Table Of ContentS RISK MANAGEMENT FOR CENTRAL BANK
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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
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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
v
(Ceská 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
Description:Risk systems in central bank reserves management by Mark Dwyer (DST International) and John Nugée (State Street Global Advisors) 151. 9.
