, we conclude Part II with a very general contribution on operational risk as relevant to central banks. Embrechts, Kaufmann and Samorodnitsky note that operational risk arises from inadequate internal processes and/or unanticipated external events, both of which are highly relevant for central banks. Hence proper quantification of operational risk may affect central bank reserve management, because the bank will generally want to react when confronted with unanticipated catastrophic events. The paper first discusses issues related to the availability and characteristics of operational risk data, and then, exploiting analogies [...]... an asset management environment Although the reserves management of central banks is in many aspects comparable to asset management, a rigorous implementation based on hard limit concepts currently appears to be more in line with the general prudent attitude of many central banks From risk control to risk management Originally, the risk control functions in central banks were designed for reserves. .. the excitement presently associated with risk management in central bank foreign reserves contexts, as cutting-edge techniques from private sector asset management are adapted to central bank environments Indeed, the contributions make it clear that best practice central bank reserves management is already in a state of flux, owing to improvements in asset management techniques and decreasing supplies... example for the nation Specifically, central bank foreign reserves management must set investment guidelines that are consistent with their special tolerances for shorter-term risk of large losses (capital preservation) and the ability to access funds in a market crisis or period of national emergency (liquidity management) This means that central bank foreign reserves management objectives need to be... and requirements of central banks and official international agencies and institutions, in terms of their foreign reserves management, leads to the division of the foreign reserves portfolio into two sections: “liquid” and “liquidity-challenged”, each with different investment objectives and different investment guidelines Within the “liquid” section of the central bank foreign reserves portfolio,... management of central bank foreign reserves is substantially more difficult compared to the portfolio management world of private sector financial institutions, pension funds, or other long-term pools of private sector capital Managing liquid capital for the long term, with multiple objectives and constraints, is a tough task in any market environment What makes managing central bank foreign reserves over... and thereby explicitly accounts for diversification effects between benchmark risk and active management risk (Chow and Kritzman, 2001) Risk budgeting could also be seen as a technique for tracking the risk per unit of return Strategic asset allocation for foreign exchange reserves 2 15 Organisational set-up Most central banks today are subject to stringent reporting requirements vis-à-vis the general... allocation for foreign exchange reserves 23 risks In the latter case, the ability to bear financial risks would be determined by the bank s capital and provisions Analogous to the risk tolerance, the investment horizon for the reserves strategic asset allocation is closely linked to the objectives and constraints laid down in the investment principles If reserves are held to provide ready liquidity for financing... politically stable and industrially mature countries to see that their central banks still require a high level of liquidity in their foreign reserves portfolio The “liquidity-challenged” section of the central bank foreign reserves portfolio, small as this section may be, should be allowed to focus on long-term, straightforward risk- return criteria with little or no constraints on asset classes or... “liquiditychallenged” section of the central bank foreign reserves portfolio, used for long-term investment, more straightforward risk- return criteria can apply, which allows for long-term efficient allocation of scarce resources, including the ability to earn liquidity, complexity, or volatility premiums available to long-term investors 1 Introduction Certain types of institutions, especially central banks, have unique... vulnerability, foreign reserves holdings also take into consideration the country’s external debt Furthermore, reserves serve as a store of national wealth Central banks have to choose an appropriate strategic asset allocation of the foreign reserves in agreement with these general policy objectives An important consequence of the chosen asset allocation is its impact on overall performance and risk over . RISK MANAGEMENT FOR CENTRAL BANK FOREIGN RESERVES RISK MANAGEMENT FOR CENTRAL BANK FOREIGN RESERVESEUROPEAN CENTRAL BANK EDITORS: CARLOS. with risk management in central bank foreign reserves contexts, as cutting-edge techniques from private sector asset management are adapted to central bank