Guidelines for Foreign Exchange Reserve Management -- Part II

II COUNTRY CASE STUDIES 1 Australia

Governance and Institutional movements in exchange rates, relative returns in Framework bond markets, and changes in the level and slope of yield curves. These changes were set in place in Objectives of reserves management 1991. 156. Australia’s foreign currency reserves are 158. Experience with active management was managed by the Reserve Bank of Australia (RBA). reviewed in 2000 after nine years of operation. The At the end of June 2002, the gross value of the review highlighted the fact that short-term invest- reserves portfolio was US$20 billion, representing ment decisions designed to take advantage of mar- around half of the central bank’s assets. The pri- ket anomalies had consistently made positive mary role of the reserves portfolio is to fund for- returns, albeit small. In contrast, investment posi- eign exchange market operations that arise as part tions taken in anticipation of medium-term of the Bank’s broader monetary policy function. macroeconomic developments had made positive Reflecting this, the reserves are managed in a man- returns of reasonable size in some years, but these ner that gives priority to low levels of credit risk, had been largely offset by negative returns in other limited exposure to market risk, and maintaining a years, leaving only a small positive return from this high degree of liquidity. Subject to these objectives, activity overall. The RBA decided that the low aver- the Bank also seeks to earn a positive return on the age, and high variability, of returns did not warrant portfolio. taking investment positions of the same size and 157. In 1990, the Bank undertook a formal frequency as in the past. As a result, management review of its approach to foreign exchange reserves discretion was curtailed, significantly reducing the management. The outcome of the review was the importance of discretionary management as a establishment of a rigorously defined operational source of return for the reserves portfolio. framework for managing risk and return. The cen- terpiece of the framework was the development Institutional framework and implementation of benchmark portfolios for currency and asset allocation, and for the duration 159. The RBA’s responsibility to manage of the asset portfolios. The benchmarks are Australia’s foreign exchange reserves is given intended to represent the optimal mix of risk and through broad legislative powers that allow the return for the RBA given its management objec- Bank to buy, sell, and otherwise deal in foreign tives. The review also provided a greater role for exchange (among other things) to achieve mone- active management to take advantage of expected tary policy objectives. Responsibility is not shared

35 36 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT

Figure 1. Organizational Structure

Governor

Assistant Governor Assistant Assistant Governor Financial Markets Group Governor Corporate Services

Audit

Head of International Department

Dealing Payments Financial Support Settlements Administration Front Office Analysis (Middle Office) Department Department (Back Office)

New York London Sydney Dealing Dealing Dealing Center Center Center

with other government agencies, reflecting the in New York, London, and the Bank’s Head Office role of reserves as a source of intervention capital. in Sydney. These centers execute trades and have The RBA acts independently in its management small discretion for position taking. The RBA has decisions. found considerable informational benefit in locat- ing dealing staff in major offshore centers. The front office is also supported by an analytical group Organizational and decision-making structure with responsibility to provide in-depth analysis of 160. The organizational structure of reserves international financial and macroeconomic devel- management at the RBA is summarized in Figure 1. opments that may impact on the value of the Responsibility for management of reserves is dele- reserves portfolio. gated by the Governor of the Bank to the Financial 162. Also part of the Financial Markets Group, Markets Group (FMG). This group comprises two but not within the International Department, is a departments, International and Domestic Markets. middle office function, known as Dealing Support. The International Department is responsible for This unit is responsible for measuring risk and the Bank’s front office operations in markets for return and for maintaining front office systems. foreign exchange, gold, and offshore assets. Valuation, performance, and risk information are 161. The International Department front provided to the front office operation and to office manages the currency and asset allocation senior management on a daily basis. The middle positions of the portfolio, and directs policy issues office reports directly to the Assistant Governor regarding investment of reserves, such as assessing overseeing the Financial Markets Group. instruments and the structure of the benchmarks. 163. There are several other areas outside of It is supported by three dealing centers: one each the Financial Markets Group that provide services 1 • Australia 37 to, or scrutinize the actions of, the front office sion making unwieldy and, therefore, poorly suited reserve management operation. These include the to a more active risk management framework. It back office (Payments Settlements) and account- also constrained initiative at manager levels. With ing (Financial Administration) functions. The back the move to more active management in the early office provides standard settlement and communi- 1990s, the Governor’s discretion for day-to-day cation services to the reserves management front management of reserves was delegated to an office and is responsible for the final approval of all Investment Committee within the Financial transactions—dealers in the front office cannot Markets Group. The Committee, made up of confirm trades. There are back office operations in senior managers from units involved in reserves each of the dealing centers, with Sydney having management, had discretion to take sizable posi- overall responsibility. The Audit Department is also tions in currency and asset allocation subject to outside of the Financial Markets Group. This limits approved by the Governor. The Investment department has a direct reporting line to the Committee met regularly and took positions Governor. largely based on assessments of the medium-term 164. The structure and delineation of responsi- macroeconomic outlook of countries in which the bilities in reserves management have evolved over reserves were invested. A small and qualified time as the nature of, and the RBA’s approach to, amount of trading discretion was delegated to reserves management has changed. Until the late managers in the trading centers. 1980s, the International Department was responsi- 167. The Investment Committee’s structure ble for both middle and front office functions. and its discretion to take positions changed fol- Indeed, front office staff performed many of the lowing the review in 2000. Senior managers over- middle office responsibilities. Importantly, the back seeing front office operations are now responsible office was also located in the International for day-to-day management of currency and asset Department, albeit with separate reporting lines to allocation, maintaining the portfolio close to the Assistant Governor, Financial Markets Group, benchmark. They report directly to the Assistant from those of the front office. This seemed to be a Governor of the Financial Markets Group. An out- reasonable structure, given the conservative limits line of the decision-making structure is shown in on risk and the lack of flexibility in the RBA’s invest- Figure 2. ment operations at the time. However, as the 168. Reflecting the more passive trading envi- approach to reserves management changed in the ronment, there are no longer any formal meetings early 1990s and the scale of the operation increased, to discuss investment strategy. In contrast, man- the Bank set in place a number of changes to reduce agers in the dealing centers have retained their operational risk and reflect best-practice in funds small amount of discretion to set short-term tacti- management. cal positions. These centers are also responsible for 165. Establishment of a middle office within the lending stock from the portfolio. Financial Markets Group, which reports independently to the corresponding Assistant Governor, was Transparency and accountability a major change that occurred in the mid-1990s. Separation of the back office function was com- 169. With the introduction of a more rigorous pleted in 1998 when the back office was physically approach to reserves management, where decision relocated to a different floor of the RBA’s Head making was delegated to a large extent, the RBA Office building and put under control of the needed to be confident that an adequate level of Assistant Governor, Business Services. control was being maintained and that its actions 166. Decision-making processes have also were properly accounted for in line with market evolved. In the early 1980s, almost every transac- best practice. This required a system where indi- tion in reserves management had to be approved viduals and operational units were fully aware of by higher management. While this maximized con- their delegated authorities, the risks, and the value trol over the management process, it made deci- added from their decisions. 38 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT

Figure 2. Decision-Making Structure

Governor

Assistant Governor Financial Markets Group

Front Office

Senior Management Economic Dealing Support Analysis - Currency and Asset Allocation (Middle Office) - Market Analysis - Reserves Management Policy - Performance and Risk Measurement - Front Office System

Dealing Centers - Trading - Market Analysis

170. A key element in the control of opera- Over the past ten years, efforts have been made to tional risk has been the development of manuals maintain a core of experience at senior levels detailing investment and risk management proce- within the operational areas while, at the same dures. The manuals specify the kinds of instru- time, allowing rotation at junior levels in order to ments in which investments can be made, the risk build a foundation of experience. Compensation is parameters for each portfolio, and the responsi- reviewed regularly to ensure competitiveness with bilities of various positions associated with other organizations and staff are encouraged to reserves management. They also specify how participate in a range of courses, both internal and risks and returns are calculated and how office external, relevant to their work. These measures systems should be used in specific circumstances. have contributed to an average tenure over the Procedures manuals also exist for middle and operational areas of four years. back office staff. 172. The Governor requires that reserves are 171. Staffing policy is another key element. accounted for in line with best practice and that The RBA has found considerable benefit in spe- the level of transparency is consistent with that in cialization of professional staff in operational other parts of the RBA’s monetary policy opera- areas. Frequently rotating staff in and out of these tions. To this end, the RBA publishes statistical areas in order to provide a breadth of experience information on its reserves and foreign currency was felt to be a significant constraint on maintain- transactions in its monthly Bulletin. Also, since ing adequate levels of experience and knowledge. 1992, the Bank has provided an overview of 1 • Australia 39 reserves management operations and return rela- Table 2. Currency, Asset, and Duration Benchmarks tive to benchmark in its Annual Report. This has United included in recent years an outline of the compo- States Europe Japan sition of the benchmark portfolios and a discussion Currency allocation (%) 45 45 10 of the RBA’s approach to risk management. Asset allocation (%) 45 45 10 173. The RBA’s annual financial statements are Duration (months) 30 30 30 prepared in accordance with Australian Accounting Standards and other mandatory reporting requirements contained in the Commonwealth Authorities and Companies Act. The statements are scrutinized foreign currency portfolios. The decision was by an external auditor, the Australian National taken to spread the composition across the three Audit Office, to ensure that they comply with rele- major reserve currencies—the U.S. dollar, vant standards. deutschemark (later the euro), and Japanese yen. 174. Reserves management functions are This also provided a diversified portfolio and audited internally each year in accordance with meant, too, that the RBA’s assets would be recommended control frameworks published by invested in capital markets that are liquid and the Bank for International Settlements and highly rated. From very early on, mean-variance requirements set out by the Australian Financial analysis, in addition to judgmental factors, has Markets Association. The internal audit reports played a major role in deciding on the weights on compliance with controls and seeks to assigned to the three currencies in the bench- strengthen management processes where it sees mark portfolio. potential for loss through inadequate control. It 177. The choice of a duration benchmark of 30 reports to an Audit Committee, which is chaired months for each of the asset portfolios was made by the Deputy Governor of the RBA and consists on the basis of factors specific to the RBA in its of a non-executive member of the RBA’s Board responsibility for managing reserves and analysis of and an external appointee. risk and return for each asset. This duration represents the maximum price risk that the RBA will allow itself while keeping the probability of capital Capacity to Assess and Manage Risk15 loss to an acceptable level over the Bank’s investment horizon. An example of this analysis is given Benchmark portfolios in Figure 3. 175. The composition of the currency and 178. The RBA’s investment horizon is twelve asset benchmarks, and the duration benchmark for months. This is based on the Bank’s investment each asset portfolio, are shown in Table 2. The objectives and the period in which it reports on its benchmarks represent the risk-return trade-off operations to the Australian Parliament. Over acceptable to the RBA over the long term, given its a twelve-month period, the RBA expects the management objectives and its primary objective return on the portfolio to fall within a 95 percent for holding reserves. Statistical, practical, and judg- confidence band around the mean return, and mental factors relevant to the RBA are important will accept a negative return on only 2.5 percent in deciding the appropriate composition. of occasions. On this basis, return is maximized 176. With the aim of maximizing the Bank’s at point A in Figure 3, where the lower boundary capacity to intervene, it was decided that a trade- of the confidence band crosses the horizontal weighted basket of currencies would be an appro- axis. priate currency and asset composition for the 179. In addition to the currency and asset benchmarks, the RBA has established benchmarks for the composition of each of the three asset port-

15An account of the RBA’s approach to risk management is folios. These benchmarks are set out in Table 3. detailed in the Bank’s 2000/01 Annual Report. Like the other benchmarks, practical and judg- 40 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT

Figure 3. Horizon Analysis which has the security advantage of being collateralized with government securities. Return (percent) 182. The benchmarks are reviewed periodically 30 to ensure that they continue to reflect the RBA’s

95 percent confidence band long-term management objectives. There have 20 been relatively few changes. They have been made to take account of structural changes to markets or changes in the nature of the Bank’s operations. 10

A Instruments 0 183. In addition to the assets held in the –10 benchmark portfolios, the RBA’s dealing centers 0 1 2 3 4 5 have discretion to hold a small range of other Duration (years) highly rated instruments. These include the U.K. Gilts, Dutch and Swiss government paper, and deposits and medium-term notes issued by the mental factors, combined with the liquidity charac- Bank for International Settlements. With the teristics in each market, are important in deciding exception of BIS deposits, these investments have the appropriate asset structure of the portfolios. accounted for a negligible share of total holdings. 180. The desire to maintain a liquid and secure Discretion to hold U.K., Dutch, and Swiss paper is portfolio led the RBA to limit its benchmark invest- a remnant of a period in the 1980s when the comments to government securities and cash instru- position of Australia’s official foreign currency lia- ments. Typically, some 75 to 80 percent of the bilities influenced the composition of the reserves RBA’s benchmark foreign investment portfolios portfolio. Discretion also exists to hold U.S. are held in government paper. This comprises Federal Agency debt in the U.S. portfolio as a Treasury bills and notes in the U.S. portfolio, and source of return enhancement. However, total Japanese government bills and bonds in the yen holdings are restricted to a maximum of US$500 portfolio. For the European portfolio, the RBA has million. decided on a combination of French and German 184. In 1994, the Bank began trading interest government securities as the best structure to sat- rate futures contracts. This decision was driven by a isfy requirements for credit risk and liquidity. In desire to improve management of market risk and, order to limit exposure to price risk, the maximum in particular, to provide a liquid hedging instru- maturity of securities holdings is restricted to 10!/2 ment to minimize the risk of capital losses when years in each portfolio. interest rates were rising. An additional attraction 181. Cash invested under repurchase agree- of using futures was the greater liquidity and flexi- ments (repo) and deposits with highly rated banks bility they provide in some markets when imple- make up the balance of the asset benchmarks. menting investment strategies. Some futures Historically, the RBA has found the short duration markets are more liquid than their underlying offered by deposits to be attractive in markets physical bond markets in that the bid-offer spread where access to short-term government debt was is usually much narrower. Futures trading has been limited. They have also been a good, immediate concentrated in the European and Japanese port- source of liquid funds during episodes of currency folios. The RBA does not use any over-the-counter intervention. That said, the proportion of foreign or exchange-traded options in its reserves manage- exchange reserves invested in deposits has ment activities. declined in recent years, reflecting tighter credit 185. Stock lending is also an activity under- constraints and changes in cash management prac- taken by the dealing centers. Over the past few tices. The RBA now makes greater use of cash repo, years, stock lending, particularly from the U.S. 1 • Australia 41

Table 3. Composition of Individual Portfolio Benchmarks

______United States ______Europe ______Japan Asset class Percent of total Asset class Percent of total Asset class Percent of total

RPs/Deposits 22 RPs/Deposits 30 RPs/Deposits 22 Treasury bills 21 Treasury bills 15 Treasury bills 33 Treasury notes 57 Bonds 55 Bonds 45

portfolio, has risen to be a major component of portfolio in order to control the amount of curve return enhancement. Though the back office risk. Breaches of the limit are reported to Assistant workload associated with this activity can be large, Governor on the day they occur. The dealing cen- the RBA sees this activity as relatively low risk. ters are also required to report daily losses that exceed US$1 million to senior management in the Financial Markets Group. Risk and performance measurement 188. The “dollars-at-risk” measure also forms 186. Market risk and return enhancement are the basis of the Value-at-Risk (VaR) methodology, measured relative to the benchmark portfolios. which the RBA has used since 1995 to estimate the For currency and asset allocation, senior manage- consolidated exposure of the Bank’s foreign cur- ment in the operational areas of the RBA’s rency reserves to market risk. Though the overall International Department may allow the portfolio limits to control market risk—i.e., the discretionary to vary by 1 percent either side of the benchmark trading bands around the benchmark—are not weights.16 Currency and asset positions are man- defined in terms of VaR, the RBA has found that it aged separately within the discretionary band nonetheless provides a useful tool for conveying through the use of foreign currency swaps. The information about the overall portfolio exposure cost/benefit of these swaps is taken into account to senior management and staff involved in when measuring the performance of the asset and reserves management. currency positions relative to benchmark. Foreign 189. The VaR number represents the portfolio exchange dealers in each of the three dealing cen- loss the RBA could incur once every 20 business ters have a small amount of discretion (set in days in normal market conditions. Two VaR mea- terms of a maximum open position) that falls sures are calculated each day—one based on the within the ±1 percent discretionary limit on cur- correlation method and the other based on histor- rency allocation. ical simulation methodology. The assumptions 187. Risk measurement and trading discretion underlying these VaR methodologies are reviewed around the duration benchmark for each asset periodically and their performance is tested regu- portfolio are based on the concept of “dollars-at- larly. In accordance with best practice, the RBA risk.” This is the change in portfolio value arising also stress tests the portfolio. This involves simulat- from a one basis point change in yield. Within each ing and evaluating the impact of extreme market of the portfolios, the dealing centers are required movements on the value of the portfolio. to maintain dollars-at-risk to within US$70,000 per basis point at all times. This limit applies to the Information system aggregate position of the portfolio and to the position undertaken in each maturity bucket of the 190. All international transactions entered into by the RBA are processed through a main-frame electronic Global Trading and Settlement System (GTS). This system has been developed by an 16Prior to the performance review in 2000, management had discretion to vary the portfolio as much as 20 percentage external software provider to our specifications, points either side of the benchmark. with functionality expanded as new products are 2 Botswana

Governance and Institutional Balances Tranche (TBT) and the Liquidity Framework Investment Tranche (LIT). The TBT functions as a current/checking account to take care of inflows Reserve management objectives and and outflows. The rest of the reserves are invested coordination in the long-term Pula Fund. It is relevant to note 191. The major responsibilities of the Bank that the government has not experienced a need to include the management of foreign exchange issue government securities for funding purposes, reserves on behalf of the government. The Bank as budgetary surpluses have been a feature of the ensures their safety and return by diversifying Botswana economy for a long time (Figure 4). investments within a framework of acceptable risks. 193. Relative to many other central banks in A major feature of the reserves management prac- the region, the Bank of Botswana has for many tice is to divide the reserves into sub-portfolios, years had a high level of external reserves, approx- namely, the Pula Fund (long-term) and the imately 39 months of import cover as of December Liquidity Portfolio (short-term). The Bank’s poli- 31, 2001. As such, the maintenance of a minimum cies for the management of the foreign exchange level of reserves has not been a concern to the reserves can be summarized in terms of three main Bank. Furthermore, the high level of reserves has principles. In order of importance, these are safety, permitted the Bank to create the long-term fund liquidity, and return. With respect to the long-term (Pula Fund). portfolio, the Pula Fund, return takes priority over 194. One of the objectives of establishing the liquidity, while safety continues to have the highest Pula Fund is to take advantage of the high level of priority for both the Liquidity Portfolio and the the reserves and invest part of them in assets such Pula Fund. As of the end of 2001, the split between as long-term bonds and equities, with the expecta- the Pula Fund and Liquidity Portfolio was 80 per- tion of earning a higher return than could be cent and 20 percent, respectively. achieved on conventionally managed foreign 192. The appropriate level for the Liquidity exchange reserves, thereby developing a long-term Portfolio is determined such that the portfolio acts earner of foreign exchange for the country. Such as a buffer against short-term trade and capital earnings would allow sustained long-term income account fluctuations, and as a cushion to finance even if export revenues were to be adversely unforeseen developments in the external pay- affected by factors over which Botswana has no ments situation. The Liquidity Portfolio is further control. Based on historical data and financial the- subdivided into two tranches: the Transactions ory, long-term bonds and equities are expected to

43 44 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT

Figure 4. Portfolio Structure

Aggregate Portfolio

Liquidity Portfolio Pula Fund

Transactions Liquidity Global Equities Balances Investment Fixed Tranche Tranche Income

Global Regional Mandate Mandates (Passive) (Active)

outperform short-term assets, such as cash and considered to have merit, matched asset/liability short-term bonds, which comprise the bulk of management was later considered to be more use- investments in the Liquidity Portfolio. Returns on ful for countries with more debt or very low long-term assets are, however, more volatile than reserves in terms of import cover and, accord- returns on short-term assets. Therefore, it became ingly, the assets held in MALP were transferred to necessary to have a longer investment horizon for the potentially higher yielding Pula Fund in the the Pula Fund in order to benefit from the mid-1990s. expected higher returns. 197. In Botswana, one of the key features of reserve management is the contribution that the income earned from the reserves makes to gov- Coordination with monetary policy and external ernment funding. In this regard, over the past five debt management years, income from external reserves has been the 195. To date, the external reserves have not third most important constituent of budgetary been used as a mechanism for supporting the revenues. exchange rate in the context of the Bank’s monetary policy objectives. The Bank of Botswana does Institutional framework not intervene in the foreign exchange market. 196. With regard to coordination with exter- 198. The Bank of Botswana Act, 1996, outlines nal debt management policy, the Bank had a the primary functions of the Bank, which include, Matched Asset Liquidity Portfolio (MALP), which inter alia, the management of the foreign exchange was established for the purpose of separating a reserves. In particular, the Act provides that the portion of the reserves and investing them in Bank shall be responsible for establishing and main- fixed income instruments that had the same taining a Primary International Reserve (Liquidity maturity profile as external debt. It was consid- Portfolio), which shall, in general, consist of liquid ered that combined asset/liability management short-term assets. Furthermore, the Act provides for would lead to better risk management than when the establishment of the long-term investment fund assets and liabilities are managed separately. (Pula Fund), subject to meeting the requirements While the reason behind establishing MALP was of the primary reserve. 2 • Botswana 45

199. Within this enabling legislation, other sions of the Investment Committee. In addition, parties in the reserve management process are the the Financial Markets Department is responsible Board, Investment Committee, Financial Markets for monitoring external fund managers and other Department, and external fund managers. external relationships. The Department is structured as follows: Board Dealing and Strategy Unit 200. The Board is composed of members from 203. The Dealing and Strategy Unit is respon- the public and private sectors as well as academia. sible for research and analysis of various financial The Board is responsible for governance and ulti- and capital markets and for the compilation of the mately the investment results; it enunciates the mis- background paper for the Investment Committee. sion, goals, and policies, as well as designs the The Unit implements the decisions of the structure with appropriate accountability. Conse- Investment Committee by trading in bonds and quently, the Board sets the overall strategy for the foreign exchange. management of reserves by approving investment Risk Management Unit guidelines, size of portfolios, asset allocation, strategic benchmarks, and exposure limits. 204. The Risk Management Unit focuses on the risk associated with all the investment portfolios. The Unit coordinates the risk management process Investment Committee and advises on all aspects of risk, performance, and 201. The Investment Committee is responsible compliance with the investment guidelines for the for strategic decisions against the benchmarks as externally and internally managed portfolios. well as the rebalancing of the portfolios. In doing Open Market Operations Unit this, the Investment Committee receives and acts on the recommendations of in-house analysts, who 205. The Open Market Operations Unit is not maintain close contacts with the Bank’s counterpar- directly involved in the management of the foreign ties in major markets. The Investment Committee exchange reserves; it is complementary to that meets periodically about 12 times a year to discuss function. The Unit is responsible for the provision developments in the international financial and of foreign exchange to the Bank’s customers, deal- capital markets, based on background papers pre- ing in Bank of Botswana Certificates (BoBCs), and pared by the implementing Department. At the the management of daily liquidity in the domestic Investment Committee meetings, broad decisions money market. are made for the Bank-managed portfolios on cur- Settlement Unit rency composition and modified duration within each market. The decisions made by the Investment 206. The Settlement Unit’s primary responsi- Committee are subsequently implemented by the bility is to ensure that the Bank meets its obliga- Department responsible for reserve management. tions to pay and receive correct value for The Investment Committee is composed of the transactions as contracted with counterparties, and Governor as Chairman, Deputy Governor responsi- to execute foreign currency payments for the gov- ble for the Financial Markets Department, Director ernment and other customers. of that department, analysts for respective markets Verification Unit (including the Chief Dealer), and the Director of the Research Department. 207. The Verification Unit provides the necessary “checks and balances” to ensure that the Settlement Unit pays out and receives the correct Financial Markets Department amount of funds on due dates and at the right 202. The Financial Markets Department is places. In the event that any of these factors are responsible for the implementation of the deci- incorrect, the necessary steps are immediately taken 46 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT to restore the position, and this includes, in the namely, asset allocation, manager search, and per- main, communication with foreign counterparties formance measurement. and banks. The Verification Unit is also responsible for following up on issues raised by the Reconcilia- Transparency and accountability tion Unit of the Accounting Department. 211. The Bank of Botswana has recognized that accountability and transparency must be built into Fund managers the reserves management process. The Board has 208. A cardinal feature of the Bank’s opera- given decision rights and delegated authority to tional strategy for managing the reserves is the use the Governor, with the actions of the latter being of external fund managers. The Bank has had con- measurable in terms of performance against the tractual arrangements with overseas fund man- Board-issued benchmarks. The following are other agers since 1981. External management of reserves mechanisms that are built into the reserve man- provides an alternative or a fallback position in the agement process: absence of specific relevant skills in the Bank (e.g., equity management) and in case of a possible brain Investment guidelines drain of the Bank’s scarce manpower resources. 212. These are a strategic set of rules that Furthermore, the incremental benefits that accrue defines the means of achieving the Board’s invest- to the Bank in terms of the training provided by ment policy. They address issues such as currency the fund managers to Bank staff over the years have risk, equity risk, interest rate risk, credit risk, and made a positive impact. The fund managers also instruments and liquidity. provide the Bank with a means of performance comparison, given that both the fund managers and the Bank’s performance are measured against Procedures manuals common benchmarks. 213. The front, middle, and back office opera- 209. The Bank manages approximately 50 tions are guided by operations manuals, which are percent of the foreign exchange reserves inter- specific to respective functions. The responsibili- nally. The intention is for the Bank to eventually ties and functions are defined such that there is manage a higher proportion of the fixed income clear separation of duties between the front and portfolios internally in line with development of back office. The middle office acts as a policeman relevant skills. A small proportion of reserves to ensure the proper implementation of the writ- would be managed externally for the purpose of ten procedures. performance comparison. In pursuing this objective, the Bank would obviously have to be cog- nizant of local manpower constraints in reserve Auditing management. 214. The reserves management procedures and processes are subject to regular audits by both Specialist advisory support the internal and external auditors. 210. Since its establishment, the Department Regular reporting responsible for managing the reserves has bene- fited from the services of a number of advisors. At 215. Regular reports to the Board and Audit present, there is one advisor for the reserve man- Committee are produced outlining the reserves lev- agement function. Consistent with past practice, els, trends, and performance as measured against the advisor is also engaged in in-house training of the benchmarks. The reserves are also marked to citizen staff. Furthermore, the Bank has retained market with currency and market gains and/or the services of an offshore investment consulting losses disclosed to the Board and Audit Committee firm that advises the Bank in three main areas, as part of the financial statements. 2 • Botswana 47

Capacity to Assess and Manage Risk Board about the risk/reward profile at the aggregate portfolio level. Risk management 216. The objective of tranching the foreign Currency risk exchange reserves is to reflect the different roles of reserves in the Botswana economy. The Liquidity 221. The Bank follows conventional policies in Portfolio is maintained at the equivalent of nine establishing an appropriate currency mix. Eligible months of import cover and is invested in short- currencies must be convertible, relatively less sus- term money and bond market instruments. On the ceptible to frequent and sharp exchange rate fluc- other hand, the Pula Fund is invested in long-term tuations, generally free from restrictions on their instruments, such as long-term bonds and equities. use, and products of well-developed financial mar- The Liquidity Investment Tranche (LIT) serves to kets. Accordingly, the Bank has established a mini- insulate the Pula Fund from frequent drawdowns, mum credit rating of a country’s sovereign debt to which could undermine the latter’s investment be Aa2/AA for its currency to be eligible, except objectives. for the G-7 member countries, whose minimum 217. In determining the adequate level of the rating is Baa3/BBB-. Liquidity Portfolio, the Bank undertook a comprehensive analysis of factors that impact on the for- Currency benchmarks eign exchange reserves. Based on these factors, a framework for the determination of an appropri- 222. The underlying philosophy for currency ate level of liquid assets was derived. For each fac- exposure is that it is not appropriate to modify tor, an estimate of monthly import cover is used to currency weights in response to short-term arrive at a total of an equivalent of nine months of exchange rate fluctuations. The Bank mainly import cover. invests in the U.S. dollar, euro, pound sterling, 218. Risk is controlled at various levels of the and yen. The other eligible currencies are for pur- reserve management process by different entities poses of diversification. In determining the in accordance with the broad strategy of risk man- appropriate currency weights, the following agement, investment guidelines, and procedures approaches were considered: the SDR-based cur- manuals. rency allocation, relative size of the economy, relative use of the currency, market capitalization, equal weighting, and optimal currency allocation. Asset allocation The Bank has adopted a combination of the 219. This is a key decision in the investment pro- “SDR-based currency allocation,” the “optimal cess as it seeks to balance return with risk as well as currency allocation,” and a market capitalization recognize correlation of asset classes. With regard to approach. the Pula Fund, 40 percent of assets are allocated to 223. The TBT currency benchmark is equities and 60 percent to long-term fixed income constructed in such a way that it matches the assets. The appropriate asset classes for the Liquidity international trade flows affecting the domestic Portfolio are a combination of short-term income currency. and money market instruments. The underlying 224. The Pula Fund fixed income currency objective in asset allocation is to diversify across the benchmark replicates the SDR weights. The ratio- main asset classes and geographic regions in order nale for this choice is the neutral and unbiased to achieve a low correlation coefficient. character of the SDR currency basket as a repre- 220. Using the currently allowed asset classes, a sentation of world economic activity and SDR use portfolio optimization process is undertaken every as a reserve currency. The currency benchmark for three to four years to determine the Pula Fund LIT is SDR-based and the portfolio is invested in asset mix. This process is complemented by “what fixed income instruments with a shorter duration if” scenario analysis to assure the Management and (currently around 1.5 years). 48 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT

Interest rate risk tion allocated to each equity market is deter- 225. Modified duration is used to control inter- mined by MSCI country weights. Generally est rate risk. Overall interest rate risk is a function of accepted restrictions are detailed in the invest- three factors—the size of the portfolio, modified ment guidelines. duration, and the actual or expected change in bond yields. The Bank has adopted mainstream Risk management at portfolio level and market-based benchmarks to facilitate risk management and attribution of performance to 231. Once the portfolio is constructed, the various decision levels. Customized versions of the actual portfolio management brings a different JPMorgan and Salomon Smith-Barney Government level of risk, as the portfolios are allowed to deviate Bond Indices have been adopted for the Pula Fund from the neutral position in order to outperform and Liquidity Investment Tranche, respectively. the benchmark. The main risks incurred in portfo- 226. Liquidity and the safety of the funds are lio management are of three types—operational, paramount in the TBT. For this reason, no specific liquidity, and market risk. duration benchmark is specified other than a max- 232. The Bank manages operational risk by imum maturity period of four months. using generally accepted practices, including segregation of duties. The internal and external audit work add a level of oversight to the initial strong Credit risk emphasis on control risk self-assessment. Straight- 227. The Bank is exposed mainly to three kinds through-processing will be achieved shortly, thus of credit risk, that is, bank risk, sovereign/suprana- reducing manual intervention and its inherent risk. tional risk, and corporate risk. Additional risks relat- 233. The liquidity risk is addressed mainly by ing to the use of counterparties, fund managers, the layering17 of the portfolio into different and the global custodian are also addressed. The tranches that take into account the recognized Bank subscribes to Fitch/IBCA in order to monitor norm of three months of import cover as well bank risk and utilizes rating reports of Standard as the “Greenspan rule”—the importance of and Poor’s and Moody’s Investor Services to moni- taking into account capital flows in the whole tor sovereign/supranational and corporate risk. economy. 228. Credit risk is low for the TBT because of 234. Market risk includes currency risk, inter- the strict limit on counterparties’ credit ratings. In est rate risk, and credit risk. The currency risk is the Pula Fund, corporate risk is allowed but con- controlled in a more traditional way by defining strained to top-quality issuers and to a small por- ranges around the neutral positions. For example, tion of the portfolio. U.S. dollar exposure can be in the range of 35–55 percent of the portfolio—plus/minus 10 percent Fund management styles deviation from the benchmark. 235. The interest rate risk is monitored in a 229. A combination of active and passive fund similar way to the currency risk. A range of management styles is adopted for diversification plus/minus 1.5 years is allowed around the aggre- purposes. In addition, the award of a management gate portfolio duration. This currently translates contract takes into consideration the firm’s techni- into allowing duration to fluctuate between zero cal expertise with regard to global or regional man- and three years for the LIT portfolio. date. Fund management styles are also diversified, 236. As mentioned earlier, the fixed income for instance, U.S. equity value, growth, or broad benchmark is 100 percent government bonds. It is, market styles. nonetheless, allowed to hold spread products in

Global/regional equity mandates 17 230. Specialist fund managers are appointed First, the TBT is virtually all cash. Then LIT invests only in short-term bonds and money market instruments. Finally, the to manage various equity components. The por- Pula Fund is fully diversified. 2 • Botswana 49 the actively managed portfolios. The permitted risk 237. The Bank of Botswana is gradually evolv- taking is offset by the need to diversify by country, ing toward quantitative risk management method- industry, and issuer as well as a very high minimum ologies that will allow the portfolio risk to be credit rating. managed at an aggregate level. 3 Brazil

Governance and Institutional gic allocation and defining the investment policies. Framework Therefore, they have established a detailed benchmark and guidelines and opted for an active man- Reserve management objectives and agement of the reserves. The Vice Governor coordination responsible for the monetary policy—Dipom— 238. The objectives of reserves management are is responsible for the active management, as subordinated to Banco Central do Brasil’s monetary decided by the Board. The International Reserves and foreign exchange policies. Brazil has a floating Operations Department—Depin—executes the currency regime and interventions are infrequent necessary transactions to follow up the benchmark with no sizable changes in reserve holdings. and Dipom’s active strategies. Depin is also respon- 239. The main objectives in holding external sible for suggesting modifications in the bench- reserves are to: mark according to changes in long-term market conditions and/or other factors, and for providing • Support monetary policy. Dipom with market updates and strategy proposals. • Control excessive volatility of the foreign An Investment Policy Committee for active man- exchange market. agement meets monthly to analyze the market scenarios and to propose active strategies. • Guarantee payment of foreign exchange 242. The Investment Policy Committee was debt. created by a board decision, while the investment 240. Based on these objectives, reserves process was defined by a formal document signed are managed to ensure safety, liquidity, and by the Vice Governor of Monetary Policy. The fol- profitability. lowing officers participate at the meetings as voting members: Institutional framework and decision-making — Vice Governor responsible for Monetary structure Policy (retains veto power); — Head of International Reserves Department; 241. Banco Central do Brasil (BCB) is the sole authority empowered by the Constitution to man- — Deputy Head of International Reserves age Brazilian foreign exchange reserves. No other Department; government agency can hold foreign currencies. — Head of International Reserves Investment Regarding the allocation of roles, the BCB Board Division; of Governors is responsible for the reserves strate- — Head of Foreign Exchange Division;

50 3 • Brazil 51

— Interest Rate Portfolio Managers (1 joint ability in managing reserves and reporting results. vote); The main procedures taken to follow these objec- — Foreign Exchange Portfolio Manager; tives were: — Interest Rate Strategists (1 joint vote); and • Definition of a detailed and replicable — Foreign Exchange Strategist. benchmark with clear guidelines and unam- 243. Active management positions may be biguous sharing of responsibilities within taken at strategic and tactical levels. Strategic posi- Banco Central do Brasil’s hierarchy; tions have an investment horizon of 1 to 3 months • Public disclosure of reserve management and are subject to discussion and decision at the parameters and procedures; Investment Policy Committee. • Quarterly performance reports to the Board 244. Depin is organized in three distinct areas: of Governors; front office (trade desks), middle office (compliance, risk management, performance evaluation, • Hiring of an independent auditing firm; pricing, and IT), and back office (accounting and • Adherence to the IMF’s SDDS—Special Data settlement). Dissemination Standard. 245. In the middle office, a compliance area checks all guidelines defined by the Board on a 250. In terms of auditing, there are four sepa- daily basis and is responsible for standardizing pro- rate inspections, which are conducted by the cedure manuals. This area is also responsible for Internal Auditing Department of BCB (Deaud), an checking transaction prices against market prices external independent auditing firm, the Ministry in order to identify any kind of mismatching. A of Finance, and the Brazilian Court of Accounts new area was recently created to ensure correct (TCU). All these auditing inspections are periodic asset pricing and to verify data integrity and cor- and have the objective of verifying compliance pro- rectness by performing checks of other numerical cedures, accounting systems, IT systems, limits, variables such as VaR, returns, etc. controls, etc. 246. An Ethics Code, which outlines standards 251. Banco Central do Brasil’s training pro- for the conduct of civil servants, was implemented gram for the reserves management area is made in 2001. In addition to this, all civil servants must up basically of courses offered by the external present their annual income tax returns. managers18 and periodic visits to other central 247. The BCB Board of Governors defined that banks and premier commercial banks. In order to the investment strategy should match reserves with obtain qualified staff, the International Reserve sovereign external liabilities in terms of currency Operations Department of BCB—Depin—selects exposure. In this way, we have an integrated personnel from within the Bank, based on their Asset/Liability Management (ALM) in terms of market experience/skills and quantitative back- foreign exchange exposure. The main benefit of ground. In some cases, a deep knowledge of com- this strategy is to prevent a short-term loss of puter systems is required. To retain the staff, Banco reserves caused by a mismatch in currencies Central do Brasil has a defined professional career between reserves and short-term obligations. track and incentives for employees to pursue grad- 248. Improper tracking of external liabilities uate degrees in Brazil or abroad. However, there is and lack of a formal ALM long-term strategy may no specific wage/bonus incentive related to market cause inefficiencies. Efforts are being made in the operations or to performance. direction of unifying strategies and coordinating all sovereign external debt with reserves management.

18The External Asset Management Program was implemented Transparency and accountability in October of 2000 with two main objectives: to keep Depin’s team updated with the best investment practices available in 249. In recent years, Banco Central do Brasil the market and to be used as a reference for the performance has promoted increased transparency and account- evaluation of the internal active portfolio. 52 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT

252. Banco Central do Brasil has made huge 256. Banco Central do Brasil takes into account investments in system information resources updat- market, credit, liquidity, operational, and legal ing. In fact, technical areas have access to the most risks. In terms of market risk, the Board has defined sophisticated mathematical and statistical engines a VaR limit for the active management relative to available in the market. This policy has been very the benchmark, i.e., a differential VaR. This limit is important to allow financial model improvements calculated on a daily basis, using RiskMetrics’ and also to retain research-oriented employees. methodology with 95 percent confidence level and one-day time horizon. The VaR is back-tested and the results of the methodology adequacy are pre- Capacity to Assess and Manage Risk sented in the quarterly performance reports. The Board defined a VaR limit for the active manage- Risk management ment, and it is up to the Investment Policy 253. Banco Central do Brasil investment policy Committee to approve a risk budget among its sub- for foreign exchange reserves is based on three pil- portfolios, as suggested by portfolio strategists. The lars—the reference portfolio, investment guide- VaR limit can be considered small in the sense that lines, and performance measurement. The first returns come basically from the reference portfolio, one, also known as the benchmark, is replicable with active management giving a marginal result. and details unmistakably the included assets. This 257. Credit risk is managed using two distinct portfolio reflects the Board of Governors’ risk/ approaches for the money market portfolio. The return preferences for the international reserves. first one is for the portfolio as a whole. In this case, The second pillar is the list of guidelines that a proprietary model was developed based on define operational limits, allowed investment Creditmetrics and the Merton model. This model instruments, risk methodologies, and deviation uses expected and unexpected default probabili- limits for the active management. ties, and the Board stated limits for these two vari- 254. The third pillar is a quarterly perfor- ables. The main objective of this approach is to mance measurement report for the Board, which impose geographical and counterpart diversifica- states the results of passive (reference portfolio) tion, not to calculate VaR exposure. The second and active management. The Association for approach is transaction oriented, for which the Investment Management and Research (AIMR) Board has approved minimum counterpart ratings standards, when applicable, are followed for pre- (short-term and long-term), maximum volume, senting results of benchmark and active strategies and maturity exposure based on the counterpart policies. total assets and ratings. For the fixed income port- 255. The complexity of the benchmark frame- folio, BCB accepts only federal government, agen- work imposed the use of information technology cies, and supranationals issues restricted to tools. Considering the existence of appropriate minimum rating. In terms of liquidity risk, the human and IT resources for the development of a Board approved additional constraints related to software system, Depin opted for an in-house soft- the permitted range of investment instruments ware solution. The system includes several man- and maximum exposure in each asset. agement tools such as market risk (VaR), credit risk 258. Operational risk losses in reserves man- (expected and unexpected default), performance agement are tracked with the objective of getting evaluation, performance attribution, reference statistics about internal procedures and the rela- and active portfolio management, operational risk, tionship with counterparts. and compliance. Besides that, the system gives the 259. The BCB’s legal department analyzes and possibility of executing stress tests for active strate- approves contracts, and together with audit entities gies. These tests can be based on historical data or ensures that each transaction has the necessary stress scenarios defined by the user. Depin is now legal support. beginning to perform stress tests for the reserves as 260. Regarding external managers’ portfolios, a whole on a regular basis. the operational guidelines are basically the same as 3 • Brazil 53 the ones defined for the self-managed portfolio, Government Bond Index” is the reference for each except for the VaR limit. Since external managers respective currency. Minimizing the probability of are restricted to fixed income investments and do capital loss over a certain time horizon was one not have a money market tranche, they have a important aspect considered when choosing the larger VaR limit. Banco Central do Brasil receives 1–3 year index. The fixed income portfolio denom- daily transaction reports and monthly perfor- inated in Japanese yen is, in fact, allocated in the mance reports from the external managers and euro and U.S. dollar portfolios, with currency from the global custody agent and has periodic hedge to Japanese yen. portfolio reviews with the managers. 266. Six external asset managers manage a small part of the reserves, about 3 percent. They have the same benchmark as our fixed income Reference portfolio portfolio and similar guidelines. The main purpose 261. The reference portfolio, as approved by of the program is know-how transfer. the Board, is divided into three tranches: gold, 267. Market indexes were chosen as refer- emerging markets, and core reserves. The core ences because they represent the industry stan- reserves tranche represents the large majority of dard, are replicable, and contain sufficiently liquid the reserves, as the position in gold and emerging assets. In terms of performance, they make the markets debt is less than 3 percent of total comparison with other managers possible. reserves. This tranche is denominated in three Regarding maturity, the decision of using the 1–3 base currencies: the U.S. dollar, euro, and year index was made taking into account the risk/ Japanese yen and is divided between money mar- return trade-off, since it has a small probability of ket and fixed income portfolios. Allocation is 60 quarterly negative return. percent in the fixed income market and 40 per- 268. All portfolios, except money market, are cent in the money market. closed portfolios, that is, they have no inflows or 262. The gold portfolio is divided into two outflows, except for coupon and amortization pay- portfolios: one located in Brazil and the other ments. In a normal situation, the money market invested in short-term gold deposits in the interna- portfolio absorbs all changes in the size of the tional market. external reserves. Portfolios are rebalanced on an 263. The emerging markets portfolio is man- annual basis to maintain the proportion between aged using the “EMBI Brazil +” index as a reference. the fixed income and the money market portfolios Banco Central do Brasil is restricted to investing in and also the size of the emerging market portfolio. Brazilian sovereign external debt bonds. 269. Regarding the currency hedge, the core 264. The money market portfolio has four reserve replicates the currency distribution of the tranches. A small working capital tranche is fully short-term sovereign external debt up to the invested in U.S. dollar overnight deposits. It has amount of the core reserves. In order to imple- the purpose of controlling excessive volatility and ment this strategy, Banco Central do Brasil follows providing liquidity for a sustainable domestic for- up the external debt currency composition on a eign exchange regime eventually. The other three daily basis. However, to avoid excessive turnover, portfolios are for each one of our benchmark cur- the benchmark is rebalanced every time the exter- rencies (U.S. dollar, euro, and Japanese yen). The nal debt currency proportion differs by more than term of the deposits can go as long as 6 months, 2 percent from the reference portfolio. but the total duration of the money market portfolio is about 1 month. Eurodeposit is the reference Investment guidelines instrument and LIBID is used as the reference index. 270. Investment guidelines have been estab- 265. The fixed income portfolio is divided into lished for each aspect of risk management. To con- two subportfolios, one based in U.S. dollars and trol market risk, a daily VaR limit is in place for the other in euros. J.P. Morgan’s “1–3 years deviations from the benchmark. It is enforced for 54 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT the active strategies of the whole reserves. Intraday 274. There are other limits, such as: VaR calculation has not been implemented yet. • Permissible financial instruments; Banco Central do Brasil does not use automatic stop-loss techniques in monitoring market risk lim- • Breakdown of gold reserves in Brazil and its. In case of any breach of VaR limit, the abroad; Investment Policy Committee will meet to decide • Size of the gold portfolio; and whether the positions should be kept or not. If the decision is that it is in order to maintain the posi- • Size of the emerging market portfolio. tions, it must be submitted to the Board of 275. Options investments are not allowed, but Governors for approval. currency forwards and futures, interest rates and 271. In terms of liquidity and credit risk, there gold futures and swaps, commercial papers issued are different approaches to money market and by financial institutions, CDs, CPs, repos, and fixed income portfolios. For the money market reverse repos can be used. portfolio, the Board of Governors has established 276. Risk and compliance areas are indepen- the following investment guidelines: dent from the front office but not independent • Maximum expected and unexpected default from active management decisions in the hierar- probabilities for the actual portfolio devia- chical structure; we overcome this problem by tion from the benchmark; using a software function that automatically informs the Board of Governors of any breach of • Minimum rating limits of “A” and “P-1” for limit, at the same time that the compliance area each counterpart, according to Moody’s; receives the alarm. Afterward a confirmation is • Maximum allocation per counterpart calcu- delivered to guarantee that it was not a system or a lated as a percentage of the counterpart’s human failure. On the same day, the portfolio total assets, limited to a certain maximum managers have to explain the reasons for the amount per counterpart; and occurrence to the Board. • Three to six months’ maximum maturity depending on the institution’s rating. Information system 272. For the fixed income portfolio, the restrictions are: 277. Banco Central do Brasil uses a mainframe and a PC-based network system based on Windows • List of permissible countries for investment NT/2000. The software was entirely developed in- in terms of sovereign debt. All of them must house, except for database management software. have a minimum rating of “A” according to The mathematical and financial models were Moody’s. developed based on publicly available technical • Bonds issued by any country in a currency documentation, so there is no use of financial other than its own are submitted to addi- “turnkey systems.” The only inputs of the system tional restrictions in terms of rating; and are price data from data providers and transactions • Investments in “AAA” government-sponsored put into the system by traders. The software pro- agencies and in supranational debt are vides tools for: restricted to a maximum percentage of the • Risk management; fixed income portfolio. • Technical documentation; 273. There are also the following asset concentration limits: • Performance measurement (including performance attribution models); • Maximum percentage of the total outstanding amount of any issue; and • Simulations; • Maximum percentage of a single asset con- • Compliance (comprising automatic limit tribution to the total fixed income portfolio. controls); 3 • Brazil 55

• Back-office operations; • Natural resistance to changes in policy; • SWIFT communication; — Time to absorb new concepts and to understand the advantages that would • Accounting; and come from the new environment, like a • Trade desk support. clear performance evaluation procedure. From initial ideas to final development, 278. The software was developed considering the process took about five years. The operational and research purposes using both the main factors that contributed to this delay actual transactions database and the historical were international crises and changes of database to test new models. A large quantity of the Banco Central do Brasil executive documentation, such as BIS and IMF papers, direction. research papers in general, system technical documents, etc., is available online. The software was • Understanding the new roles in each part of also designed with audit in mind, having a full revi- the hierarchical structure; sions control, auditable numbering sequences, and — It took several months of meetings, dis- a back-up procedure. cussions, and presentations to explain the role of each part of the hierarchy to overcome this problem. Implementing a new approach in reserves management • Steep learning curve for the staff to understand risk management, performance, and 279. Reserves management in Banco Central performance attribution models; do Brasil has changed dramatically over the past five years. Before 2000, the head of Depin and the — Well-structured and intensive training trade desks could decide the overall profile of the program. The program is continuous and reserves, since guidelines established by the Board started back in 1996. were generic, with no specific rules for perfor- • Lack of an integrated computer platform; mance measurement and an unclear role of each — Acquisition of a new networked hardware player in the decision-making process. and basic software system (operational sys- 280. With the incidence of international finan- tems and other support software). cial scandals in the nineties, central banks in general became more aware of some risks that they • Modifications of the compliance system with were incurring and so, in 1997, Banco Central do the new guidelines; Brasil introduced market risk calculations of the — Adapt procedures to the new environ- reserves based on the VaR concept (US$). ment. However, there was no type of operational limit. In the following years, the importance of risk man- • Changes in accounting system related to the agement and a detailed benchmark to manage the new kind of instruments allowed; reserves became increasingly clearer to Banco — Adapt accounting system to the new Central do Brasil. Studies were made considering instruments. common market management procedures and, as • Authorization and support to develop a soft- a consequence, a proposal was developed for a new ware solution in-house; framework in the time span of about one year. — Develop a sound design environment and 281. In 2000, Banco Central do Brasil’s Board of full documentation of the proposal. Governors approved a benchmark with clear guidelines and performance measurement procedures. • Difficulties in getting consistent asset pricing 282. The main problems faced during the data, which is fundamental for the robust- design and the implementation of the new reserves ness of VaR calculations and performance management concept and their solutions were: measurement. 56 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT

— Creation of a new workgroup (area) to able. This approach allowed a modular-based check and guarantee asset pricing consis- development, i.e., each application module (e.g., tency and new data providers. market risk, credit risk, reference portfolio, performance attribution, etc.) was developed inde- 283. However, there were some aspects that pendently and connected to the system in a later were essential for the successful design and imple- phase. The kernel that was developed initially mentation of the new framework for reserves supported basic portfolio management and had management: the main software functions encapsulated in a • Human resources with deep knowledge of procedural environment. finance, mathematics, and computer science 285. The kernel and the modules of market and previous experience in developing and risk, credit risk, reference portfolios, and compli- managing software with large databases; ance were designed and developed in nine • Existence of an IT area in the International months, and another three-month period was Operations Department—Depin; necessary for tests. The operations began in July • Necessary infrastructure resources to imple- 2001. Afterward, other modules such as opera- ment the system, such as computers, commu- tional risk, documentation, and stress testing were nication lines, data sources, etc.; and included. 286. Improving the software system and the • Emphasis on training, including periodic vis- reserves management framework is an endless and its to premier financial institutions and other continuous task as market practice keeps evolving central banks. In this case, our external asset in time. management program was an invaluable 287. Nowadays, Depin is focusing on improv- tool. ing stress test procedures, performance attribution 284. The software architecture was structured models, operational risks statistics, and reference in independent modules and it is fully upgrad- portfolio. 4 Canada

Introduction • to provide general foreign-currency liquidity for the government; and 288. In Canada, foreign reserves are owned by • to provide funds to help promote orderly the government and managed by both the Bank of conditions in the Canadian dollar in the for- Canada and the Department of Finance. As of eign exchange market. December 31, 2001, Canada held about US$34 billion in total international reserves. Of that amount, 291. The management of reserves has changed about US$30 billion (89 percent of total reserves) over the past 25 years, reflecting developments in was held in liquid assets.19 financial markets. The government has increased 289. These liquid reserves are held in a special the level of foreign reserves in recent years to account called the Exchange Fund Account (EFA) reflect increased flows in foreign exchange markets under the Minister of Finance’s name at the Bank and to bring its level of reserves more in line with of Canada. The EFA is financed with foreign- other comparable sovereigns. This increase in turn currency-denominated liabilities issued by the has required the reserve managers to focus on Government of Canada. Liquid reserves and gold asset-liability and risk management, and on reduc- are actively managed by the Bank unlike other ing the cost-of-carry of these reserves while main- components of the reserves such as Special taining a high degree of liquidity and capital safety. Drawing Rights (SDRs) and the reserve position at 292. In order to meet these objectives, the liq- the IMF. This report will focus on the liquid assets uid reserves are subdivided: of the reserves. • A proportion of reserves is held in highly liquid U.S. dollar-denominated assets to fund Governance and Institutional immediate foreign currency liquidity requirements and intervention activity. Framework • The remainder is held in a diversified port- Reserve management objectives and scope folio of high-quality assets, denominated in 290. The objectives of reserve management U.S. dollars, euros, and yen. are: 293. Reserve management activities consist of the management of foreign currency assets and liabilities, which includes the use of derivative financial 19Liquid reserves consist of marketable securities and deposits denominated in U.S. dollars, euros, and yen. instruments. Reserve management follows a well-

57 58 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT coordinated Asset-Liability Management framework Transparency and accountability of reserve described later in the paper, while at the same time management and benchmarking focusing on cost-of-carry minimization. 298. Reporting in a regular and timely manner is a key element of Canada’s reserve management Institutional framework policy. The Minister of Finance provides an Annual Report20 to Parliament on the operations of the Legal foundation EFA for each calendar year within five months after 294. Canada’s reserve assets are governed by the expiration of that calendar year, and this report the Currency Act, which serves as the legal frame- is available publicly. The EFA Annual Report also work for EFA asset management and investment includes the result of annual audit of the EFA con- operations. The Minister of Finance approves poli- ducted by the Auditor General of Canada. In addi- cies for managing the EFA, mainly through a set of tion, periodic review by external third-party experts investment guidelines. The liabilities that fund the is undertaken, and the results of such reviews are EFA are governed by the Financial Administration shared with the government. Act. 299. The EFA’s current asset management benchmark, in the context of asset-liability management Internal governance detailed later in the paper, is the government’s foreign currency liabilities. The cost-of-carry is cur- 295. The responsibility for the management of rently used as a performance measure for the EFA, the EFA is jointly shared by the Department of and is disclosed in the EFA Annual Report. Finance and the Bank of Canada while the man- Additional benchmarking approaches are also cur- agement policies are set by the Minister of Finance. rently under study. The Bank of Canada, acting as a fiscal agent, 300. Internally, the RMU provides daily reports administers and effects transactions for the on the EFA risk position to trading staff, and Account on behalf of the Minister of Finance. monthly and quarterly reports to the RMC and the 296. The Director of the Financial Markets Bank’s senior management. Division at the Department of Finance and the 301. Since July 1999, Canada has reported its Chief of the Financial Markets Department at the disaggregated reserves position on a weekly basis.21 Bank of Canada are responsible for the ongoing This disclosure of reserve positions is achieved by management of the EFA. A Policy Committee, means of the Bank’s website on the first business day which is composed of senior officials from the following the 8th, 15th, and 23rd of each month. On Department of Finance and the Bank of Canada, the third business day following month-end, a more meets semiannually to review developments and comprehensive breakdown of Canada’s reserve posi- major policy initiatives, and provide guidance and tion is published by the Department of Finance. accountability on the management of the Account. 302. In addition, documentation of the chain of The Risk Management Committee (RMC), which authority, decision making, and delegation in consists of managers from the Department of reserve management has been made public Finance and the Bank of Canada, including two through Bank of Canada Review articles.22 members with no connection to the operations of the EFA, meets quarterly to advise on the manage- 20In addition, the Department of Finance publishes an annual ment of risk related to the government’s debt pro- Debt Management Report and Debt Management Strategy gram, including the foreign exchange reserves. Report, which provide an overview of foreign reserve manage- 297. The responsibilities for the day-to-day ment operations. 21Canada was one of the first countries to fully meet the portfolio management and strategy implementa- requirements of the IMF’s and G–10’s new format for presen- tion of the EFA rests with the staff of the Foreign tation of international reserves data. Reserves Management Team at the Bank. The Risk 22See De Leon, J., 2000–2001, “The Bank of Canada’s Management of Foreign Currency Reserves,” Bank of Canada Management Unit (RMU) at the Bank oversees Review; and Rochette, M., 2001–2002, “Risk Management in and manages the risks associated with the EFA. the Exchange Fund Account,” Bank of Canada Review. 4 • Canada 59

Establishing a Capacity to Assess and Over the long run, EFA assets and liabilities are Manage Risk expected to be held in approximately equal market values, thus keeping the account balanced. Assets Risk management match liabilities for the euro- and Japanese yen- 303. The goal of risk management is to balance denominated reserves. At present, U.S. dollar lia- risk and return. In 1997, the Bank and the bilities exceed U.S. dollar assets, largely due to Department of Finance jointly established an RMU foreign exchange intervention and commitments to oversee the risk position of the government of made to the IMF in 1998. This imbalance has been Canada. reduced through a program of U.S. dollar acquisition in foreign exchange markets, and the plan is to eliminate the mismatch over the next year. In Strategy for managing risks order to minimize the impact of any mismatches, 304. The EFA is exposed to various types of the “excess” U.S. dollar liabilities are concentrated risk, such as credit risk, market risk, liquidity risk, at the short end of the yield curve. operational risk, and legal risk. The government’s 308. In addition, two types of forward-looking risk management strategy is to recognize, measure, techniques, namely “stress test scenario analysis” and and manage each type of risk individually as well as “sensitivity stress testing,” are conducted. Stress test collectively. scenario analysis is based on a potential market 305. The RMU manages EFA risk in three event, such as a stock market crash. Sensitivity steps: stress testing is based on standardized moves in closely linked market risk factors, such as a parallel • Identifies, analyzes, evaluates, and models yield curve shift.23 These scenarios are explicitly the risks; defined and reported on a monthly basis. • Advises on guidelines to limit the risks; and • Ensures day-to-day adherence to the guide- Liquidity risk lines, while periodically proposing new risk 309. Various policies are implemented to limit control mechanisms. liquidity risks. These policies require that no more than 10 percent of any single issue be held in the Credit risk EFA, and that the issue size be a minimum of 306. To control credit risk, the RMU currently US$500 million. Furthermore, the securities of any uses an approach based on the BIS 1988 Basel one issuer cannot exceed 10 percent of EFA liquid Accord and subsequent amendments, whereby all assets, except for “home currency” bonds issued by exposures are risk-weighted according to entity AAA sovereigns and their directly guaranteed agen- type. In addition, the RMU has adopted the BIS cies. As well, no more than 15 percent of the EFA’s Accord “add on” approach to calculating potential liquid assets can be in investments that cannot be exposure on derivative transactions. Credit risk is sold or redeemed prior to maturity (i.e., non- managed through diversification of the EFA asset marketable securities and fixed-term deposits). portfolio, with appropriate use of credit ratings, 310. In addition, to limit rollover risk, EFA lia- counterparty limits, netting agreements, and col- bilities that mature within any 12-month period lateral support. cannot exceed one-third of EFA assets. Finally, other means of raising liquidity include a short- term U.S. dollar commercial paper program Market risk (Canada Bills) and holdings of highly liquid U.S. 307. To limit market risk, the government fol- dollar, euro, and yen securities. lows an asset-liability management framework whereby foreign reserves are managed so that 23Bank for International Settlements, 2001, A survey of stress assets match liabilities in currency and duration. tests and current practice at major financial institutions (April). 60 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT

Operational risk 315. The Currency Act allows the EFA to transact in foreign exchange on a spot and forward 311. To control operational risk, the RMU basis, and to invest in deposits of supranational uses a “bottom-up” method that is consistent with organizations and financial institutions, and in the concept of total quality management. It starts securities issued by sovereigns and their agencies. from examining the different aspects of opera- It also allows the EFA to lend any of the eligible tions performed by the organization and then instruments, and enter into derivative transactions maps the process. based on any of the eligible instruments. In addi- 312. Sound operational risk management also tion, the government is moving toward more requires qualified staff and adequate management extensive use of collateral in its reserve manage- information systems. In the case of the EFA, the ment operations to protect against current and RMU analyzes operational processes and estab- potential credit exposure. lishes controls that are regularly reviewed. Although the RMU is not directly involved in personnel management, the bank has a human Use of derivatives resources strategy to maintain a competitive com- 316. Among the eligible derivatives mentioned pensation structure with abundant training and earlier, the government of Canada has made exten- learning opportunities. It also offers various flexi- sive use of long-term interest rate and currency ble working hour agreements. The Bank is also swaps since 1984–85. The government uses these currently improving its operational processes and swap agreements to obtain cost-effective financing, implementing relevant technological applications to fund the foreign exchange reserves, and to per- such as a new integrated straight-through process- mit flexibility in managing liabilities. For example, ing system. cross-currency swaps are currently used to convert Canadian-dollar-denominated fixed-rate debt into Legal risk euro and U.S. dollar fixed-rate liabilities. In addition, short-term currency forwards and gold 313. The government’s Department of Justice options have been used by the EFA. has the responsibility of advising on legal risk, and the preparation of an annual legal risk report for the Risk Management Committee and senior man- External managers agement. The report identifies any potential legal 317. The government uses external securities risk issues with respect to existing documentation. lending managers to manage a securities lending program for a portion of its U.S. dollar-denomi- Currency composition and eligible nated securities. Formal agreements are signed investment instruments between Canada and the external managers. The external managers must follow the policies and 314. There are restrictions on the EFA’s cur- guidelines provided by the government. To man- rency composition and the types of eligible investment age the risks, there are restrictions as to the securi- instruments to control overall risk. The EFA’s eligi- ties allowed to be lent, the types of borrowers, ble currencies are the U.S. dollar, euro, and yen. eligible collateral, and investment of cash collat- The EFA portfolio must be composed of a mini- eral. The external managers are required to submit mum of 50 percent U.S. dollars with the rest allo- reports, on a monthly basis and upon request, cated in euros, and Japanese yen, according to the describing details of the loans and investments. funding and investment opportunities in each cur- Currently, there are two external managers. rency. This currency composition reflects the important role of the U.S. dollar as a reserve currency, and the fact that intervention in support of Recent trend with respect to reserve management the Canadian dollar has been historically under- 318. Consistent with best practices in risk man- taken through the U.S. dollar. agement in recent years, the government has been 4 • Canada 61 moving toward making more extensive use of col- Reserve Management Operations in lateral to reduce credit risk exposure in its foreign Deep and Liquid Markets reserve operations. 319. This year, the government has put in place 320. Canada’s reserve management operations a collateral management framework for the gov- are undertaken in the most efficient and liquid ernment’s derivative counterparties. Canada’s col- markets in the world, i.e., the U.S., Japanese, and lateral management system requires counterparties European markets. Foreign currency borrowing to put up collateral to the government when credit that finances the EFA’s reserves is also conducted exposure on swaps and forwards exceeds given lev- so as to maintain Canada’s reputation as a “suc- els. An external firm is being used to manage secu- cessful borrower” in international capital markets. rities posted as collateral to the government. In 321. Continued access to these capital markets 2002, the government will also be moving a large is facilitated by ensuring that Canada has the nec- proportion of its uncollateralized short-term U.S. essary legal documentation in place to allow dollar deposit investments to collateralized repur- reserve managers to raise funds in a variety of mar- chase agreements. kets and jurisdictions. 5 Chile

Developing a Sound Governance and foreign exchange interventions, on September 2, Institutional Framework 1999, the CBCh announced a free float of its currency. Reserve management objectives and 325. For the remaining balance of reserves not coordination directly devoted to meeting liquidity needs, the fol- 322. The mission of the Central Bank of Chile lowing factors are taken into account in determin- (CBCh) is to safeguard the stability of the local cur- ing the way they are managed: rency and the normal functioning of internal and • The CBCh’s foreign debt composition. The external payments. International reserves provide CBCh aims to replicate the currency compo- the CBCh with one of the policy instruments that it sition and duration of its debt. In this cate- has in order to attain its mission. Within the mon- gory, any debt denominated in local etary policy framework, based on inflation target- currency but linked to a foreign currency is ing and a floating exchange rate that it has also considered. embraced, the CBCh intervenes in the foreign • The currency composition of liabilities (pri- exchange market in exceptional and qualified cir- vate and public), in order to back the pay- cumstances. In addition, the Treasury and private ment of capital and interest of debt due banks are allowed to maintain foreign currency within twelve months. deposits at the central bank. 323. In this context, the basic goals of reserve • The currency composition of trade imbal- management are to maintain an appropriate level ances, in order to finance any trade deficits of liquidity in foreign currency and to protect the in the event that access to the international value and safety of investments. Subject to con- credit markets is limited. straints derived from the above goals, reserves are • Risks and financial considerations. managed to obtain maximum return. 324. For liquidity purposes, the CBCh holds a 326. In considering all of the above aspects, the Cash Portfolio in order to meet any intervention reserves of the CBCh, from an asset management needs and also to handle deposits and withdrawals perspective, can be defined as a multicurrency from foreign currency accounts held by the portfolio invested in products ranging from Government Treasury, other public institutions overnight deposits to bullet bonds with maturities (like Codelco and Banco Estado de Chile), and up to thirty years, issued by prime rated countries, private banks at the central bank. Regarding agencies, and financial institutions.

62 5 • Chile 63

327. A small percentage of the reserves are held approves the quarterly investment strategies with a under the management of external asset managers. medium- to long-term perspective, and monitors This program was started in 1996 as a way to have an tactical and strategic decisions made at lower levels additional and real benchmark for comparison and of the organization. to gain further knowledge of markets and instruments. The asset management program will proba- Management level bly be extended during 2003 to create an externally managed portfolio of mortgage-backed securities. 334. The Investment Manager reviews the 328. The CBCh manages its international strategies designed by the front desk and proposes, reserves and foreign exchange rate policy, and to the Director of the International Division, the does not take responsibility for the management of optimal way to implement them. Additionally, the other public funds. Other public institutions are Investment Manager and the front desk may able, nevertheless, to establish time deposits with develop and implement tactics that could deviate the CBCh and to maintain current accounts with from the original plan and/or the benchmark, in the Bank as previously mentioned. No special coor- order to extract value with short-term views on mar- dination efforts between the CBCh and such pub- ket developments. lic institutions are needed to service said accounts. In fact they are treated as normal liabilities of the Operational level CBCh, just as the ones held by commercial banks. 335. The International Money Desk Depart- ment (the front desk): Here the Head of the Institutional framework Money Desk and Portfolio Managers design the 329. The Constitutional Organic Act of The quarterly investment strategies and implement the Central Bank of Chile, Law No. 18,840 of October decisions approved at the upper levels of the orga- 10, 1989, establishes that the Central Bank of Chile nization. Using financial tools and techniques, they is an autonomous entity, in terms of the decisions decide the timing and the security selection in it makes and in terms of the ownership of its capi- order to achieve the strategic and, at times, tactical tal. The Law establishes explicitly its ability to man- allocations. age, hold, and dispose of its international reserves. 336. International Treasury Department (the 330. At the central bank, there is a clear setup back office): The Treasury Department completes and separation of responsibilities, which is and processes the transactions made by the portfo- reflected in the organizational chart attached in lio managers. This department interacts with the Annex I. internal accounting systems and sends confirma- 331. The decision-making process at different tion messages to all the parties involved. It should levels of the organization is also clearly defined. be noted that no single transaction can be completed without the authorized signatures of both a portfolio manager and a senior member of the Board level Treasury Department. This department, among 332. The CBCh’s Board defines the main other things, also ensures that the Front Desk’s reserve management objectives and approves the operations comply with internal investment guide- investment parameters articulated in the invest- lines. This task is carried out by the Operation and ment policy guidelines of the central bank. Control Unit of the department. 337. Performance and Risk Measurement Department (middle office): This department Division level reports directly to the Director of the International 333. Acting on behalf of the CBCh’s Board, and Division. The middle office calculates risk parame- under a scheme of delegated responsibilities, the ters and measures the performance of the portfolio Director of the International Division reviews and in absolute terms and relative to the benchmark. 64 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT

Transparency and accountability trolled by a clear separation of functions, responsi- 338. The Law clearly states the CBCh’s man- bilities, and internal controls. date, powers, and accountability. At least three 341. The central bank also fully discloses times a year, the CBCh’s Board meets with the reserve management goals and counterparty trans- Finance Committee of the Senate, and once a year action rules to market participants. The selection with the plenary of the Senate, to present the state criteria, for both the countries and the counter- and prospects of the economy and the actions parties, are objective: taken by the CBCh to achieve its main objectives. It • Country Criteria: Long-term credit risk rat- also prepares audited annual reports, which are ing, debt level of the country, and the relative available to the public. size of the country measured by its Gross 339. The CBCh releases periodic disclosures of Domestic Product. the reserves’ accounting value on a biweekly basis. • Commercial Banks: Long-term credit risk rat- It also adheres to the Special Data Dissemination ing and size of the institution measured by its Standard of the IMF. Therefore on a monthly basis equity. (with a time lag), the central bank reports the level of international reserves and foreign currency liq- • Counterparties: Primary dealers and broker- uidity, and discloses the end-of-year value of the age houses that have their own credit rating reserves in its annual report. In the annual report, within the ranges required by the central an accounting measure of the absolute return of bank, or those that are at least 90 percent the investments is presented and measured in local owned by approved commercial banks. currency terms. There is also analysis of the composition of returns, i.e., those derived from interest Internal reporting and capital gains and those attributed to variations in the value of the local currency vis-à-vis foreign 342. There are different levels of reporting at currencies. the CBCh: 340. The information disclosed about reserve • On a monthly basis, the International Division management, such as internal governance proce- reports to the Board the absolute and relative dures and specific investment policies, is regularly performance of the internally and externally under review. In the 2001 Annual Report, new para- managed portfolios compared to their bench- graphs were added that describe the way the CBCh mark. These reports also contain different risk achieves the liquidity goal of reserve management. measurements, such as duration and Value- These paragraphs list the types of financial instru- at-Risk. ments in which reserves are invested and the composition of reserves at year-end (showing the • On a semiannual basis, the International percentage of reserves allocated to two broad cate- Division reports to the Board the list of gories: bank (time deposits) and fixed income issuers and counterparties used in the man- instruments). In the same section of the Report, agement of reserves during the reporting there is also a discussion of how the CBCh controls period. credit, market, and operational risks and protects • Annually, the International Division reviews the value and safety of the investments. In order to the soundness of the current benchmark, and control credit risk, minimum credit ratings for coun- proposes changes if deemed appropriate. tries and counterparties are specified. Market risk is managed by diversifying the portfolio of investments • The Front Desk and the Investment Manager among different currencies, instruments, and terms report their operations to the Division to maturity. Market risk is also measured and con- Manager in a weekly meeting. This meeting trolled by calculating the duration and Value-at-Risk is also used to report credit risk news that (VaR) of the reserves (the year-end duration and may affect margins and eligibility of either VaR are presented), and operational risks are con- countries and/or counterparties (reported 5 • Chile 65

by the middle office) and to decide on spe- margins. This unit is also responsible for monitor- cific issues related to the implementation of ing external asset managers, the securities lending the investment strategies. For example, there programs, and custodian services. may be a decision to change the timing for a certain investment allocation, or if there are new market developments, there may be a Establishing a Capacity to Assess and decision to make a tactical deviation from the Manage Risk original plan and/or benchmark. Policy guidelines 345. Risk management forms an integral part Auditing of the CBCh’s broad policy guidelines for investments. For instance, one of the main objectives of 343. Different agents constantly audit the man- the policy guidelines is to first define the playing agement of the reserves: field for the investment decisions. The central • On an annual basis, there is an audit by an bank’s Board defines these guidelines and then established independent auditing company, delegates the responsibility for implementing them whose observations are included in the cen- to the International Division. These guidelines tral bank’s annual report. implicitly incorporate the main objectives of the reserve management and therefore represent the • Internal independent auditors, who do not investment philosophy of the fund. This overriding report to the Director of the International philosophy takes form in the ranges and limits Division, conduct internal audits at least imposed on different types of investments. three times a year. The audit process covers 346. The policy guidelines can be categorized all aspects of reserve management, from into the following groups: compliance with the guidelines to broad recommendations about different aspects of the Foreign currency exposure/composition investment process and operations, such as the auditing of the securities lending pro- 347. There are guidelines governing which for- grams, the physical security inside the deal- eign currencies can be held, their amounts ing room and the treasury department, etc. (expressed as a percent of the total portfolio), and margins of deviation from these amounts. The cri- • Independent internal auditors, who report teria for choosing the currency composition, which directly to the central bank’s Board, also con- was previously presented, takes into account the tinuously monitor compliance with invest- hedging needs for covering the liabilities of the ment guidelines and the nature of accounting CBCh, the country’s trade deficit, any short-term profits and losses. This monitoring process is external debt servicing needs, and financial con- done on a remote basis through the use of the siderations derived from the use of financial opti- central bank’s accounting system, which is mization models. The reserve portfolio has four managed by a separate group, the Manage- main currency blocs (U.S. dollar, euro, pound ster- ment and Development Division. ling, and Japanese yen) and minor currencies, sub- 344. The Operation and Control Unit is part of ject to additional holding restrictions, i.e., the Treasury Department and reports to the Head exposure limits, which are associated with the main of the Department and to the Investment Manager. currencies. The process of association of the minor This unit is responsible for checking the portfolio currencies to the main ones rests on the correla- managers’ daily compliance with investment guide- tion of the historical returns. lines. These checks look for compliance on standard procedures related to financial transactions Credit exposure (such as ensuring that the obtained prices were in 348. We define three main sources of credit line with market levels), issuers, counterparts, and exposure: 66 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT

Bank risk • The Cash Management or Liquidity Portfolio: It consists of overnight and weekend deposits, 349. Bank exposure, which takes the form of and is the preferred source of liquidity to face time deposits, current accounts, certificates of daily demand stemming from withdrawals deposit, and foreign exchange operations, is man- from accounts held by public and/or com- aged in two ways: mercial banks. The liquidity portfolio can • The maximum authorized amount of global receive/transfer funds from and to a second bank risk is limited to a specific percentage of portfolio (short-term investment portfolio) total reserve assets. when its balance is too low or too high. • There are also limits on the time to maturity • The Short-Term Investment Portfolio (Buffer and amount of investment exposure the Portfolio): Acting as a buffer for liquidity pur- Bank can have with any single banking insti- poses, this portfolio may receive/transfer tution. To meet the criteria for counterparty funds from and to the liquidity portfolio. It is eligibility, banks also must comply with mini- invested in bank deposits and money market mum size requirements (measured by their instruments, ranging from a week to twelve- equity) and have a certain long-term debt month maturity. credit rating. • The Long-Term Investment Portfolio: Sovereign and supranational Invested in medium- to long-term instruments, including nominal bullet bonds and 350. As previously mentioned, the country risk inflation-protected securities (U.S. TIPs) eligibility depends on the relative size of the coun- with maturities ranging from one year to try, the level of public debt, and its long-term debt thirty years. Transfers of funds from the credit rating. Individual maximum exposures are long-term portfolio to the short-term one assigned to each country. The supranational expo- (and vice versa) are mainly due to financial sure is subject to a global maximum limit, while the considerations, although at times it has to individual amounts depend on the credit rating of absorb excess liquidity or meet liquidity each agency and its size measured by its equity. shortages. Counterparty risk 353. In general, the strategic investments in 351. The eligibility of counterparties is also and between short- and long-term portfolios are subject to objective parameters. Primary dealers, as subject to an investment review, which is done at well as brokerage houses with approved credit rat- least on a quarterly basis. The resulting investment ings and 90 percent owned subsidiaries of eligible strategy is based on external forecasts and our banking institutions, are eligible to be the central expectations of future domestic and foreign finan- bank’s counterparties. cial market developments. The general macroeconomic scenario is provided by the International Analysis Department while the International Definition of sub-portfolios Money Desk (front desk) forecasts future yield 352. According to the degree of immediacy curves and rates of return (the financial scenario). that the funds may be needed, i.e., depending on These scenarios and expected values are presented how transitory or permanent the funds are,24 we and discussed at meetings chaired by the Director have defined three sub-portfolios: of the International Division and attended by senior staff of the area, in order to achieve a con- sensus view at the Division level. 24Johnson-Calari, Jennifer, “Risk Management Practices at the 354. The expected rates of returns for three- World Bank: Global Liquidity Portfolios,” Risk Management for and twelve-month horizons are fed into an opti- Central Bankers (London: Central Banking Publications), defines the liquidity requirements as stable, discretional, and mization model; the results are analyzed and then operational. adjusted according to the market experience of 5 • Chile 67 our officials. That is particularly the case when term portfolios, as well as for the overall portfolio using standard, although imperfect, mathematical (excluding the liquidity portfolio), there are dura- models that do not take into account the costs of tion benchmarks and predefined margins of devia- adjustments, and may recommend allocations that tion from these benchmarks. On an ex ante basis are too aggressive or too concentrated in a limited and as unofficial calculations, the portfolio man- number of assets. agers calculate the duration, VaR, and tracking 355. The composition of the benchmark for errors associated with the strategy for the invest- comparison purposes comes from the output of a ment of the reserves. All day-to-day operations and historical standard mean-variance optimization reports of the front and back office are prepared model, which is subject to a number of ad hoc con- using internally developed systems that are able to straints reflecting the risk-return profile of the cen- interact with the general accounting system of the tral bank. For example, there is a constraint central bank and with the SWIFT system for inter- limiting the percentage of assets allocated to matu- national messages. From the moment a portfolio rities greater than three years. This constraint is manager closes a trade, approximately 90 percent designed to limit the duration or the market sensi- of the steps needed to complete the transaction are tivity of the overall portfolio, thereby preserving automated. There are still some activities that can the capital of the fund. be automated. For example, the manual entering 356. The reserve benchmark is a tailor-made of each transaction by back office personnel could combination of internationally known indices. For be replaced by an automated system, where the example, we use BIS’s six-month Fix Bis index for portfolio managers directly enter trades into the the short-term portfolio associated with the short- system. This system upgrade would save time and term sovereign and supranational investments, a lower the risk of clerical mistakes. The financial cal- Libid index for the banking investments, and sec- culations are done using mainly Bloomberg and tor indices of the JPMorgan Chase global index for RiskMetrics. the bond portfolios. There is a similar index for each main currency of the portfolio. Financial risks (Ex post measurement) 357. As mentioned, investment and allocation strategies for the portfolio are reviewed at least on a 360. The official calculation of different port- quarterly basis, but sudden market moves can make folios’ durations is the responsibility of the middle the portfolio managers take a position that goes in a office. This calculation is presented to the invest- different direction than the one recommended by ment officials twice a month, at the time of the the current strategy. These actions are previously weekly meetings chaired by the Division Manager. approved by the Investment Manager and commu- As a recent development, the middle office is also nicated to the Director of the Division. By how much calculating the VaR (absolute and relative) of the can portfolio managers deviate, and what is the net portfolio, which is analyzed every week at the effect of those particular actions are issues that the weekly meetings. An internally developed system is Division is currently addressing. The Division is also used for the calculation of the duration of the port- making efforts to better identify the attribution and folio, and RiskMetrics is used to compute the VaR composition of returns of the overall portfolio. parameter.

Risk management framework Credit risk 358. Risk management is approached in four 361. The middle office is responsible for mon- different ways or instances: itoring this type of risk. This unit monitors changes in credit ratings and names due to the ever-evolv- Financial risks (Ex ante measurement) ing processes of mergers and acquisitions of banks. 359. The primary indicator of financial risk is According to the changes, the list of approved the portfolio’s duration. For the short- and long- banking institutions varies, incorporating new 68 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT names, taking out others, and changing the maxi- Range of products mum individual amounts and maturity of invest- 365. In an effort to increase the returns on ments with each bank. reserves, the CBCh is about to expand the range of products eligible for investment. This project Operational risks specifically is considering the incorporation of U.S. 362. The Operation and Control Unit, which is Agencies (GSEs), German Pfandbriefs, and mort- part of the International Treasury Department, gage-backed securities. monitors operational risk by checking compliance with the guidelines, in terms of exposure to institu- Securities lending tions, approved names and locations of subsidiaries, margins, and internal operational 366. Yield-enhancing activities such as a U.S. procedures established for financial transactions. dollar securities lending program have been in The control conducted by this unit is mainly man- place since July 20, 1998. The program was subse- ual and done on a spot check basis over a random quently extended to euro-denominated notes and sample of operations. Because no software system bonds on May 10, 2000, to the portfolios held by has been developed yet and because these activities the external asset managers on April 9, 2001, and also apply to the external asset managers, there is a to the portfolio of assets held in pounds sterling on considerable workload in regard to the manage- October 26, 2001. ment of operational risk, and a related need for automated processes. External consulting 367. Another interesting initiative that we Performance evaluation recently began was to rely on external consultants 363. The official performance calculation for advice and recommendations to the entire done for internal purposes is the responsibility of investment area. This is a requirement of the the middle office. It issues a monthly report with a CBCh’s Board, and so far, two external consultan- time lag that contains the accounting and marked- cies have been used in the last four years. They to-market returns of the investment portfolios have been helpful in ensuring soundness of actual managed internally and externally. An extensive procedures within the area and identifying areas effort has been made to reduce the time lag where improvements could be made. The creation between the reporting date and the month that is of the Operation and Control Unit in 1999 is one being reported. The performance report includes of the results of these external consultancies, as the monthly return and rolling twelve-month well as some of the current observations to our returns for all the portfolios and managers (inter- area that are actually included in this document. nal and external asset managers), and ranks man- The external consultants were senior staff mem- agers by their performance. There is also a bers of prestigious institutions in the reserve man- discussion of other topics, such as the duration of agement arena. Through these exchanges the the portfolio, VaR, and financial developments investment area has the opportunity to learn from during the reporting period. the experience of more developed operations, and from central bank partners (or supranational institutions) that do not view consulting as a business, Recent developments but rather as a collaborative effort aimed at devel- 364. In this section we highlight the most rele- oping institutions with similar goals and levels of vant developments and actions taken by the area: capacity. 5 • Chile 69

Annex I: Organizational Chart: Central Bank of Chile and the International Division Area

Board of Governors

General Management

General Counsel Research Division International Management and Financial Policy Division Development Division Division

International Financial General Auditing International Investment Foreign Trade and Operations and Management Management Commercial Policy Analysis Management Management

Performance and Risk International Money International Treasury Measurement Department Desk Department Department

Head of Department + Head of Department + Head of Department + Back Office Operation and Control 5 Analysts 6 Portfolio Managers 8 Analysts 4 Analysts 6 Colombia

Introduction 370. There are three reasons for holding reserves: (i) for transactional purposes, to support 368. In 1997 the Banco de la República (BR), trade in an open economy; (ii) for precautionary Colombia’s central bank, developed a long-term motives, associated with potential balance of pay- strategic project designed to manage the interna- ments crises; and (iii) as collateral, to improve a tional foreign exchange reserves of the country in country’s access to the international capital mar- the most efficient manner, given the stated objec- kets via maintaining sound foreign exchange liq- tives for holding reserves in line with the highest uidity policies. The first two motives have international standards and practices. This ambi- traditionally had strong theoretical support, tious project, which is reviewed periodically, has led whereas the last motive has been referred to in the to significant changes in the organizational struc- literature only recently. ture, the decision-making process, the human 371. Before the 1990s, the main objective of resource policy, the technological platform, the reserves was the transactional motive, for which risk control procedures, as well as the reserve man- reserve adequacy was set in terms of the months of agement policies. imports required to support its trade-related operations. The reserve adequacy objective also took into account the fact that the country was under a Governance and Institutional crawling peg foreign exchange system and had a Framework low exposure to capital outflows due to restrictive Reserve management objectives, scope, and regulation. During recent years, the BR has coordination reviewed its reserve adequacy objective in light of the following: (i) the deregulation that has taken Objectives place during the last decade; (ii) empirical evi- 369. Reserve management seeks to maintain dence of the growing impact of contagion in devel- an adequate level of assets denominated in con- oping nations; and (iii) a review of the relative vertible foreign currencies readily available to meet importance of sound liquidity policies in the coun- a defined range of objectives for holding reserves try’s overall creditworthiness. in the most efficient manner. In order to under- 372. On the domestic front, three main devel- stand reserve management policy in the case of the opments had an important impact on the reserve BR, it is important to first identify its objectives for adequacy objective. In 1991, Congress approved holding reserves. Law 09, by which the foreign exchange market was

70 6 • Colombia 71 deregulated in order to encourage foreign direct to run current account deficits.27 The inclusion in investment and facilitate trade-related operations. the reserve adequacy objective of real exchange In the same year, the crawling peg was gradually rate misalignments is under study. replaced by a currency band system, and in 1999, a free float exchange regime was introduced.25 Implications on reserve management Finally, the traditional sources of funding for public debt in the international markets via syndicated 376. The changes that took place in the deter- loans were replaced by the issuance of bonds in the mination of the reserve adequacy objective of the international capital markets, and the private sec- BR had three important implications on reserve tor’s exposure to external indebtedness increased. management policy. 373. During the same time period, the 377. The amount of reserves invested to cover Mexican, Asian, and Russian/LTCM crises high- immediate liquidity requirements in a Working lighted the vulnerability of developing countries to Capital liquidity bucket was significantly lowered contagion. Based on empirical evidence of the from almost 90 percent of total reserves before impact of such crises in developing nations with 1994 to 5 percent, given that under a free float sufficient but limited access to the international exchange rate regime the probability of recurrent capital markets, Bussiere and Mulder (1999) con- intervention decreased. cluded that countries that maintained during this 378. In order to lower the opportunity cost of period a ratio of at least 1 in the reserves/short- maintaining reserves for precautionary and collat- term debt indicator were less vulnerable to conta- eral purposes, two additional liquidity buckets were gion, even in conditions of slight misalignments in defined with investment guidelines that are consis- their current account and real exchange rates.26 tent with their expected investment horizon. These For larger misalignments in these variables, the were the Intermediate Liquidity bucket to cover authors recommended a higher reserve adequacy potential intervention requirements over a one- objective. year period and the Stable Liquidity bucket for 374. Furthermore, the motive for holding such funds with the lowest probability of being reserves as collateral is emphasized by the fact that used over a one-year period. the international capital markets use the Bussiere 379. As the higher return objectives for the and Mulder indicator as a yardstick to measure new liquidity buckets implied additional risks, the appropriate liquidity levels, an important variable central bank committed resources for the enhance- in the country risk models that determine a coun- ment of its risk control capabilities and delegated try’s creditworthiness and the cost of its access to the management of the Stable Liquidity bucket to international capital markets. specialized asset managers. 375. As a result of this evaluation, the central 380. A more detailed description of the criteria bank adopted as the minimum reserve adequacy used by the BR to determine the size of each liq- objective the expected value of one year’s public uidity bucket, its liquidity policies, its investment and private residual debt payments and amortiza- guidelines, and its risk management capabilities is tions due, plus a provision for current account provided later in this chapter. deficits that can range from zero to the standard deviation of the long-term component of the cur- Scope rent account, given that the country has a tendency 381. The scope of reserve management is limited to those assets denominated in convertible cur- 25In 1991, the central bank defined target zones within which the market determined the exchange rate, at first through the rencies that are readily available and are under the issuance of exchange certificates until 1994. 26Bussiere, Matthieu, and Christian Mulder, 1999, “External Vulnerability in Emerging Market Economies: How High 27The Economic Research Department, using the Hodrick- Liquidity Can Offset Weak Fundamentals and the Effects of Prescott methodology, estimated long-term component of the Contagion,” IMF Working Paper 99/88. current account and volatility. 72 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT control of the central bank to meet its objectives, bank Board of Governors in order to ensure the including claims in the derivatives market used to sustainability of fiscal policy and the maintenance hedge currency and interest rate exposures. The of adequate liquidity levels. BR also manages the liabilities it acquires for the sole purpose of supporting the liquidity of reserves. Transparency and accountability However, it does not manage the liabilities of the central government, which are under the control of 386. The BR’s mandate that supports its man- the Ministry of Finance (MOF). agement of the country’s foreign exchange reserves is defined in the political constitution of Colombia and in Law 31 of 1992. Coordination and strategy 387. Chapter 6, Article 371, of the political 382. The key elements that influence current constitution of Colombia determines that the cen- reserve management policy are the country’s tran- tral bank “...will be organized as a public legal body sition to a free float exchange system, character- with administrative, patrimonial and technical ized by a rapid process of deregulation in its autonomy, subject to its own legal regime.” Among exchange/capital controls, and its increasing the functions that the Constitution assigns to the dependency on the international capital markets central bank is the administration of the foreign for financing. The maintenance of a high level of exchange reserves and the requirement that it foreign exchange reserves in order to reduce the should inform Congress periodically on the per- impact on the country of contagion is also deemed formance of its different responsibilities, including to be a very important element in setting reserve reserve management. management policy. 388. Law 31 of 1992 Chapter IV further elabo- 383. The BR does not use the purchase or sale rates on the mandate the central bank has in the of reserve assets against domestic currency as an management of the foreign exchange reserves in instrument of monetary policy. It determines the the following way: “The Board of Directors of value of reserves in accordance with the desired Banco de la República will administer the foreign reserve adequacy level, for which monetary effects exchange reserves in conformity with public inter- that are derived from changes in the level of est, to benefit the national economy and with the reserves are sterilized, if necessary through open objective of facilitating the external payments of market operations, in order to keep the monetary the country. Its administration involves the man- base within the ranges defined by the BR’s Board agement, investment, custody and disposition of of Governors. reserve assets. Reserve assets will be invested sub- 384. On exchange rate policy, the central bank ject to criteria of security, liquidity and return in is committed not to influence the exchange rate, assets denominated in freely convertible currencies unless it is to maintain an orderly market in extreme or gold.” Furthermore, the Law permits the BR to volatility conditions for which it auctions volatility set up capital subscriptions with international mul- options to the market whenever the exchange rate is tilateral institutions, so long as such subscriptions above or below 4 percent of its 20-day moving aver- can also be considered reserve assets; it cannot age. The BR at its discretion may also tender options grant loans on account of the international to accumulate or sell reserves to adjust its reserve reserves; it is allowed to open margin accounts to adequacy objectives. Any changes in the policy of enable it to execute operations in the derivatives intervention trigger a review of the central bank’s markets for hedging purposes; and it allows it to liquidity and investment policies. contract credits to support the balance of payments 385. On the fiscal front, there is no clear link as long as the product does not affect the monetary between reserve management and debt manage- base. The law establishes the immunity of the for- ment as each pursues different investment objec- eign exchange reserves against seizure. tives. Nevertheless, at a macro level there is a close 389. Insofar as the IMF Code of Good Practices coordination between the MOF and the central on Transparency in Monetary and Financial 6 • Colombia 73

Policies section 2.1 refers to operations of the cen- ties and includes a summary of the level, composi- tral bank in the domestic markets, the BR has tion, investment criteria, and performance on defined rules and procedures for the implementa- reserve management during the previous period. tion of its monetary and exchange rate policy. These rules and procedures clearly define the con- Auditing ditions, obligations, and rights a counterparty should meet in order to participate in open market 393. The political constitution of Colombia and foreign exchange operations with the central establishes that the President of the Republic exer- bank. The rules and procedures are publicly dis- cises the control of the central bank. Law 31 of closed in regulation that is easily accessible to the 1992 establishes that the President delegates the public, for example, at the BR’s website. function of control of the central bank to an exter- 390. For the management of the foreign nal auditor, appointed by him, for the purpose of exchange reserves, in which the BR does not act as “certifying the Bank’s financial statements, comply a market maker, it selects its trading counterparties with the functions that the code of Commerce of through internal formal processes of selection Colombia assigns to the agent responsible for fiscal where the relevant criteria are established at the supervision, and exercise the control over the activ- highest levels of decision-making hierarchy depend- ities and performance of the entity,” including its ing on the type of service required, restricted to management of the foreign exchange reserves. As counterparties that are members of well-established such, the auditing process has an autonomous bud- trading associations such as the Bond Market get from any other department within the BR and Association (BMA), the International Securities is conducted by an auditor who is independent of Market Association (ISMA), or the Commodities the central bank. Futures Trading Commission (CFTC). In certain 394. The auditor’s notes on the central bank’s cases, standard legal contracts are entered into with financial statements, which constitute the end counterparties to strengthen the procedures of result of its functions, include commentaries on the trading in addition to market practices established management and performance of the international by the relevant trading association. reserves that are publicly available at the Bank’s 391. The BR is fully compliant with the Special website and widely disseminated through national Data Dissemination Standard (SDDS), and its asso- newspapers. The auditor certifies that the account- ciated data template on international reserves and ing of reserve assets is conducted in conformity foreign currency liquidity position, which is pub- with accounting principles determined by the lished according to specified schedules. Additional Superintendency of Banks of Colombia and pre- information on foreign exchange reserves is dis- sents quarterly evaluations on the different aspects closed to the public on a preannounced schedule of the management of the foreign exchange through the central bank’s website as follows: reserves to the President, the Superintendency of Banks, and the Board of Governors. • Position and foreign exchange liquidity on a 395. This year, apart from the external audi- weekly basis. tor appointed by the President of Colombia, the • Monthly and quarterly audited accounting BR engaged the services of an international audit- balances are delivered to the Superintendency ing firm, Deloitte & Touche, to audit its financial of Banks and the General Public Accounting statements. Office of Colombia. At the beginning of every year, the annual balance sheet as of December Accounting 31 of the previous year is published in a widely distributed national financial newspaper. 396. The accounting procedures for reserve management follow the guidelines set by the 392. The semiannual report to the Congress Financial Accounting Standards Board (FASB), provides an overview of the Central Bank’s activi- insofar that they are not in conflict with the 74 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT

Figure 5. Organizational Structure

Board of Directors Reserves Committee (Board of Directors, General Manager) Audit Department

General Manager

Technical Manager

Internal Reserves Committee Executive Manager (Technical Manager, VP of International and Monetary Affairs)

Vice President of International Vice President of Vice President of and Monetary Affairs Internal Control Banking operations

Director of the International Director of the Director of the Reserves Department Operational Department International Department

Front Research Middle Confirmation Payments Accounting Conciliations Office Unit Office

accounting regulations of the Superintendency of affect the P/L but are reflected in changes in Banks of Colombia.28 The reserve’s portfolio is equity in the balance sheet of the institution. marked to market on a daily basis, with the P/L affected by both realized and unrealized profits Institutional framework and losses. However, it must be highlighted that there are distinctive characteristics to the distribu- Legal foundation tion of P/L results over a financial year. In the case 397. As mentioned earlier, the BR’s mandate to of profits due to interest rate exposure, including manage the international foreign exchange hedging, these are distributed to the government reserve of the country is established in the political within the first three months after the end of each constitution of Colombia and Law 31 of 1992. financial year. Profits on the foreign exchange exposure to non-U.S. currencies in terms of the U.S. dollar may be registered in a special reserve to Internal governance cover future losses. Finally, the results of the valua- 398. The organizational structure of reserve tion of the reserves in local currency terms do not management is described in Figure 5. 399. The Reserves Committee and the Internal Reserves Committee were created by an internal resolution approved by the Board of Directors that 28 The main difference between FASB rules and the establishes the objectives, functions, and responsi- Colombian Superintendency of Banks has to do with the procedure involved with the valuation of derivative products, bilities of each Committee, updated last year in resulting in marginal differences. accordance with the recommendations contained 6 • Colombia 75 in the “Guidelines for Foreign Exchange Reserve icy, their procedures, and practices on a recurrent Management” approved by the Executive Board of basis. the IMF in September 2001. 400. The Reserves Committee meets every two Human resource policy months, and is presided over by the Governor of the central bank and integrated by the Board of 405. The Bank’s human resource management Directors. It is responsible for the determination of strategy includes specialized selection, training, the objectives, principles, and general policies for remuneration, evaluation, and promotion policies. reserve management. Selection of the staff involves recruiting the top 10 401. The Internal Reserves Committee was cre- percent of graduates in different disciplines from ated last year in order to define the operational the top-tier universities in the country, out of which procedures for reserve management, in accor- personnel are selected on the basis of an evaluation dance with the objectives, principles, and general process that includes their level of technical exper- policies determined by the Reserves Committee. It tise, their proficiency in English/computer skills, meets monthly, and it is presided over by the and an evaluation of their personal characteristics. Technical Manager of the central bank (not a 406. The training program is structured in member of the Board of Directors) and integrated three levels, as described in Table 4. by the Executive Vice President of the Monetary 407. In order to reduce the risk of staff’s rota- Affairs and Foreign Reserves Department and the tion, a special remuneration scheme is used based Director of the Reserves Department. on the HAY GROUP methodology. Under this sys- 402. The Director of the Reserves Department tem a salary/benefit curve is established for the is responsible for ensuring that the investment bank based on a comparison with that of its peer policies set by both the Reserves Committee and group within the country for each area.29 Each the Internal Reserves Committee are observed. position is evaluated and graded according to the Within the Reserves Department, the front office is required know-how, responsibility, and problem- responsible for the trades of the portfolio managed solving skills, for which the attainment of each level internally. The middle office is in charge of com- of CFA by the employee is crucial in order to estab- pliance, risk management, and performance attri- lish the salary and benefits within the Bank’s over- bution for both the internally and externally all salary curve. managed portfolios, reporting directly to the 408. In 1999, a five-year human resource man- Internal Reserves Committee to guarantee trans- agement plan was deployed with the support of parency and independence. A Research Unit was external specialized consultants. This plan created to support the Department’s training, included the definition of technical and personal development, and research requirements. competencies required for the bank’s employees, 403. The Operational Department is in charge annual performance indicators, and development of accounting, confirmation, and settlement of plans to promote these competencies. The operations carried out by the Reserves Department Reserves Department uses this framework to deter- in a highly automated environment. Additionally, it mine the different types of training and salary base keeps track of operational issues with the custodi- for employees with basic, intermediate, and ans, counterparties, correspondent banks, and advanced proficiency levels. asset managers. Reserve assets are reconciled on a 409. All employees are subject to both daily basis by a separate Department. Colombia’s Disciplinary Code for public servants 404. The Internal Control Department was cre- established by Law 200 of 1995 (later modified by ated in accordance with Law 87 of 1993, by which the procedures that regulate the exercise of internal controls of public entities were stipulated, in 29After five years the employee receives a salary increase that order to evaluate independently from the areas in gradually reaches a level equivalent to 20 percent of the aver- charge of implementing reserve management pol- age salary paid by the industry. 76 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT

Table 4. Training Programs

Level Objectives and Activities

Basic Learning specific procedures/manuals of the area and an overall knowledge of the Bank, reserve management theory, and basic financial and economic concepts. Intermediate Sponsorship of three levels of Chartered Financial Analyst (CFA) certificates to all front and middle office personnel (as of this year, replacing the ISMA General Certification Program). Internships with external managers. Management skills programs are given to senior members of the group to ensure the continuity of the department’s development. Advanced This level includes the sponsorship of postgraduate studies at top international universities in fields such as financial engineering, international economics, and business administration, with a strong emphasis in finance; this step implies a long-term commitment between the employee and the Bank.

Law 734 of 2000) and the Bank’s general code of assessment of its liquidity requirements that are employment conditions that establishes their rights determined largely by the fact that under a floating and obligations, including the appropriate code of exchange rate regime the probability of recurrent conduct that every employee must observe. intervention has fallen and, at the same time, the Employees of the Reserves Department are also level of reserve adequacy has increased. As such, in subject to a special internal code of conduct that order to cover intervention requirements in the concerns the nature of the operations on reserve most efficient manner, total reserves have been management. The institution that regulates Public segregated into three liquidity buckets as follows: Service in Colombia requires that every year, all • Working Capital to cover immediate liquidity employees declare their assets and liabilities for the requirements, composed mostly of overnight period. investments at the Federal Reserve Bank. This bucket may fluctuate within a range Establishing a Capacity to Assess and defined by the Reserves Committee, accord- Manage Risk ing to current intervention policy, and is managed internally by the Bank. Risk management • Intermediate Liquidity Bucket to cover up to 410. The overall framework for risk manage- one year’s liquidity requirements, which are ment at the BR seeks to enable it to comply with its estimated to be equivalent to the annual reserve management objective at all times; that is, to volatility of historical percentage changes in ensure that an adequate level of foreign exchange foreign exchange reserves with a 99 percent reserves is maintained readily available to meet inter- confidence level.30 These funds are managed vention requirements in the most efficient manner. internally by the BR under an indexation It must be highlighted, however, that some of the policies described below are in a transition phase due to be fully implemented at the end of this year. 30The central bank is at present working on a dynamic stress test model for the balance of payments in order to determine more precisely its liquidity requirements over a one-year period. Under the current procedure liquidity requirements Liquidity risk over a one-year period may be overestimated given that the historical volatility of the reserves reflects the prolonged 411. The financial risk management frame- period in which the country was under a crawling peg and a work of the central bank is based initially on the managed float exchange regime. 6 • Colombia 77

mandate to a benchmark that reflects the temporary basis when the cost of such currency composition of the balance of pay- arrangements, collateralized by securities ments consisting of a combination of money traded as “specials,” which are part of the market instruments referenced to LIBID and Intermediate Liquidity Bucket, is lower than highly liquid government bonds with a mod- the cost of liquidating a particular security ified duration of 1.45 years. As such, its main in the Stable Liquidity Bucket in abnormal source of added value over the Working market conditions. Capital is its higher exposure to short-term credit risk, duration exposure, and currency • A policy on the use of contingency lines avail- diversification. able through multilateral institutions. • Stable Liquidity Bucket, composed of the 414. Furthermore, periodically the Internal excess of reserves over the value of the first Reserves Committee reviews the liquidity require- two buckets, which by definition have the ments in light of the changes in the intervention lowest probability of being used for interven- policy and/or changes in the underlying assumption purposes over a one-year period. At a tions that support the value of each bucket. benchmark level these funds reflect the cur- 415. To determine the investment guidelines rency composition of the balance of pay- and risk management policies of the Intermediate ments, invested in a combination of money and Stable Liquidity Buckets, the Reserves market instruments referenced to LIBID and Committee drew on the international standards highly liquid government bonds with a mod- and practices documented by the IMF, the ified duration of 2. Furthermore, this bucket Bank for International Settlements (BIS), the is delegated almost in its entirety to special- Group of Thirty, and the Colombian Super- ized external managers under non-indexa- intendency of Banks. As a result, the bank defined tion mandates that permit the possibility to a risk management policy framed in a five-step invest in a range of nongovernment asset dynamic process: identification, measurement, classes, credit risk, non-benchmark curren- monitoring, limits/control, and validation, to be cies, and active duration strategies. fully implemented by December 31, 2002. The overall risk management framework is depicted in 412. The rationale behind the construction of Figure 6. such liquidity buckets is to allow the central bank sufficient time to liquidate the Stable Liquidity Bucket to cover unexpected intervention require- Benchmark risk ments under extreme market conditions, in order to minimize the risk of either assuming higher 416. The benchmark approved by the Reserves than normal transactions costs in liquidating less- Committee represents the most efficient long-term liquid nongovernment asset classes or being strategy to accomplish the reserve management unable to meet such needs in a timely manner. As objectives of the BR for its investment portfolio such, a formal liquidity policy was devised in order (both the Intermediate and Stable Liquidity to reduce further this risk. Buckets), constrained to assets with the highest liq- 413. The value of the Working Capital and the uidity characteristics. The benchmark embodies Intermediate Liquidity Bucket together can fluctu- the following two objectives: ate within a sufficiently ample range (the equiva- • The currency composition of the benchmark lent of the historical volatility of reserves changes of the total investment tranche, both the with a 90 percent, minimum, and 99 percent, max- Intermediate and Stable Liquidity Buckets, imum, confidence level) before liquidating the must reflect the moving average of three Stable Liquidity Bucket. years of the currency composition of the out- • A policy on the use of repos to attend to flows of the balance of payments, in order to unexpected liquidity requirements on a maintain the capacity of reserves to respond 78 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT

Figure 6. Overall Framework for Risk Management

Absolute Benchmark Risk + Aggregated Tracking Error

(We + Wi ) < 0.48% at actual market value Total Investment No losses at the 95% confidence interval in 1 year Portfolio

Tracking Error < 1%

External Adm. (We) Internal Indexed (We)

Minimal Tracking Error (Indexed)

Ext. Adm. Ext. Adm. Ext. Adm. Ext. Adm. Ext. Adm.

Tracking Error = 0.2% over Benchmark per Adm.

to external pressures.31 As such, in order to by its sensitivity to parallel, twist, and curva- measure this risk, an in-house model was ture changes in the term structure of interest developed in order to determine the cur- rates for a given modified duration/convex- rency composition of the outflows of the bal- ity, using an exponentially time-weighted VaR ance of payments. associated with these factors and a variance- covariance matrix to estimate the correlation • The interest rate exposure of the benchmark between different index components. In of the total investment tranche, both the addition, historical stress tests are conducted Intermediate and Stable Liquidity Buckets, is to evaluate the consistency of the model and limited to a 95 percent confidence level that determine worst-case scenarios. it will not register negative returns in any given year. This limit is set so as not to hinder 417. The composition of the benchmark that the desired reserve adequacy level with complies with these two objectives is described adverse price movements and/or to expose later in this chapter. At the end of each financial the central bank to criticism for its handling year the Reserve Committee reviews both the cur- of reserve management. The exposure of the rency composition and interest rate exposure of benchmark to interest rate risk is determined the benchmark in light of the changes in the underlying assumptions in the models that support these decisions to determine adjustments, if any, in 31Since this is a reserve adequacy objective, a reserve account its currency composition and modified duration to was created in the balance sheet of the institution composed comply with these investment objectives over the of the foreign exchange profits resulting from the non-U.S. dollar exposure of the portfolio in terms of the U.S. dollar. In next financial year. Normally, such adjustments on the case of losses this reserve account is used. the total investment tranche are applied to the 6 • Colombia 79

Intermediate Liquidity Bucket only, in order not to to the different specific types of risks that can be incur unnecessary transaction costs implicit in the taken by the portfolio managers as presented in types of assets in which external managers invest Table 5. The investment guidelines of the portfolio the Stable Liquidity Bucket. are presented later in this chapter.

Portfolio risk Operational risk 418. The overall annual tracking error the port- 422. Operational risk arises from inadequacies, folio managers may take against the benchmark is failures, or nonobservance of internal controls and limited to 0.50 percent of the total value of the procedures, which threaten the reliability and investment portfolio (both Intermediate and Stable operation of business systems. The Director of the Buckets). The Intermediate Bucket is managed Reserves Department is responsible for identifying internally under an indexation mandate to the and establishing the controls or procedures to mit- benchmark, as a result of which its contribution to igate these risks. In addition, the Internal Control overall tracking error is minimum. Most of the Department and the Audit Department evaluate authorized tracking error is allotted to the Stable the procedures to control this risk, and make rec- Bucket that is managed exclusively by external asset ommendations in this respect, based on their own managers. The allowed tracking error, currently independent risk analyses that are supported by around 1 percent available for external managers, is international standard methodologies of audit and as a result higher than for the overall portfolio, control like the Committee of Sponsoring depending on the weight of the Intermediate Organizations of the Treadway Commission Bucket with respect to the Stable Bucket at any given (COSO) and the AS/NZS 4360:1999 (Australian moment in time. The Reserves Committee also lim- and New Zealand Risk Management Standards). its the amount of tracking error allotted to any indi- 423. The key operational risks identified in vidual mandate to a tracking error of around 1 reserves management are the following: fraud risk, percent, so long as it does not exceed 0.125 percent dealing risk, settlement risk, custodial risk, finan- of the value of the total investment portfolio, to cial error or misstatement risk, loss of potential ensure manager type diversification. income, information technology risk, contingency 419. The measurement of the concurrent events, and legal risk. The Reserves Department tracking error of the portfolios is based on a multi- and Operations Department rely upon a series of factor model based on two regressions. In the first tools to mitigate these risks, of which the most regression, it determines the exposure of the port- important is a well-established culture of auto-con- folios with respect to the benchmark to parallel, trol, where the personnel are aware of the impor- twist, and curvature changes in the term structure tance of the management of operational risk and of interest rates. In the second regression, it esti- are encouraged to verify every task and process. mates three additional sources of risk: economic The specific approach to control each of the oper- sector risk, issuer credit risk, and prepayment risk. ational risks is as follows: Foreign exchange risk is calculated as a separate 424. Fraud risk: Frauds or thefts are prevented component. Overall tracking error is estimated through strict control of the reserves operations using a variance-covariance matrix. through manuals of procedures, the assignment of 420. At the beginning of each financial year key responsibilities according to levels of hierarchy, the Reserves Committee reviews the limits on track- and an appropriate segregation of duties within ing error in order to maintain a 95 percent confi- the organization. dence level so that in addition to benchmark risk, 425. Information technology risk: The assess- portfolio risk is not inconsistent with either the cur- ment of this risk responds to the failure of the rency or the interest rate objectives. information systems and guarantees the security 421. In addition to the constraints on tracking and maintenance of critical information. The net- error, the Reserves Committee also limits exposure work infrastructure, distributed in two nodes, uses 80 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT to onths of at least two dex returns for each tion in each node of base each eligible credit rating is limited so that the maximum shortfall against government bonds complies with an annual cap of 50 basis points confidence level. a 99 percent percent instruments for hedging after a crisis recognized market makers recognized entity published global indices global indices million; maximum exposure per issue is limited to 10 each asset class average transaction costs within 4 months Transaction sizes that do not affectTransaction Periodic surveys to principal market makers for Limits on maximum transaction size according Outstanding issue size Ease of hedgeAge outstanding issue size according to Average Minimum issue size of eligible securities is $500 Existence of future contracts/substitutions of liquid futures markets or substitute Availability Issue date of each security Recently issued are preferred bid/offer spreads or market prices each asset classRecovery time to normal market conditions after an external shock Recovery time of the performance of eligible assets against government bonds after a crisis Eligible asset classes’ cumulative total return must exceed that of the risk-free asset within six m asset class Average bid/offer spread Average Periodic surveys to principal market makers for spread against governments must cover Average Heterogeneity of investor’s baseHeterogeneity of investor’s Number of market makers Periodic market surveyStandardized market practices Periodic market survey Review of trading associations and regulators Practices must be regulated by at least one Eligible asset classes must maintain a broad investor Eligible asset classes must be traded by at least five Depth Tightness Security-specific structure Resiliency Market microstructure Historical return/risk profile of representative indices for each rating category against a duration-matched reviewed periodically to check required eligibility historical return distribution of in government index criteria Analysis of corresponding index returns— The quantification of degree/type non-linearity Exposure to rating category determines eligibility. Quantitative drivers of liquidity key rate duration of underlying asset and mismatchhedging instrument calculated daily to minimize basis risk underlying and hedging derivative is limited liquidity risk Inclusion in global indices Review of asset classes included in global indices Eligible asset classes must be part Credit risk Systematic risk eligibility criteria Derivative risk resultant of difference in Estimated VaR In-house model back-tested for ex post return Maximum net key rate dura Table 5. Decomposition of Portfolio Risk Table ID MeasurementAsset class Qualitative drivers of liquidity Monitoring/Validation Limits 6 • Colombia 81 dex duration ead duration mortgages. scenarios of transition. Spread duration* historical volatility of spreads at each rating category/ Multifactor model, back-tested.economic sector. and worst-case transition Average matrices/recovery rates coupled with international rating agencies and changed in Follow-up of transition events informed by minimum number of issuers required to post in exposure to each credit rating Maximum percentage limits per issuer based on the Maximum percentage within each asset class and economic sector. simulations. index composition. returns with a low tracking error under stress Issuer selection risk is delegated to external managers with outstanding capabilities for specific issuer credit Review of transition events that affect securities held by each manager. risk analysis. N.A. Systematic risk control Nonsystematic risk Issuer risk structure of interest rates* historical volatility of each factor with respect to index. Scenario analysis and historical stress tests are applied. mortgages. volatilities and correlations against benchmark positions. Scenario analyses and stress tests are applied. against the benchmark in eligible currencies. based on a prepayment model. against the index, and maximum exposure to risk curvature movements (D3) of the term against the index, and maximum exposure to Mortgage risk Effective spread and duration calculated Prepayment model, back-tested. effective and spread Limits to portfolio’s Interest rate Duration to parallel (D1), twist (D2), and Multifactor model, back-tested. effective and spr Limits to portfolio’s F/X risk error based on historical Tracking Currency risk model, back-tested. of unhedged currency positions Maximum 5 percent 82 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT

Table 6. Information Systems

Application Platform Function Vendor

Bloomberg, Reuters, Workstation NT Information services for news, prices, Bloomberg Monitor Trading and and Datastream exchange rates, and analytics. Thompson Financial DEALING 2000 Proprietary Front-end trading system for Forex and Monitor Trading time deposit trades. OPICS Client/server: Back office application, trade entry Frustum NT/NT Oracle 8i system, settlement (SWIFT), credit risk, pricing, cash flows, and accounting. ABACUS Client/server: Performance measurement system. Wilshire Associates NT/W2000 DB2 AXIOM Client/server: Multifactor risk and performance Wilshire Associates NT/W2000 C-tree attribution system, investment guideline compliance, and portfolio analysis. SWIFT Client/server: Payment system. SWIFT NT/UNIX

a cluster architecture that allows load balancing requisite to be allowed to trade with the Bank, after and redundancy for disaster recovery of the most which it generates the appropriate payment critical services on just one node. Disaster recovery instruction via SWIFT. is possible using online mirroring of data on top of 427. Settlement risk: Trading counterparties a fiber-optic interconnection. From a security per- are reviewed and approved by the Internal spective, passwords and access controls are Reserves Committee. Standard settlement instruc- required to access computers and applications, and tions are required for each counterpart and, in the all data transmissions of sensitive information over case of disputes such as late settlement claims, the extranet and Internet use regular security fea- these are conducted based on the laws, rules, and tures. The portal Servicios Electronicos del Banco recommendations of ISMA or any other interna- de la Republica (SEBRA) handles authentication, tionally recognized trading association. encryption, and firewall functions. The manage- 428. Custodial risk: The prevention of a possi- ment of the international reserves is based on eight ble failure by the custodian is done at the selection principal applications systems that are described in process, which focuses on selecting professional Table 6. and globally recognized entities for its custodial 426. Dealing risk: OPICS is a straight-through operations. Specific requirements include: experi- processing system with a single point of entry of ence, size (measured by the volume of assets under trade operations restricted to authorized traders, custody), the maintenance of sound technological limited by the system to the type of operations each resources to carry out its operations, the robustness trader is allowed to enter; limits on transaction size; of its contingency plans, its sub-custodian network, authorized counterparties; the observance of its reporting capabilities, and its management of fail credit risk limits; and a price tolerance check of the trades. Once the custodian has been selected, its operations to ascertain that trades were transacted responsibilities are defined in a contract, and its at current market levels. Once entered, the system performance is monitored through the daily recon- generates a confirmation message of each trade ciliation of portfolios with the central bank and that matches automatically to the trade details of external managers. the confirmation received from the counterpart, 429. Financial error or misstatement risk: The including a verification of the standard settlement definition of reserve assets or liabilities follows the instructions that a counterpart must provide as a Balance of Payments methodology from the 6 • Colombia 83

International Monetary Fund. All components of fees, investment guidelines, warranties, the reserves must be registered in the balance sheet, sovereign immunity of the reserves, and the appli- and the International Exchange Department cal- cable legislation and jurisdiction. They also involve culates the total value of reserves on a daily basis, the establishment of new contracts, as well as the with the support of the Accounting and Economic maintenance of the current contracts in accor- Information Departments, to evaluate the consis- dance with the central bank’s internal regulations tency of this information. and international market regulations. 430. Loss of potential income: The control of the ledger accounts of the BR is executed through External management program the Cash Management Systems provided by its correspondents, which control in real time both debits 433. The objective of the external manage- and credits on the account, represent an alternative ment program is to add value to the benchmark to SWIFT to execute payments in a contingency, and through the specialized management of risks that permit investment of excess funds throughout the the Bank cannot manage internally. The frame- day in different overnight alternatives. In addition to work for the external asset management program the above, the BR is in the process of contracting includes: with its correspondents’ overnight repo facilities to • Program size: The Stable Investment Bucket generate liquidity collateralized by government is allocated to external managers, with the bonds as part of its general liquidity policy. The cash exception of a small portfolio managed inter- flow module in the OPICS processing system is used nally under a non-indexation mandate. in addition to the Cash Management System to determine the required balances of the ledger • Tracking error: 0.50 percent of the value of accounts, a process that the Bank intends to auto- the total investment portfolio (which equates mate via an interface between the two systems, and currently to 1 percent of the value of the a separate Department from the Reserves Depart- Stable Liquidity Bucket), of which 0.125 per- ment, which is in charge of the control of treasury cent can be allocated to one single external operations, conducts daily reconciliation of the manager to ensure manager type diversifica- ledger accounts using the nostro conciliation system tion (currently around 1 percent per man- provided by SWIFT. date). 431. Contingency events: Based on the method- • Benchmark and investment guidelines: The ology documented by the Disaster Recovery total program shares the benchmark and Institute International, the Reserves and the IT investment guidelines described in Section D. Department have established contingency plans to • Types of managers: Manager diversification is guarantee the continuity of reserves operations at promoted through the selection of global different levels of contingency. Important aspects of managers and U.S. sector rotation managers, the contingency plan include a daily backup system with appropriate benchmarks and special- with an updated copy of all vital information and an ized investment guidelines for each that off-site contingency location that fulfills all trading together reflect the overall desired exposure and system requirements. to the different specific types of risk. 432. Legal risk: The management of legal risk is under the responsibility of the Reserves Depart- • Selection process: The selection of the man- ment and the Legal Department of the BR, with agers is based on a Request for Proposal the support of an external advisory firm. The pro- (RFP) that evaluates the company, organiza- cess focuses on the administration of contracts and tion, investment philosophy, historical per- legal documents associated with the reserves oper- formance, risk management capabilities, ations; that is, external management, securities back-office processes/reporting, and addi- lending, futures trading, custody, etc. These con- tional services provided, such as research tracts specify each party’s right and obligations, facilities. Finalists in the RFP process are vis- 84 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT

ited on-site and asked to provide an eco- time horizons such as monthly, year to date, yearly, nomic offer. rolling three years, and since inception, using U.S. • Fee structure: A performance fee structure dollars as the base currency. This is applied to both based on percentages of the normal fixed fee the benchmark and the portfolios and therefore charged by each manager for a given market returns can be measured on an absolute and a rela- value of the mandate, tailored in such a man- tive basis. Both gross and net returns are calculated ner that at the expected long-term excess for the portfolios, deducting operating costs such as return of each type of mandate (Global or fees, custody, and administrative expenses. In addi- U.S. Asset Rotation) the normal fixed fee and tion, risk-adjusted returns are also calculated 32 the performance fee are equal. through the use of the following measures: • Performance evaluation: A three-year hori- • The information ratio that measures average zon is used to measure the performance of excess return over the benchmark per unit of each mandate. observed risk. This indicator evaluates the efficiency with which the managers have uti- 434. Managers for each mandate are classified lized risk. as outstanding when excess return is above the long-term expected average, acceptable when it is • The risk ratio that measures average excess in a range between the normal fixed fee of the man- return over the benchmark per unit of track- ager and the long-term expected average, and low ing error ex ante. This indicator evaluates when performance is below the normal fixed fee. the success of managers’ use of allowed track- 435. Each category is reclassified according to ing error. the information ratio obtained by each manager. • The efficiency ratio measures the consistency 436. Guideline compliance and operative of the risk models used by the managers by errors are also evaluated in terms of both the num- comparing observed tracking error with ex bers of errors and potential cost. ante tracking error. 437. On the basis of this evaluation the Reserves 439. Attribution analysis is performed by Committee adjusts the mandates of external man- Axiom using its multifactor model for each of the agers. The Internal Reserves Committee reviews the risk factors at the following levels: security, asset performance of the asset managers on a monthly classes, countries, currencies, portfolio, and com- basis, as well as any breaches of the guidelines or posites. This model offers an attribution measure- operative errors. The middle office in the Reserves ment that goes beyond the traditional approach33 Department is responsible for the day-to-day control of the asset managers who have to report their oper- since it allows an integrated analysis of return and ations daily to both the OPICS processing system for risk factors, which determines the efficiency of the accounting purposes and Axiom for risk, perfor- overall investment strategy. mance, and compliance control. The role of efficient markets Performance measurement and attribution 440. As explained later in this chapter, the BR 438. Performance measurement is based on a is extremely sensitive to liquidity risk. On the one daily mark-to-market valuation of the portfolios cal- hand, it constrains its reserve management activi- culated by the Abacus system from Wilshire ties to markets that have sufficient liquidity as mea- Associates Inc., which complies with the AIMR sured through qualitative and quantitative factors (Association for Investment Management and Research) and GIPS (Global Investment Perform- ance Standards). A daily time-weighted rate of 32These risk-adjusted measures are implemented following the RiskMetrics methodology. return that is geometrically linked is used to calcu- 33The Brinson-Fachler model measures attribution in terms of late a monthly figure. Performance is measured for asset allocation, security selection, and an interaction effect. 6 • Colombia 85 that determine the quality of the liquidity of a par- changes in the foreign exchange reserves with a 99 ticular market, factors that are reviewed periodi- percent confidence level). cally. Furthermore, the central bank sets limits on 443. Excess funds over $4,378 million may be its exposure to a specific market, asset class, and invested in the Stable Liquidity Bucket. individual issuer/issue in accordance with the 444. In the case of a reduction in the foreign quality of the liquidity of each investment alterna- exchange reserves, the Working Capital Bucket tive in order not to affect the relevant market and then the Intermediate Liquidity Bucket will be through its own operations. Finally, the BR is also used until the sum of the two buckets reaches the sensitive to trading in abnormal market conditions minimum authorized level. After such level is for which it has set rules to buy time to liquidate reached, reserve reductions will be covered pro- less-liquid assets at such times. It also must be portionally by the Intermediate and Stable highlighted that the central bank delegates to Liquidity Buckets. In order to delay further the liq- external managers the management of non- uidation of the Stable Liquidity Bucket, repos and government asset classes since they have the nec- contingency lines may be used. essary capabilities to liquidate them more efficiently in any market environment. 1. Aggregate Benchmark 445. The Money Market portion (MM) is ref- General Investment Guidelines erenced to the iMoneyNet First Tier Institutional index and the bond portion is referenced to the Working Capital Salomon Smith Barney Government bond index Reference rate: Fed funds. weighted by country and sector as described in Size: Range from US$390 to US$750 million. Table 7. Benchmark weights in each currency Currency denomination: U.S. dollar-denominated must be adjusted over time to reflect the three- assets. year rolling average composition of the outflows Investment guidelines: Up to $390 million may be of the Balance of Payments of Colombia. The invested in overnight facilities provided by the overall average effective duration of the aggregate Federal Reserve Bank of New York, of which up benchmark (Intermediate and Stable Liquidity to $180 million may be invested in the overnight Bucket) must be consistent with a 95 percent facilities provided by other treasury correspon- probability that its exposure to interest rate risk dents. No limit is imposed on U.S. Treasury Bills will not register negative returns over any given and Fixbis. A limit of $80 million each is year. imposed on money market instruments issued by the World Bank, Fannie Mae, Freddie Mac, 2. Investment Guidelines for the Money Market and Federal Home Loan Banks. Portion of the Benchmark (applicable to both Maximum maturity of investments: Three months. Intermediate and Stable Liquidity Buckets)

Investment portfolio 3. Investment Guidelines: Intermediate Liquidity Bucket 441. The investment portfolio is segregated into two liquidity buckets: the Intermediate 446. The objective of the mandate is to repli- Liquidity Bucket and the Stable Liquidity Bucket. cate the risk/return characteristics of the bench- 442. The size of the Intermediate Liquidity mark of the Intermediate Liquidity Bucket depicted Bucket, including investments in Working Capital, in paragraph 445, with the lowest possible tracking can range between $2,120 million (the volatility of error, following the Investment Guidelines for the the percentage changes in the foreign exchange Money Market Portion described in Table 8, and reserves with a 90 percent confidence level) and matching the composition of the bond portion of $4,378 million (the volatility of the percentage the benchmark. 86 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT

Table 7. Benchmark Composition (In percent)

Intermediate______Liquidity Bucket ______Stable Liquidity Bucket ______Market ______Market Sector USD EUR JPY USD EUR JPY

MM 40 0 0 15 0 0 1–5 years 46 11 3 71 11 3 Total 86 11 3 86 11 3

Table 8. Investment Guidelines for the Money Market Portion of the Benchmark

Strategy Guideline

Duration The maximum weighted average maturity (WAM) of the money market portion of the benchmark is 90 days. Exchange risk 100% U.S. dollars. Investments are also allowed in the following currencies with their respective currency hedge against U.S. dollars: Canadian dollar, Japanese yen, euro, British pound, Swiss franc, Swedish krona, Danish krone, Norwegian krone, Australian dollar, and New Zealand dollar. Credit risk • 100% of the value of the money market portion of the benchmark may be invested in U.S. Federal Government explicitly guaranteed assets or in issuers/issues with a minimum credit rating of P–1 by Moody’s Investor Services, A1+/A1 by Standard and Poor’s, and F1 by Fitch Ratings. • At the time of purchase the issuer of an eligible asset or the eligible asset itself must be rated by at least two of the following rating agencies as: P–1 by Moody’s Investor Service, A1+/A–1 by Standard and Poor’s, and F–1 by Fitch Ratings. The ratings by two agencies can be used if and only if the third agency does not issue an opinion about the rating status of the issuer and/or issue. The lowest of the available ratings applied by any of the agencies to an issuer or issue at the time of purchase will prevail over the others. Exception is made for U.S. Government securities. • Downgrades after purchase to P–3/A–3/F–3 by any of the rating agencies mentioned above must be sold within the 10 Trading Days following this event. These rules also apply to downgrades to P–2/A–2/F–2 in excess of 5% of the money market portion of the benchmark. • The maximum non–U.S. Federal Government sector exposure as a percentage of the money market portion of the benchmark is 100% in U.S. agencies, sovereigns in eligible currencies, and supranationals in eligible currencies; 75% in banks; 50% in corporates; and 50% in asset-backed commercial paper (ABCP). • The maximum non–U.S. Federal Government exposure (current face*price/100 as determined on the date of purchase) allowed per issuer as a percentage of the money market portion of the benchmark is 5%. In the case of ABCP, when an entity guarantees more than 10% of an issue, such amount guaranteed must be added to the credit exposure of the entity. • Eligible issuers of corporate/bank debt must have a minimum book equity of $5 billion. Liquidity risk • Any type of negotiable instruments issued by eligible issuers in eligible currencies with a maximum maturity of 397 days. • Investments are also allowed in term deposits with a maximum maturity of 1 month and up to 10% of the value of the money market portion of the benchmark. 6 • Colombia 87

Table 9. The Benchmark

Sector Currency Weight1 Reference

Money Market U.S. dollar 15% iMoneyNet First Tier Institutional (gross of fees and taxes). Bonds U.S. dollar 85% 1–5 yr. Salomon Smith Barney U.S. Government Bond Index Component of the World Government Bond Index. 1These weights are not final and will be adjusted to achieve the relevant effective duration near the date of funding of the account.

4. Investment Guidelines for the Stable Bucket: –1 in absolute terms and spread duration may not U.S. Asset Rotation Mandates exceed ±2.85. 447. Of the total value of the Stable Liquidity (iii) Money market investment guidelines Bucket, 50 percent is allotted to U.S. asset rotation • In addition to the investment guidelines mandates with the following investment guidelines: described in Section 2 for the Money Market Objective portion of the benchmark, the mandate may invest up to 100 percent of its value in U.S. 448. The objective of the mandate is to generate Federal Government securities and up to 15 returns over the performance of the benchmark (as percent in First Tier Short-Term Investment described below) in excess of 30 basis points per Funds (STIF) available with the Custodian. annum over three-year rolling periods, within a maximum ex ante expected tracking error objective • The restriction in Section 2 on the maximum of 100 basis points per annum and in compliance WAM of 90 days for the Money Market por- with the investment guidelines set forth below. tion of the benchmark is replaced by the overall restrictions on interest rate risk in Benchmark Section 2.3.ii applied to the value of the over- 449. The benchmark composition is as pre- all mandate. sented in Table 9. (iv) Bond investment guidelines Risk limits • Eligible assets: bonds and debentures without (i) Currency risk attached options in eligible currencies, bonds, The Mandate may invest up to 50 percent in and debentures with embedded options eligible assets (as described below) denominated denominated in U.S. dollars only, Fixed- in eligible currencies provided that they are fully Coupon Mortgage-Backed Pass-Through hedged to the U.S. dollar within a tolerance limit Securities (MBS) denominated in U.S. dollars of ±0.25 percent of the value of the Mandate in only, Asset-Backed Securities (ABS) denomi- unhedged exposure to non–U.S. dollar currencies. nated in U.S. dollars only, collateralized by The following are the eligible currencies: U.S. dol- credit card receivables and auto loans, lar, euro, Japanese yen, Swiss franc, British pound, Collateralized Mortgage Obligations (CMOs) Canadian dollar, Australian dollar, Swedish krona, denominated in U.S. dollars only, restricted to Danish krone, Norwegian krone, and New Zealand first or currently paying tranches of sequential dollar. bonds, planned amortization classes (PAC), targeted amortization class bonds (TAC), and (ii) Interest rate risk floating rate bonds that are not support 450. The effective duration of the Mandate tranches. Private placements, including 144a may vary in a range between ±1 with respect to that securities, are not considered an eligible asset of the benchmark; its convexity may not be below class. 88 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT

Table 10. Issuer Limits

Limit in Issuer Credit Quality Percent

United States government U.S. government No limit Sovereign in local currency (includes agencies AAA 35.4 fully guaranteed) AA 21.2 A 10.6 Sovereign in nonlocal currency (includes AAA 4.1 agencies fully guaranteed) AA 1.4 A 0.3 Supranationals AAA 2.0 AA 0.7 A 0.1 U.S. agencies without explicit guarantee—GSEs Federal Home Loan Banks 10.6 Fannie Mae 5.3 Freddie Mac 3.5 U.S. agencies explicitly guaranteed Ginnie Mae 44.7 U.S. corporates AAA 0.8 AA 0.8 A 0.2 U.S. dollar-denominated ABS (restriction per AAA 0.8 individual program)

• Eligible investments must have a debt senior- Federal Government securities, 100 percent ity of guaranteed, Senior secured, or Senior. in Sovereign securities issued in local eligible • At the time of purchase the issuer of an eligi- currencies, including fully guaranteed agen- ble asset or the eligible asset itself must be cies, 8.2 percent in Sovereign/Supranational rated by at least two of the following rating securities issued in non-local eligible curren- agencies as: A3 by Moody’s Investor Service, cies, including fully guaranteed agencies of A- by Standard and Poor’s, and A3 by Fitch which 4.1 percent may be invested in Ratings. The ratings by two agencies can be Supranationals, 11 percent in U.S. Agencies used if and only if the third agency does not without explicit guarantee from the U.S. issue an opinion about the rating status of Federal Government, 45 percent in Ginnie the issuer and/or issue. The lowest of the Mae, 8.2 percent in U.S. corporates, and 8.2 available ratings applied by any of the agen- percent in U.S. Asset-Backed Securities guar- cies to an issuer or issue at the time of pur- anteed by credit card receivables and auto chase will prevail over the others. Exception loans. Sector limits described in this section is made for U.S. Government securities. are exclusive of the sector limits described in Section 2 for the Money Market. • In the case of a downgrade after purchase below the minimum acceptable level by any • Issuer limits as a percentage of the total value of the rating agencies mentioned above, the of the mandate (Current Face*price/100 as investment must be sold within ten trading determined on the date of purchase) are pre- days following this event. sented in Table 10. • Sector limits as a percentage of the total • Investments must have a minimum issue size value of the mandate: 100 percent in U.S. of $500 million in accordance with the index 6 • Colombia 89

Table 11. Noneligible Offshore Financial Centers

Africa Middle East Western Hemisphere Asia and the Pacific Europe

Seychelles Bahrain Anguilla Cook IslandsAndorra Antigua and Barbuda Macao SAR Cyprus Aruba Malaysia (Labuan)Gibraltar Belize Marshall IslandsGuernsey Bermuda Nauru Isle of Man British Virgin Islands Niue Jersey Cayman Islands Palau Liechtenstein Dominica Samoa Monaco Grenada Vanuatu Montserrat Netherlands Antilles Panama St. Kitts and Nevis St. Lucia St. Vincent and the Grenadines The Bahamas Turks and Caicos Islands

inclusion criterion established by the • For Asset-Backed Securities, the limit is set at Salomon Smith Barney indices, with the 8.2 percent of the market value of the man- exception of MBS, CMOs, and ABS, where date. this limit does not apply. Other restrictions • The maximum holding of any specific issue is restricted to 10 percent of the issue size of (i) Restriction on eligible financial markets any security, with the exception of MBS, 451. Eligible issuers may not be located in the CMOs, and ABS, where this limit does not offshore financial markets described in Table 11. apply. (ii) Restrictions on managers (v) Investment guidelines for instruments with 452. Managers may not invest in securities embedded options issued by themselves, their parent company, or any • The mandate may invest in assets with of their affiliates (or any special-purpose subsidiary embedded options other than MBS or its for which they serve as incorporator, manager, or derivatives and ABS up to 8 percent of the trustee, or in which they are an investor). total value of the mandate. This provision Derivatives does not apply to Treasury Inflation Protected Securities (TIPS). (i) Over-the-counter (OTC) currency forwards • For MBS a limit is set at 45 percent of the • Foreign exchange forward transactions can market value of the mandate, of which 7.5 be executed for hedging purposes only. percent can be allocated to eligible CMOs. • The maximum maturity of foreign exchange For CMOs the notional amount of any secu- forward transactions cannot exceed four (4) rity purchased will be added to the exposure months as from the date of transaction. of the issuer of the security, not to the exposure of the issuer of the underlying asset, and • Eligible counterparties for forward and spot they are to be issued and collateralized by an foreign exchange transactions must have a eligible GSE. minimum credit rating of A-1 by Standard & 90 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT

Table 12. Eligible Exchanges and Futures Contracts

Exchange Contract

Chicago Board of Trade U.S. treasury bond; U.S. 10-year treasury note; U.S. 5-year treasury note; U.S. 2-year treasury note; 5-year and 10-year interest rate swap futures contracts Chicago Mercantile Exchange Eurodollar Eurex Schatz; Bobl and Bund contracts London Financial Futures and Euribor Options Exchange Long Gilt Tokyo Stock Exchange JGBs Bourse de Montréal Canadian government bond Stockholmsbörsen Swedish government bond Sydney Futures Exchange Australian government bond; New Zealand government bond Københavns Fondsbørs Danish government bond

Poor’s, P-1 by Moody’s Investor Service, and (ii) MBS to-be-announced (TBA) trades F-1 by Fitch IBCA by at least two of these agencies. • TBA trades are authorized restricted to a settlement date not exceeding three months • If any eligible counterparty with which there from trade date. is an open position is downgraded below the minimum permitted credit rating by any of • The underlying pools for TBA trades must the credit agencies, the position must be come from an eligible MBS. closed with such counterparty during the ten (10) trading days following such event so (iii) Exchange-traded futures contracts long as the Adviser maintains an enforceable • The futures contracts and corresponding netting agreement with such counterparty. exchanges that are shown in Table 12 are • The net exposure in open foreign exchange authorized: forward and spot operations with any eligible • The maximum expiration or delivery date of counterparty cannot exceed 10 percent of any contract cannot exceed six (6) months the value of the mandate at any given from trade date. moment of time. • Eligible counterparties for futures contracts: • The maximum amount of foreign exchange broker-dealers designated as futures commis- operations to be settled on the same date sion merchants by an appropriately desig- with any eligible counterparty cannot exceed nated self-regulatory organization or govern- 5 percent of the value of the mandate. For ment body as required by applicable laws and counterparties with which the manager does regulations. Eligible broker-dealers must be not have an enforceable netting agreement members of the clearinghouses associated in place, the limit shall be 2.5 percent. with the following exchanges: Chicago Board • The notional amount of all open foreign of Trade, Chicago Mercantile Exchange, exchange forward operations may not exceed Eurex, and London Financial Futures and 50 percent of the value of the mandate. Options Exchange. 6 • Colombia 91

Table 13. The Benchmark

Sector Currency Weight Reference

Money Market USD 15% iMoneyNet First Tier Institutional (gross of fees and taxes) Bonds USD 57% 1–5 yr. Salomon Smith Barney U.S. Government Bond Index EUR 22% 1–5 yr. Salomon Smith Barney German Government Bond Index JPY 6% 1–5 yr. Salomon Smith Barney Japanese Government Bond Index

(iv) Restrictions on leverage maintains the currency composition of the benchmark. The following are the eligible 453. The notional amount of all long futures currencies: U.S. dollar, euro, Japanese yen, and MBS TBA positions shall not exceed the mar- Swiss franc, British pound, Canadian dollar, ket value of all assets with a final maturity of less Australian dollar, Swedish krona, Danish than 397 days. krone, Norwegian krone, and New Zealand dollar. 5. Investment Guidelines for the Stable • The mandate may deviate up to ±10 percent Liquidity Bucket: Global Mandates in unhedged currency exposure in any of the 454. Of the total value of the Stable Liquidity eligible currencies with respect to its partici- Bucket, 50 percent is allotted to global mandates pation in the benchmark, subject to the con- with the following investment guidelines: straint that the maximum aggregate currency Objective exposure is 10 percent of the value of the portfolio. The aggregate currency exposure 455. The objective of the mandate is to gener- shall be calculated as the sum of all net long ate returns over the performance of the bench- positions in each individual eligible currency mark in excess of 30 basis points per annum over against the benchmark. three-year rolling periods, within a maximum ex ante expected tracking error objective of 100 basis (ii) Interest rate risk points per annum and in compliance with the 457. The effective duration of the mandate investment guidelines set forth below. may be in a range between ±1 with respect to that The benchmark of the benchmark.

456. The benchmark composition is as pre- (iii) Money market investment guidelines sented in Table 13. • In addition to the investment guidelines Risk limits described in Section 2 for the Money Market (i) Currency risk portion of the benchmark, the mandate may invest up to 100 percent of its value in U.S. • The mandate may invest up to 50 percent of Federal Government securities and up to 15 the value of the account in eligible assets (as percent in First Tier Short-Term Investment described below) denominated in eligible Funds (STIF) available with the Custodian. currencies, in addition to the eligible assets of the benchmark, provided that they are • The restriction in Section 2 on the maximum fully hedged in such a way that the account WAM of 90 days for the Money Market por- 92 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT

Table 14. Issuer Limits

Issuer Credit Quality Limit in Percent

United States government U.S. government No limit Sovereign in local currency (includes fully guaranteed agencies) AAA 35.4 AA 21.2 A 10.6 Sovereign in nonlocal currency (includes agencies fully guaranteed) AAA 17.9 AA 6.0 A 1.2 Supranationals AAA 8.9 AA 3.0 A 0.6 U.S. agencies without explicit guarantee—GSEs (Noncallable Federal Home Loan Banks 10.6 debentures only) Fannie Mae 5.3 Freddie Mac 3.5

tion of the benchmark is replaced by the of the rating agencies mentioned above, the overall restrictions on interest rate risk in Adviser must sell the investment within the Section 4.3.ii applied to the value of the 10 trading days following this event. overall mandate. • Sector limits as a percentage of the total (iv) Bond investment guidelines value of the mandate: U.S. Federal Govern- ment Securities, 100 percent; Sovereign • Bonds and debentures without attached in eligible local currencies, including options in eligible currencies. Floating rate fully guaranteed agencies, 100 percent; notes with a maximum final maturity of five Sovereign/Supra-national in eligible non- years and a maximum reset period of up to local currencies, 36 percent, of which 18 per- one year. 144a securities, including private cent can be invested in Supranation- placements, are not considered an eligible als; U.S. Agencies (GSEs) without explicit asset class. guarantee from the U.S. Federal Govern- • Eligible investments must have a debt senior- ment, 11 percent. ity of guaranteed, Senior secured, or Senior. • Issuer limits as a percentage of the total value • At the time of purchase the issuer of an eligi- of the mandate (current face*price/100 as ble asset or the eligible asset itself must be determined on the date of purchase) are rated by at least two of the following rating depicted in Table 14. agencies as: A3 by Moody’s Investor Service, • Investments must have a minimum issue size A- by Standard & Poor’s, and A3 by Fitch of $500 million in accordance with the Ratings. The ratings by two agencies can be index inclusion criterion established by the used if and only if the third agency does not Salomon Smith Barney indices. issue an opinion about the rating status of the issuer and/or issue. The lowest of the avail- • Investments in any security may not exceed able ratings applied by any of the agencies to 10 percent of its issue size. an issuer or issue at the time of purchase will Other considerations prevail over the others. Exception to this stip- ulation is made in the case of U.S. Federal (i) Restrictions on eligible financial markets Government securities. 458. Eligible issuers may not be located in the • In the case of a downgrade after purchase following financial offshore centers described in below the minimum acceptable level by any Table 15. 6 • Colombia 93

Table 15. Noneligible Offshore Financial Centers

Africa Middle East Western Hemisphere Asia and the Pacific Europe

(ii) Restrictions on managers • The net exposure in open foreign exchange 459. Managers may not invest in securities forward and spot operations with any eligible issued by themselves, their parent company, or any counterparty cannot exceed 10 percent of of their affiliates (or any special purpose subsidiary the value of the mandate at any given for which they serve as incorporator, manager, or moment of time. trustee, or in which they are an investor). • The maximum amount of foreign exchange Derivatives operations to be settled on the same date with each eligible counterparty cannot exceed 5 (i) Over-the-counter (OTC) currency forwards percent of the value of the mandate. For coun- • The maximum maturity of foreign exchange terparties with which the manager does not forward transactions cannot exceed four (4) have an enforceable Netting Agreement in months as from the date of transaction. place, the limit shall be 2.5 percent. • The notional amount of all open foreign • Eligible counterparties for forward and spot exchange forward operations may not exceed foreign exchange transactions must have a 50 percent of the value of the account. minimum credit rating of A–1 by Standard & Poor’s, P–1 by Moody’s Investor Service, and (ii) Exchange-traded futures contracts F–1 by Fitch IBCA by at least two of these agencies. 460. The authorized futures contracts and corresponding exchanges are depicted in Table 16. • If any eligible counterparty with which there • The maximum expiration or delivery date is an open position is downgraded below the cannot exceed six (6) months from trade minimum permitted credit rating by any date. of the credit agencies, the position must be closed with such counterparty during • Eligible counterparties for futures contracts: the ten (10) trading days following such broker-dealers designated as futures commis- event so long as the manager holds an sion merchants by an appropriately desig- enforceable netting agreement with such nated self-regulatory organization or govern- counterparty. ment body as required by applicable laws and 94 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT

Table 16. Eligible Exchanges and Futures Contracts

Exchange Contract

Chicago Board of Trade U.S. treasury bond; U.S. 10-year treasury note; U.S. 5-year treasury note; U.S. 2-year treasury note Chicago Mercantile Exchange Eurodollar Eurex Schatz; Bobl and Bund contracts London Financial Futures and Exchange Options Euribor, JGBs and U.S. Treasury contracts Long Gilt Tokyo Stock Exchange JGBs Bourse de Montréal Canadian government bond Stockholmsbörsen Swedish government bond Sydney Futures Exchange Australian government bond; New Zealand government bond Københavns Fondsbørs Danish government bond

regulations. Eligible broker-dealers must be (iii) Restrictions on leverage members of the clearinghouses associated 461. The notional amount of all long futures with the following exchanges: Chicago Board positions shall not exceed the market value of all of Trade, Chicago Mercantile Exchange, assets with a final maturity of less than 397 days. Eurex, and London Financial Futures and Options Exchange. 7 Czech Republic

Developing a Sound Governance and stable, and readily available for use. Positiveness Institutional Framework and stability represent the risk limits, and availability for use ensures liquidity. This is a widely Reserve management objectives and defined objective, and more detailed and con- coordination crete objectives are defined by the management 462. The functions and objectives of holding of CNB depending on the conditions in the mar- reserves determine the reserve management strat- kets. However, even clear objectives are not easy egy of the Czech National Bank (CNB). There are to transform into measures of risk management two main functions of reserves. The first is to serve such as investment horizon, duration, or the best as a source of liquid funds for meeting known and currency composition. potential foreign liabilities and obligations of the 464. From the inception of the Czech koruna central bank. In a wider sense, the obligations of the in 1993 until 1997, it was pegged to a basket of CNB are (i) to meet foreign exchange intervention two currencies, namely, the deutschemark and requirements; (ii) to meet foreign exchange pay- the U.S. dollar. It was easy to define the currency ments of CNB’s clients (of which the government is allocation in terms of the basket while at the same the most dominant one); and (iii) as a “backup” for time avoid accounting losses. On a daily basis, the meeting balance of payments crises. The second central bank bought (rarely sold) hard curren- function is to serve as a form of national wealth, cies. Each reserve currency was divided into two although it is only the central bank that has access to portfolios. One was the investment portfolio, reserves. Foreign exchange reserves are a by-prod- which was fixed in size, and the other was the liq- uct of the monetary and exchange rate policy of the uidity portfolio, which absorbed all inflows. The central bank. Due to the exchange rate regime and risks in each portfolio were managed separately other developments since 1993, foreign exchange with separate benchmarks primarily for duration inflows are being absorbed into reserves. The for- and instruments. During the first three years of its eign exchange inflows in the form of foreign direct existence, the central bank had accumulated sub- investment (FDI) or speculative capital put pressure stantial reserves with the level increasing by on the domestic currency, and by reverse interven- almost nine times. These inflows reduced the tions, the foreign exchange is accumulated in for- overall duration of the reserve to zero, thereby eign exchange reserves of the CNB. affecting returns when the yield curve was 463. The general objective of reserve man- upward sloping. This situation arose because the agement is to ensure that reserves are positive, focus was too much on the individual portfolios

95 96 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT instead of on the entire reserves. There were Institutional framework no automatic procedures that would properly adjust the risk profile of reserves (the overall 466. The CNB, since its inception after the fall duration to development of balance of payment). of the old central planned economy, has per- This policy was changed in 1999 and today all the formed all the functions, including reserve man- limits are set up first at the overall level, and the agement. In the Law of the CNB, international limits of individual portfolios are derived from reserves management is defined as one of the main the overall limits. Furthermore, the limits are activities of the central bank. When carrying out expressed in relative terms (i.e., their absolute this activity, the CNB acts independently of the gov- level is a function of the size of reserve) and the ernment. The reserves are part of the balance future development of reserve size is taken into sheet of the CNB. However, by the same law, all the consideration. property of the CNB, including the reserves, is the 465. It is important to note that except for the state property, which the CNB is mandated to man- central bank’s obligations and liabilities, the for- age. Therefore it is sometimes difficult to point out eign reserves do not reflect the liabilities of any the legal owner of reserves. The CNB can freely other entity. Even the central government’s posi- deal with the reserves and the return on reserves is tion in foreign exchange is treated separately part of the CNB’s total performance. The bank’s from the position of the central bank. If the gov- net profit, after appropriation to certain funds, is ernment would like to either eliminate or hedge transferred to the central government budget. The its foreign exchange position it must deal with the performance report that provides the details of the CNB. The central bank does not consider the gov- CNB’s profits and losses is submitted every year to ernment’s foreign exchange position while struc- the Lower House of the Czech parliament. The turing its reserves. The reason is that it would be above description confirms the central bank’s inde- hard to differentiate between the position of the pendence from the government and parliament, central government and positions of other institu- but also points out that its operations are under tions and companies financed from the central bud- certain supervision of the government and get. For example in the Czech Republic, the Parliament. This kind of supervision creates pres- government owned a company dealing with gas. sure on providing positive and stable return, indi- The company was buying gas from abroad and dis- rectly influencing the risk profile of reserves. tributing it here, meaning that this company’s assets 467. The CNB Board, which is the highest deci- were in Czech koruny while its liabilities were in U.S. sion-making level in the CNB, approves the basic dollars. This was exactly the opposite of the central strategy of reserve management and the permissible bank balance sheet. If the dollar strengthened instruments. The strategy is defined by setting the against the koruna, the central bank booked a profit currency allocation and maximum duration, and and the company booked a loss. This loss had to be stipulating rules for credit and operational risk man- covered from the central budget. The profit of the agement and rules for portfolio management. The central bank is by law transferred to the central bud- executive director for risk management sets the get. Both the central bank and the company have credit limits and the benchmarks (currency bench- separate budgets and it could happen that both mark within 5 percent from the strategic currency have the same position (if the company decides to allocation). The portfolio managers cannot deviate hedge its foreign exchange position). The question from the currency benchmark but can deviate from is whether such a setup is enough to (i) have foreign the duration benchmark up to ±20 percent only. reserves in the same structure as the company’s lia- The portfolio management rules permit deviation bilities, and (ii) allow the company to avoid hedging from the benchmark on credit quality, that is, invest- its liabilities against foreign exchange risk just ment in securities issued by issuers other than those because the loss is compensated by the central included in the benchmark. Two separate depart- bank’s profit. We believed that this is not a manage- ments—the Risk Management and Transactions able situation. Support Department and the Financial Markets 7 • Czech Republic 97

Department—provide for execution and control of Both the systems have been developed internally. reserves management independently of each other. The decision to use internal capacity was made in 1996. Until that time, the portfolio managers, the risk managers, and the settlement staff used PC- Transparency and accountability based applications such as Excel or Lotus. It was a 468. The CNB is not required under any regu- dilemma to choose between externally and inter- lation, including an internal one, to publish details nally built systems. The rationale for choosing the on reserve management. However, it regularly pub- latter was that the CNB did not want to lose the lishes the level of reserves in the “Statistics” section option to incorporate in the future its procedures of its website and, in addition, in response to pub- and methods for dealing, settlement, risk manage- lished standards of the IMF, it decided to change ment, and accounting, which it would probably the structure of the published information on have to do if it chose the external system. Some reserve management in its Annual Report for financial limits also existed and influenced the 2001. The new structure provides more informa- final decision. Working with an external adviser, tion on the results achieved in reserve manage- the basic content and structure of the system was ment rather than on the market conditions as was designed in such a way that it is flexible to future the case until now. The chapter on reserve man- internal changes in terms of organization struc- agement now consists of absolute and relative per- ture, new products and instruments, new risk formance and risk profile of reserves, including methods, changes of the accounting standards, credit, interest, and currency risks. The CNB sub- and similar demands. Until now we have been suc- scribes to the SDDS of the IMF and has been pub- cessful in implementing functions like real-time lishing its balance sheet since the last decade. distribution, deal entry, a database of historical Information on the basic structure of reserves and prices, and a database of approved instruments. foreign liabilities of the CNB can therefore be Within the next two years, we plan to implement accessed. the position keeping functionality and some of the 469. The foreign reserves management as a risk measurement calculations, and connect the whole, including results, trading and settlement front office with the back office system. The advan- procedures, control and check systems, informa- tages of an internal system are that it is flexible and tion systems, and distribution of responsibility are friendly to changes, it is built under a controllable audited every year as part of the overall external budget, and other aspects like backup or emer- audit of the CNB. The central bank does not carry gency installation are less difficult to do from the out special audit of only the reserve management operational point of view. It is, however, unclear if function. The auditor is selected by public tender, these advantages are not offset by the fact that the its term is five years, and both the CNB Board and system is still to be completed and the delay of four the Minister of Finance must approve the selected years limits the implementation of new risk mea- auditor. The performance of the CNB is not surement methods and introduction of new instru- audited by the highest auditing office but, as men- ments. Because the project is in a very advanced tioned above, the performance is submitted to the stage, it was agreed that it should be finalized. But Parliament. The Parliament can either agree or dis- the planning and budgeting process and mainly agree with the report. If Parliament disagrees with the control of the time schedule and budget are the report, the central bank is requested to provide based on the limited capacity of the CNB, which additional information and data. suffers a major handicap in IT projects compared to external and specialized firms. Information systems Human resources 470. There are two major information systems in use in the area of reserve management—one for 471. In the field of the human resources, the the front office and the other for the back office. position of the CNB does not differ a great deal 98 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT from other central banks. On the position of port- monitored. The reporting consisted of the gains folio manager, of which we have six positions, 24 and losses from foreign exchange trading and did men have changed during the last 11 years. A very not include mark-to-market valuation of term similar situation exists in the area of risk manage- trades such as forwards. Six dealers and four back ment, IT support, and open market operation. The office operators performed the entire reserve man- limited financial capacity of the CNB to pay com- agement function. In 1992, the central bank petitive salaries has resulted in most of our staff bought its first security, the U.S. Treasury bill, and being fresh graduates from universities. We would thereafter the risk management department was like to share an interesting and useful experiment established. The main task of the department was that was organized by the CNB together with the liability management, credit risk management, and World Bank in 1991. Through the public tender, 25 benchmarking. With the help of the World Bank men were selected according to their knowledge of and neighboring central banks (the Austrian cen- mathematics, statistics, and English. These individ- tral bank mainly) the new book of limits was cre- uals were offered work in some commercial banks ated based on the financial strength of the banks. and in the central bank, mostly in treasury areas. The formula calculating the limits was a function They had to undergo a three-year course on finan- of the bank’s rating, capital, and assets. The cial markets, instruments, and banking; several approach is currently more sophisticated and the short seminars; and affiliations in commercial term of the investment is considered, as a distinc- banks abroad. The course was financed by the cen- tion is made between the trading counterpart and tral bank and the commercial banks. The partici- the debtor. pants of the course agreed to return the loan, in the event they left the course before completion or Benchmarking process if they left the banks they had joined. Currently, many of the successful participants have reached Interest rate risk the highest levels of management in the central 473. The benchmarking process started in bank, the commercial banks, and financial institu- 1993 with simple benchmarks applied on each of tions in Czech Republic (e.g., vice governor of the the portfolios. They were combinations of general CNB, executive director of risk management of the maturities such as one-week and three- month CNB, board member in Komercni banka and GE LIBOR indices for the liquidity portfolios, and Capital Bank, etc.). two-, three-, and five-year benchmark government notes and bonds for the investment portfolios. The overall duration, calculated ex post, was around 1.5 Establishing a Capacity to Assess and years in the very beginning, though the rationale Manage Risk for choosing this duration is difficult to find out. This approach was changed in 1999 when the new Risk management benchmark representing the entire reserve and 472. The CNB started active reserve manage- two sub-benchmarks for each reserve currency ment in 1991. At that time bank deposits were the were set up. The benchmark is a composite of a only instrument used for investment. Foreign general maturities index for the money market exchange trading was used as an additional source part and the external Merrill Lynch government of return. Risk management was “operated” by index for the medium- and longer-term part of the both the front office and back office. The back yield curve. The most important fact is that the office provided the liquidity structure and the deal- overall duration is derived from the objectives and ers managed liquidity. There also was a book of lim- targets of reserve management. Duration is estab- its for deposits with approved banks but limits were lished based on the requirement that the portfolio “impressionistic” rather than based on any strict should not record a loss in any three-month formula or rule. The interest rate risk, the foreign period. For setting the target duration, historical exchange risk, and the operational risk were not time series of yields on the relevant financial mar- 7 • Czech Republic 99 kets are used. In addition to historical data, the currencies in the international reserves, the CNB methodology for setting duration takes into analyzes the historical time series of the yields on account the current situation in the financial mar- U.S. and European markets and the EUR/US$ kets. If short-term interest rates are higher, the exchange rate. Other factors taken into considera- higher is the interest rate risk that can be accepted. tion include the nature of the domestic foreign By historical statistical data, it is proved that by exchange market, where EUR/CZK is the most using this approach the benchmark performs bet- important and most traded currency pair. Based on ter by 5–10 basis points. This type of reset of the these considerations, the currency composition benchmark is done quarterly and therefore has was set at 73.4 percent for euros and 26.6 percent marginal impact on transaction costs. It is our for U.S. dollars. experience that neither the internal nor the external (public) benchmark would help to decide what Credit risk duration and currency composition is ideal. 475. Credit risk issues can be divided into two groups: issues relating to the selection of the Currency risk issuers of the financial instruments used for 474. The currency risk was until May 1997 rel- reserves management, and issues relating to the atively easy to manage. The koruna was fixed to a selection of business partners for the execution of basket of U.S. dollars and deutschemark, and the reserves management transactions. The sole currency allocation of reserves was identical to the acceptable issuers are the governments and central basket. The U.S. dollar and deutschemark offered banks of OECD countries as well as certain govern- the two most liquid markets and absence of yield ments and international organizations (e.g., the diversification was compensated by the fact that World Bank) and selected banks from those coun- there was no risk of accounting losses when the tries. Moreover, maximum maturity is limited to 10 reserves were valued in domestic currency. In May years for government bonds and 3–6 months for 1997, the CNB decided to float the koruna, and the claims on banks (depending on the bank’s rating). basket as an anchor for reserve currency allocation The credit risk management is based on two sets of ceased to exist. The deutschemark was declared as limits—one for banks and financial institutions as the intervention currency and thus emerged large the CNB’s counterparties, and the other for banks foreign exchange risk because reserves were in and financial institutions as debtors of the CNB. In both U.S. dollars and deutschemark whereas the both the cases, the limits are calculated by using a koruna was floating. Taking into consideration, the formula that is a function of rating, capital, and currency of intervention, benefits of diversifica- size of assets. The minimum rating of banks as tion, and the need to operate in liquid and effi- debtors is individual C, long-term A-, and mini- cient markets, it was decided to hold reserves only mum assets of US$10 billion. Any exception can be in U.S. dollars, deutschemark, and yen and the cur- made only by the Board of the central bank in writ- rency allocation decision was based on the struc- ing with a fixed termination. ture of the balance of payments, that is, 65 percent in deutschemark, 30 percent in U.S. dollars and 5 Operational risk percent in Japanese yen. After three years, due to problems with rating of Japan and its banking sys- 476. Operational risk control is based on the tem, it was decided to hold reserves in U.S. dollars split between responsibilities for execution and for and euros. The allocation of reserves into these the benchmarking and settlement at the highest currencies takes into account various factors, an managerial level. There are two departments cover- important one being investment diversification. ing the reserve management, and their executive The aim is to attain the most stable income possi- directors report directly to the board. One is respon- ble given the exchange rate between the reserve sible for trading and execution, the second is currencies. When setting the ratio between the two responsible for risk management, settlement, nostro 100 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT accounts management, and for IT support. The data lower than the activity of the internal managers and regarding the execution are passed on from the therefore know-how transfer was very limited. front office to both risk management and the back Finally, the fees paid to the managers were higher office. The back office also provides data about the than the relative performance. The benefits of hav- settlements to the risk management. Within the risk ing external managers were that it helped build management department, all the data are compared contact with the asset management industry, pro- and the final position of the bank is created every vided the results of the tests, and confirmed the day. The back office monitors the credit limits right approach to reporting. Despite the negative before the trades are settled, while the risk manage- experience, we are preparing another set of man- ment monitors limits at the end of the day. The dates that would test for U.S. corporate bond port- director of risk management has the right to stop folio management, mortgage-backed securities the settlement if unauthorized trades are submitted (MBS), and foreign exchange trading. These are to the back office. Since the executive directors in the areas of limited capacity of the CNB. charge of execution and control are different, it is 478. The external managers’ portfolios are difficult to manipulate the results. subject to the same performance measurement rules and are used to verify and assess certain procedures that could potentially also be used for Experience with external managers internal reserves management. These externally 477. The CNB has had quite a long experience managed portfolios constitute approximately 2.3 with external managers. The experience has been percent of the reserves. expensive and rather negative. During the last six years there were six mandates. The first two were Operations in efficient markets signed in 1996. The goals at that time were to test if the internal benchmarks were realistic and to bene- 479. The CNB currently invests its reserves in fit from transfer of know-how. However, the exter- only euro- and U.S. dollar-denominated deposits nal managers’ performance was worse than that of and government bonds. Almost by definition these the internal managers and the activity of external markets are considered as the most liquid and effi- managers’ was almost five times lower than that of cient. That is why we do not test and analyze the the internal managers. The mandates were, there- depth of these markets. fore, terminated in 1999. In 2000, another three 480. It is important to note that one of the mandates were signed. This time the target was to weak points of reserve management is that the test new instruments and ways of foreign exchange Czech law is different from the international one, risk management. One mandate was supposed to mainly the U.S. and the U.K. law, according to test Pfandbriefs with a maturity of up to five years; which most of the agreements are governed. The the second one U.S. agencies’ global notes; and the difference means that there are not enough third one’s role was to replicate our benchmark’s lawyers familiar with the international laws and basket of currencies of 35 percent in U.S. dollars there have been very few events where these two and 65 percent euros and to invest on a hedged different types of laws have been tested in the basis in 12 other major government markets. All court. In the event of some legal dispute, the managers ranked among the biggest firms and, uncertainty is high. except for one (FFTW), all managers were chosen by tender. The same reporting requirements were Dilemmas in Reserve Management applied and the amounts under management were around US$100 million. Even here the experience 481. Finally, the following is a list of dilemmas was negative since all managers had sizable prob- that must be solved generally and that the CNB is lems with reporting (in one case two CNB experts currently working on. The first dilemma is cur- had to visit the manager and help with the report- rency allocation versus the fact that the reserve’s ing system) and their activity was, in general, much biggest foreign exchange risk comes from the defi- 7 • Czech Republic 101 nition of reserves (i.e., the reserves are in currency benchmarks during the last six years is by far in favor other than the domestic and accounting cur- of internal managers. So the question is at what level rency). The foreign currency risk in a floating the asset managers should take the market view— exchange rate regime (meaning an unhedgeable when setting up the benchmark or when managing position) is so large and hopefully the horizon so the portfolio? long that it is not clear if it makes sense to deal with 484. There is also another dilemma linked to currency allocation of reserves unless one takes the the benchmark. Today it becomes standard to mea- market view on the reserve currencies’ exchange sure the risks by statistical methods. We can either rates against each other. compare the duration of two “portfolios”—where 482. The second dilemma is how to treat the one is the real portfolio and the second is the ratings. Once the ratings express the probability of benchmark—or we can compare two VaRs—where companies to default and once the central bank one is the value at risk of the real portfolio and the bases the credit limits on rating, the question is second is just the limit number meaning how much should the central bank differentiate between rat- we are prepared to lose. However, apart from the ings of the banks and corporates. Why is it that no risk, benchmarks are used for performance mea- central bank has a problem with depositing funds surement despite the fact that the benchmark may in an AA bank, while only a few central banks not provide the best investment alternative. would purchase AAA corporate debt? Therefore one can eliminate the benchmark port- 483. The other dilemma is the link between the folio for risk measurement purposes and measure benchmarks and their traditional functions. The the performance against an “ex post” calculated benchmark usually serves as the set of risk con- number. The proposal is that every day we can for straints expressed in assets that can be bought in the certain markets and certain instruments (like the market (portfolio of real bonds, index, etc.). U.S. Treasuries market) calculate the best invest- Managing the portfolio against the benchmark can ment opportunity. And this best investment oppor- mean the effort to beat the benchmark or the effort tunity would be declared as the benchmarked to beat the market within the limits. Beating the performance for the previous day. To avoid the sit- benchmark means that even a wrong investment uation where the benchmark consists of one bond, decision may be considered in a relative sense as a some minimum holdings would have to be applied. value addition, even if the “benchmark’s” invest- Also, calculating the best investment out of several ment performs worse. Beating the market means hundreds of bonds might be technically difficult. that the portfolio manager is able to exploit the mar- Therefore the best investment calculation would ket opportunity and by definition would perform be done on a narrow set of bonds (instruments) better than the benchmark. Our external managers that would best represent the market moves. tried predicting the yields within certain horizons; 485. If the above methods are put together, the they went short or long and took maximum dura- new benchmark would consist of VaR limit and tion positions, while our internal managers focused return of the best overnight (alternatively over a primarily on replicating the benchmark. The com- certain period) investment alternative and no parison of these two approaches applied on our “benchmark as portfolio” would be needed. 8 Hong Kong SAR

486. This paper discusses the principles and stability can be performed with a higher degree of practices of reserve management in the Hong professionalism and continuity, in the lead-up to Kong Monetary Authority (HKMA). It further out- 1997 and beyond, to command the confidence of lines the framework of our risk management sys- the people of Hong Kong and the international tem, which helps to achieve our statutory roles financial community. and our long-term investment objectives in a risk- controlled manner. Statutory role of the Exchange Fund

489. The Exchange Fund’s statutory role, as Developing a Sound Governance defined in the Exchange Fund Ordinance, is pri- and Institutional Framework marily to safeguard the exchange value of the currency of Hong Kong. Its functions were extended The Exchange Fund of Hong Kong with the enactment of the Exchange Fund 487. Hong Kong’s Exchange Fund was estab- (Amendment) Ordinance of 1992 by introducing a lished in 1935 by the Currency Ordinance (later secondary and subsidiary role of promoting the renamed the Exchange Fund Ordinance). Since its stability and integrity of the monetary and financial inception, the Exchange Fund has held the back- systems, and maintaining Hong Kong as an inter- ing to the note issues of Hong Kong. In 1976, the national financial center. role of the Exchange Fund was expanded. The assets of the Coinage Security Fund, which held the Objectives of reserve management backing for coins issued by the government, and the bulk of foreign currency assets held in the gov- 490. The investment strategies for the ernment’s General Revenue Account were trans- Exchange Fund should at all times be consistent ferred to the Exchange Fund to enhance its ability with the objectives of the Exchange Fund. With the to regulate the exchange value of the Hong Kong primary statutory purpose to safeguard the dollar. exchange value of the Hong Kong dollar, coupled 488. On April 1, 1993, the HKMA was estab- with the need to repay the fiscal reserves money lished by merging the Office of the Exchange Fund deposited with the Fund on demand, there is a with the Office of the Commissioner of Banking. need to maintain a high degree of liquidity of the This was done to ensure that the central banking Exchange Fund assets. As the reserves represent a functions of maintaining monetary and banking store of value for the future, a secondary objective

102 8 • Hong Kong SAR 103 is to maintain the long-term purchasing power of • a portfolio of liquidity reserves to be avail- these reserve assets. The four key objectives for the able whenever required to meet market management of the Exchange Fund are: operational needs; and • to preserve capital; • an investment portfolio to preserve the value of the Exchange Fund for future gen- • to ensure that the entire monetary base erations of the people of Hong Kong. will be at all times fully backed by highly liquid short-term U.S. dollar-denominated 494. The investment management styles for securities; these three portfolios were different. For the • to ensure sufficient liquidity for the purpose hedge portfolio, a mix of money market and fixed of maintaining monetary and financial sta- income securities denominated mainly in U.S. dol- bility; and lars was held to match the maturity profile of the liabilities. The prime consideration in choosing the • subject to the above, to achieve an invest- investments for this portfolio was the credit stand- ment return that will preserve the long-term ing of the issuers; this was to provide maximum purchasing power of the assets. security for the assets and ensure that holders of the Exchange Fund’s liabilities (i.e., Exchange Institutional framework Fund Bills and Notes) have the greatest protection and assurance that those liabilities will at all times 491. The authority for the investments held be honored. by the Exchange Fund rests with the Financial 495. For the liquidity tranche, the Exchange Secretary, who consults with the Exchange Fund Fund held prime liquid U.S. dollar-denominated Advisory Committee (EFAC) to establish the long- money market securities. The choice of U.S. dol- term strategic investment direction of the lars is partly because the U.S. dollar remains the Exchange Fund. base currency for the foreign exchange markets of 492. While the long-term strategic investment the world and for the HKMA’s market operations, strategy is set by the EFAC, the day-to-day manage- and partly because the U.S. market is the largest ment of the Exchange Fund is carried out by the and most liquid in the world, enabling a very large Reserves Management Department of the HKMA. sum of funds to be mobilized, if required, without In carrying out its responsibilities, the Reserves disrupting the global financial market. Management Department operates under the del- 496. The investment portfolio was a multicur- egated authority from the Financial Secretary and rency portfolio invested in the major money mar- within investment policy approved by the EFAC. kets and fixed income markets of the world, with a small holding in foreign equities. The majority of the assets was denominated in U.S. dollars, reflect- Management of the Exchange Fund ing the fact that our base currency is linked to the Portfolio segregation before October 1998 U.S. dollar. 493. Prior to October 1998, the HKMA identified three main operational functions of the assets Portfolio segregation after October 1998 held in the Exchange Fund. The three operational 497. In September 1998, the Monetary Base portfolios were: was redefined to include Exchange Fund Bills and • a portfolio of assets to act as a hedge against Notes in addition to Certificates of Indebtedness, coins the interest-bearing liabilities of the in circulation, and the aggregate clearing balance Exchange Fund (i.e., deposit placements maintained by banks with the HKMA. In order to from the Hong Kong Government), to enhance the transparency of the operation of the ensure that the Exchange Fund can at all currency board arrangements, a Backing Portfolio times meet all of the claims upon it; was created by designating certain asset and liabil- 104 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT

Table 17. Investment Benchmark of the Exchange Fund

Investment Benchmark Investment Benchmark Since 1999 Before 1999

Bonds 80% 90% Equities 20% (Hong Kong: 5%) 10% (Hong Kong: 0%) Currencies 80% U.S dollar bloc 70% U.S. dollar bloc 15% European bloc 20% European bloc 5% Japanese yen 10% Japanese yen

ity items in the Exchange Fund as those specifically 501. Having regard to the above considerations, related to currency board operation. a new investment benchmark was constructed for 498. From October 1998 to date, the Exchange the Exchange Fund in 1999. This investment bench- Fund is managed in only two distinct portfolios, mark has been in use since then. The principles and namely the Backing Portfolio and Investment methodology to construct this investment bench- Portfolio. The Backing Portfolio was established mark are described in further detail in paragraphs such that the monetary base is at all times fully 538–542. The new investment benchmark defined backed by foreign reserves and that the changes in in January 1999 and the previous benchmark are the aggregate size of the monetary base corre- presented in Table 17 in simple terms. spond to the inflows and outflows of funds. Assets 502. Over the years, the Exchange Fund has in the Backing Portfolio are therefore short-term, embarked on a greater use of the long-term capital highly liquid U.S. dollar-denominated interest- markets by diversifying into new markets and bearing securities to fully back the monetary base. instruments. As shown in Table 18 below, the cur- 499. The balance of the assets of the Exchange rent strategic investment benchmarks permit the Fund that constitutes the Investment Portfolio is Exchange Fund to invest in greater numbers of invested in OECD bond and equity markets to pre- bond, equity, and currency markets than previously serve the long-term purchasing power of the allowed in 1995. Fund’s value for future generations of Hong Kong. Adequacy of Hong Kong’s foreign Redefining investment benchmark currency reserves 500. In 1998, three events led us to conduct, at 503. As of end March 2002, the foreign currency the end of the year, a major revision of the invest- reserve assets stood at US$110.2 billion, which ment strategy of the Exchange Fund. placed the Hong Kong SAR Government’s foreign reserves as the fourth largest in the world after • First, the decision was taken to allow the fis- Japan, Mainland China, and Taiwan. These reserve cal reserves, from April 1998, to earn a assets represent over seven times the currency in cir- return that is the same as that for the Exchange Fund as a whole. • Secondly, the HKMA purchased a large Table 18. Permissible Markets for Investment of the Exchange Fund amount of Hong Kong stock in August 1998 through market operations. 2002 1995 • Thirdly, the assets of the ex-Land Fund were Bond markets 26 19 merged into the Exchange Fund in Equity markets 23 1 Currency markets 21 13 November 1998. 8 • Hong Kong SAR 105 culation, or 43 percent of Hong Kong dollar M3, US$15 billion. Thirdly, we made the monetary base one of the highest ratios in the world. Hong Kong’s much bigger in order to reduce the sensitivity of substantial official reserves provide backing for the interest rates to inflows and outflows of funds. This Hong Kong dollar and offer a valuable—and grow- involved committing another US$13 billion as ing—source of security for future generations. additional backing. 504. Experience suggests that Hong Kong 508. It should be noted that we had, in fact, needs considerably more in foreign reserves than mobilized the foreign reserves amounting to a few the bare theoretical minimum to maintain currency times the then-theoretical minimum requirement stability. Despite the fact that we have probably the of US$12 billion in the foreign reserves for the pro- most robust exchange rate system—by design and vision of 100 percent backing to the monetary as a result of our continuous efforts to strengthen it base. We were able to do so without causing a ever since its establishment in October 1983, it is breakdown of confidence in monetary and finan- also true that our exchange rate system, character- cial management in Hong Kong on the part of the ized by Currency Board Arrangements, only international financial community, to a large requires our monetary base, currently at HK$233 extent because we had significantly more foreign billion, to be fully backed by foreign reserves of reserves in the Exchange Fund than the sums about US$30 billion at an exchange rate of 7.8. It is, mobilized and we had no liabilities other than the however, incorrect to take the view to consider this fiscal reserves deposited there. theoretical minimum as all we need in foreign 509. A strong position of foreign reserves can reserves. safeguard the ability of the HKMA to deliver, when 505. The crucial lessons from the Asian finan- necessary, the statutory purpose of the Exchange cial turmoil in July 1997 and the excessive volatility Fund, which is to defend the exchange value of the that rocked the financial markets in 1998 high- Hong Kong dollar and to maintain the stability and lighted the importance of strong reserves, prudent integrity of Hong Kong’s monetary and financial management of the Fund, and the critical role of systems. This also supports our role as the lender of risk management in the investment process. last resort. In order to maintain the stability of 506. During the initial attack on our currency in Hong Kong dollars under the Currency Board October 1997, the robustness of our exchange rate System, the size of foreign reserves we need is system automatically transferred the pressure on the probably “the more the better.” This foreign cur- exchange rate to our interest rates, without the need rency reserve involves a natural buildup process to use foreign reserves in the Exchange Fund other through inflow of capital, investment gains, or than those dedicated to backing the monetary base. increases in fiscal placements. Reflecting the severity of the currency attack, our overnight interest rate went up for a short while to Transparency and accountability over 200 percent, and interest rates for long-term money also rose sharply. This caused a lot of pain, to 510. Hong Kong’s Legislative Council defines the community and speculators alike. and limits the HKMA’s powers and responsibilities, 507. In August 1998, the attack on the cur- and sets out the Monetary Authority’s accountabil- rency came again and was many times more severe ity to the Legislative Council under Article 64 of than in 1997. In that incident, we sold foreign the Basic Law. But the HKMA also recognizes a reserves of about US$10 billion for Hong Kong broader responsibility to the community of Hong dollars, in anticipation of the drawdown of fiscal Kong SAR, and a duty to promote an understand- reserves deposited with the Exchange Fund, and ing of our role and objectives, and to keep our- relieved some of the pressure on the exchange rate selves informed of community concerns and open and obviated the need for a repeat of the very to public debate. sharp interest rate hike of 1997. We also sold large 511. To this end, the HKMA pursues a policy of sums of foreign reserves for Hong Kong dollars for transparency and accessibility. This policy has two the purchase of Hong Kong stocks equivalent to main objectives: 106 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT

Table 19. Major Milestones to Enhance the Transparency of Disclosure

Year Measures

1992 • Started publishing the accounts of the Exchange Fund annually. June 1995 • Started publishing the accounts of the Exchange Fund biannually. September 1995 • Started publishing quarterly figures on foreign currency assets. January 1997 • Started monthly disclosure of foreign exchange reserves. January 1999 • Started publishing monthly International Reserves in accordance with IMF’s Special Data Dissemination Standard (SDDS). • Started publishing monthly data on Analytical Accounts of the Central Bank in accordance with IMF’s SDDS. • Started publishing monthly Abridged Exchange Fund Balance Sheet and Currency Board Accounts. April 2000 • Started publishing Template on International Reserves and Foreign Currency Liquidity in accordance with IMF’s SDDS.

• to keep the financial industry and the gen- information available for general public consump- eral public as fully informed of the HKMA’s tion in print, through the press, on the Internet, work as possible; and and in our programs of educational briefings, seminars, and large-scale exhibitions. • to ensure that the HKMA is in touch with, 514. The considerations of market sensitivity, and responsive to, the community that it commercial confidentiality, and statutory restric- serves. tions on disclosure of confidential information will, of course, place some limits on the amount of Measures to increase transparency of disclosure material we can make public. Given the increasing transparency and the extremely limited discretion 512. Prior to 1992, the accounts of the over the currency board arrangements, which Exchange Fund were confidential. However, in draw their credibility from a strict rule-based sys- keeping with the commitment to greater trans- tem, a certain constructive ambiguity is also neces- parency in disclosure, the government started pub- sary if we are to have the flexibility to deal lishing the accounts of the Exchange Fund decisively with sudden crises. Within these limits, annually in 1992. Biannual accounts have been we are committed to developing our policy of published since June 1995, and headline figures transparency, and to increasing the quality and for the foreign exchange reserves have also been comprehensibility of the materials we put out for released monthly since January 1997. public consumption. 513. Over the past years, we have done a great deal to advance the policy of transparency and accessibility. The major milestones to enhance the Establishing a Capacity to Assess and transparency of disclosure are displayed in Table Manage Risk 19. This applies to technical matters such as the increased transparency of the currency board sys- Delegation and control of investment tem, the daily publication of the size and composi- management of the Exchange Fund assets tion of the Monetary Base, and the virtually real-time publication of the Aggregate Balance of 515. The delegation of investment authority the Banking System. In addition, we extend the for managing the Exchange Fund assets is achieved 8 • Hong Kong SAR 107 through a 3-level framework, covering three basic Asset Allocation Meeting of senior executives and types of investment decisions: reserves management staff is held to review invest- • Long-term strategic decisions controlled by ment strategies for the overall Exchange Fund and the EFAC; the allocations to both internal and external managers as well. • Medium-term market decisions delegated to 520. The overall EF assets will be consistently the senior management down to the tested by Value-at-Risk (“VaR”) and scenario stress Executive Director level; and testing, which are used to quantify the market risks • Short-term trading and anomaly trading inherent in the portfolios under normal and decisions delegated to portfolio manager extreme adverse market conditions. Extreme levels. adverse market events include a stock crash and drastic bond yield shift in 1987 and currency crisis 516. This 3-level framework of investment deci- in 1994. sion is reviewed every year to reflect any required 521. Using a market-based risk management change or amendment to the control and delega- model, a weekly report to evaluate both absolute tion structure. and relative (to benchmark) VaR is made at a 95 percent confidence level for a 1-month horizon. Risk management framework The calculation of expected market risk/loss takes into account the price volatility of all asset classes, 517. In developing the risk management frame- market segments, and correlation across markets work, the HKMA draws upon the best market prac- given a specified time horizon and decay factor. In tices of asset management in the private sector and addition, VaR in both U.S. dollar and percentage applies these practices in determining the parame- terms is monitored to ensure that the Exchange ters for managing risks. The risk management Fund is not unduly exposed to market risk at any framework serves to achieve two main objectives: point in time. • identify and assess the financial and opera- 522. Stress testing is employed to test the tional risks; and impact of a simultaneous recurrence of the worst • allow the management of risks within accept- equity, bond, and currency market crashes in the able parameters and levels. past 20 years on the total Exchange Fund assets. 523. Both VaR and scenario stress test reports 518. The Risk Management and Compliance are submitted to the EFAC meeting for review. Division is responsible for day-to-day monitoring and control of six major types of financial and operational risks, namely: Credit risk control (i) Market Risk; 524. With the delegation by EFAC, the Credit (ii) Credit Risk; Review Committee (“CRC”) is established to be responsible for the following objectives: (iii) Liquidity Risk; (iv) Currency Risk; • Monitor credit risks within parameters set by credit policy (v) Settlement Risk; and (vi) Operational Risk. • Review credit policy to meet the new investment policy requirements and to control counterparty or issuer credit risks Market risk control • Evaluate and set the credit limits for issuer, 519. Overall market exposure is defined by the bank, counterparty, and country Exchange Fund’s Preferred Neutral Position (“PNP”) and tactical deviation limits for each asset 525. The Risk Management and Compliance class, market segment, and currency type. A weekly Division supports the credit analysis and assessment 108 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT based on market-accessible information. The con- Currency risk control trol mechanism is segregated into 2 major areas: 529. The overall currency risk for the Exchange • Centralize the credit assessment approach Fund can be determined with the combination of by standardizing the analytical framework in the benchmark currency mix and corresponding terms of economic and financial perfor- deviation limits. The PNP of currency mix strategi- mance, debt ratio, liquidity, capital, asset cally dictates the long-term currency exposure for size, and rating assessment by international the overall Exchange Fund assets. This has taken credit agencies; and into account the long-term return and risk profile of currency as an independent asset class, together • Centralize credit line allocation for internal with all investment constraints such as the mainte- and external managers via CRC. nance of adequate U.S. dollar assets to back the 526. Day-to-day credit exposure control on monetary base under the Currency Board System. individual issuer, group level, and country levels is 530. A list of authorized currencies is deter- conducted through a pre-deal checking process for mined on the basis of underlying investment mar- internally managed assets. For external managers, kets and the liquidity condition of each currency. we appoint the custodian managers to perform the At portfolio levels, we restrict the currency mix in investment and credit compliance checking func- accordance with their respective investment tions on behalf of the HKMA, based upon the lim- requirements and constraints. In the case of the its that we segregate for external managers. At Backing Portfolio, it is restricted to U.S. dollar day-end, it is required to perform overall compli- assets. Meanwhile, the currency exposures at other ance checking on investment activities against the externally and internally managed investment credit and investment limits defined in Exchange portfolios are subject to their underlying invest- Fund Credit Policy and Investment Policy as well. ment benchmark and deviation limits.

Liquidity risk control Settlement risk control 527. The Backing Portfolio was established in 531. In order to mitigate settlement risks, October 1998 to ensure that the monetary base is we standardize settlement instructions together at all times fully backed by U.S. dollar assets. The with using delivery versus payment (for bonds assets held in this portfolio should be securities and equities), and payment versus payment meth- that have the highest liquidity and credit quality, ods to reduce the potential loss from settlement and should at all times be available to meet the failure. convertibility obligation (e.g., HKMA sells US$1 532. For externally managed assets, we use reli- for HK$7.80) to all authorized institutions that able and reputable master custodians to centralize maintain accounts with the HKMA and have access and control the settlement workflow of externally to the local Real Time Gross Settlement system. managed assets by portfolio types in order to gain 528. In addition, liquidity control measures operational efficiencies. include the following major limits:

(i) Set percent limit of foreign currency Operational risk control assets to be converted into cash within 2 and 5 working days. 533. A separation of reporting line to senior management between settlement and dealing func- (ii) Set percent limits of overall Exchange tions can achieve better control by avoiding poten- Fund assets for deposit and for term tial fraud or collusion of official reserve assets deposits over 1-month horizon. among front desk dealing staff. (iii) Set bond issue or program size limits to 534. Straight-through processing starts with ensure efficient liquidation without dis- deal input, trade instruction, reconciliation of deal rupting the markets. confirmation, and finally to dispatch of standard- 8 • Hong Kong SAR 109 ized settlement instructions (e.g., SWIFT mes- (i) to preserve capital, it is required to set a sages). After the deal is entered into the system, high probability level that returns in the operational processing requirements, including short-, medium-, and long-term will not report generation, account entry posting, and set- be negative. tlement, are electronically conducted in an auto- (ii) to ensure that the entire monetary base is matic and uninterrupted workflow process. at all times fully backed by liquid U.S. dol- 535. Money market or repo facility is estab- lar assets, it is required to set a minimum lished at every nostro account with corresponding percentage of total portfolio holdings in foreign commercial banks or central banks to rein- liquid U.S. dollar assets. vest the residual idle cash balance accumulated at the cutoff time of the domestic market. This is to (iii) to preserve the long-term purchasing ensure even the unexpected account balances due power of the assets, it is required to set a from unsettled trades are fully invested. reasonably high probability that the 536. Contingency plans for crucial modules expected benchmark portfolio return and off-site backup systems outside the main office shall exceed the long-term domestic infla- are established to control and mitigate system fail- tion rate. ure risks due to unexpected system breakdown or (iv) To measure the downside risk below the power failure or any disaster situation. long-term domestic inflation level, it is 537. Regular and firm-wide checking of the required to set the annualized shortfall in communications network, including the internal e- return against the long-term domestic mail system, is conducted to avoid communication inflation rate at an acceptably low proba- failure risk. bility level.

Determination of investment benchmark and To determine the permissible markets and tactical deviation limits instruments 538. The investment benchmark, which 540. The investment management of Exchange directed the long-term strategic investment, is Fund assets is expected to be conducted in well- expected to meet the following investment objec- established markets that have sufficient breadth and tives of the Exchange Fund: depth to ensure that transactions can be efficiently absorbed in the market without undue effects on liq- (i) to preserve capital; uidity and the availability of funds. This is particu- (ii) to ensure that the entire monetary base larly the case for central banks, including the will be at all times fully backed by highly HKMA, as most transactions are typically in decent liquid short-term U.S. dollar-denomi- size. We assess the liquidity of each market and nated securities; instrument by the following factors: (iii) to ensure sufficient liquidity for the pur- (i) bid/offer spread at both normal and cri- pose of maintaining monetary and finan- sis conditions. cial stability; and (ii) dealing size at both normal and crisis sit- (iv) subject to (i)–(iii) above, to achieve an uations. investment return that will preserve the (iii) total portfolio holdings as a percentage of long-term purchasing power of the assets. daily market turnover. (iv) availability of repo market for each instru- To quantify investment objectives and constraints ment type. 539. The investment objectives and constraints 541. Since the monetary base requires suffi- must be quantified for the optimization process: cient backing by U.S. dollar assets under the cur- 110 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT rency board system, we maintain a minimum per- lyze the risk contribution of each asset class and centage of total Exchange Fund (EF) asset hold- market type. This process serves the following 3 ings in U.S. Treasury products to ensure adequate purposes: liquidity. This prudent policy has proven to be (i) identify principal sources of risks by asset essential based on the international crisis situations classes and market segments. experienced in the past several years. 542. In summary, the Exchange Fund invest- (ii) ascertain that the risk exposures in the ment objectives are quantified into expected optimal portfolio correspond to positions return, risk, and parameters of capital preservation where we would like to take risk. and liquidity requirements. These parameters (ii) ensure that the portfolio risk is as evenly form the critical investment performance criteria balanced as possible across different in establishing the optimal new PNP, which is major international markets, including therefore expected to achieve the Fund’s currency types. risk/return objectives and other trade-offs within 547. The risk decomposition of the investment the framework of a long-term passive investment benchmark is based on a risk contribution frame- policy. work.34 548. Although the investment benchmark rep- Key features of optimization model to derive our resents an optimal asset mix for long-term invest- investment benchmark ment, reoptimization is required under the following scenarios: 543. A market well-tested optimization model is used to construct the optimal mix of asset alloca- (i) change of investment objectives and tion. Such a model overcomes the traditional constraints. mean-variance optimization method, which suffers (ii) failure to meet the critical investment per- from a tendency to create unbalanced portfolios formance criteria arising from structural for closely correlated assets such as bonds. change of market performance and 544. Due to stringent liquidity requirements for volatility structure. all the securities, only the more liquid and developed markets are included in the list of permissible asset markets. All permissible asset classes and cur- Derivation of tactical deviation limits rencies are included to conduct the optimization 549. The evaluation and selection of the invest- process. Historical returns and correlation across ment benchmark are based on the framework of all market segments are applied to find the risk critical performance criteria with return, volatility, matrix, and such a risk structure is assumed to hold and capital preservation parameters. We use the constant to derive expected portfolio volatility. No same framework to stress test the tolerance of the expected return for individual asset class is pro- Exchange Fund PNP to additional volatility. jected. We apply long-term equilibrium returns, Through incremental additional annual volatility, which are consistent with market clearing levels for we establish that the PNP is able to tolerate an addi- the global market-cap weighted portfolio. tional level of annualized volatility and still pro- 545. Institutional investors will typically set a duce an acceptable performance when compared target portfolio risk for the investment benchmark. to the critical performance criteria. Instead of using a specific portfolio risk target, we test the optimal asset allocation against a set of critical investment performance criteria, which effec- 34Risk Contribution tively reflects the control of overall portfolio risk of nth asset = ______h(n)*Vector of Marginal Volatility , level. σ 546. With the calculation of the total portfolio where h(n) is the nth element of the position vector of Marginal Volatility = Σh/σ. (Σ: Covariance matrix) risk of investment benchmark, it is required to ana- ( h: Portfolio position vector). 8 • Hong Kong SAR 111

550. With the established overall tracking (iii) Currency effect error, a risk-based approach is used to calculate the (iv) Benchmark adjustment effect. permissible tactical deviations for short- to medium-term trading for currency composition, allocation by asset class, allocation by market Portfolio management effect (i.e., portfolio active within each asset class, and duration of each bond return) market. This method is essentially a VaR approach 554. This is the active return at portfolio levels used by institutional investors to control the risks relative to their benchmarks. From end of 1999, we arising from trading positions. This is also consis- began to use a market-based multifactor model to tent with the risk/return optimization method analyze the active returns of bond portfolios by fac- used to construct the Exchange Fund PNP. tors of duration, curve steepness, curvature, and 551. All things being equal, the most volatile selection effect. asset would logically be given the least permissible 555. In the near term, another market based deviation. In calculating the deviations, we adopt a multifactor model is used to identify the sources of conservative approach and apply the permissible active returns from active equity mandates. The risk deviation for the most volatile market segment as factors of equity analytical models are as follows: the maximum permissible deviation for the asset class containing such market segment. (i) U.S. equity model—Market cap, EPS ratio, BP ratio, net earnings revision, EPS torpedo, historical beta, price reversal. Performance measurement framework of the Exchange Fund (ii) Global equity model—Market cap, EPS ratio, BP ratio, earnings growth, average 552. The monthly performance attribution dividend yield, long-term debt/asset analysis identifies the out-/under-performance of a ratio, volatility of ROE, volatility of EPS. portfolio compared to its investment benchmark. 556. In addition, we internally maintain It decomposes total active return into various return-based attribution for investment managers return attributes relative to the benchmark return. with the following framework: Based on our current setting, attribution analysis is divided into 2 levels: (a) fund allocation effect, (b) (i) Alpha [α]: residual return component, portfolio management effect. Each of them is fur- i.e., to measure the ability of managers in ther divided into various active return attributes the selection of securities. according to the style of management, selection, (ii) Down-market Beta [β]: to measure port- manager skill, and other factors. folio exposure to benchmark in a down- market. γ Fund allocation effect (i.e., overall asset (iii) Gamma [ ]: to identify a manager’s skill allocation effect) in managing market exposure against benchmark at times of down-market and 553. Fund allocation effect is the contribution up-market. to return due to the management’s withdrawal (iv) Information Ratio (IR): Measurement of from or increased allocation to different (external risk-reward trade-off given an investment or internal) portfolios or investment types of port- manager’s added value and excess volatil- folios. At the moment, we have over 10 types of ity over benchmark. portfolios in different investment benchmarks. Under the fund allocation effect, there are 4 con- 557. We apply some quantitative methods such tribution factors, namely: as the Sharpe ratio and an information ratio to respectively measure the portfolio risk-adjusted (i) Asset allocation effect return and assess the effectiveness of use of infor- (ii) Country weighting effect mation by managers. 112 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT

Challenges of reserves management in the ment instruments, such risk has become even HKMA more evident. Stress risk management can be considered to address the above issue. This is to deter- Increased mobility of international capital flows mine risk capital based on a preset high standard 558. The world economy becomes increasingly deviation event and a covariance matrix with the more integrated. This is evidenced by global syn- assumption of perfect correlation across all mar- chronization in financial markets and increased cap- ket segments. The accumulated risk capital allo- ital flows among countries, particularly from cation should then be limited to a percentage of industrialized into emerging economies. Most cen- total capital size of a fund to avoid undue market tral banks, if not all, are therefore facing potentially exposure. large and abrupt inflows and outflows of capital, especially portfolio flows. Extreme care is needed in Use of derivatives to implement reserve managing their reserves and, in some cases, to management strategies tighten the liquidity criteria to quickly respond to external shocks. This has disturbed the manage- 560. In the long term, the supply shrinkage of ment of foreign exchange reserves and appeared to government securities due to improving budget be contradictory to the diversification requirement positions will cause central banks to keenly look for suggested by the portfolio management theory. viable investment alternatives. While many central banks remain very cautious, some central banks have made use of derivatives to better manage mar- Global financial market synchronization ket risk and liquidity risk. On the asset side, through 559. The value-at-risk approach used by the the use of futures, it is possible to achieve duration HKMA to measure the expected market risk is strategy while maintaining a better liquidity profile. based on assumptions of a normally distributed On the liability management side, central banks return series and a stable risk structure, i.e., stable responsible for this have made extensive use of return correlation across asset classes and markets interest rates and currency swaps for issuing debt to over time. These notions tend to underestimate adjust the risk characteristics of their portfolios. The actual market loss due to a breakdown of “nor- use of derivatives requires more advanced risk man- mal” price behavior across market segments at agement and IT system development to support the times of stress events. With global market syn- transactional processing, account posting, and over- chronization and increased complexity of invest- all portfolio risk assessment. 9 Hungary

Reserve Management Objectives and would not like to build reserves for the pure pur- Coordination pose of wealth accumulation. As stated above, the NBH aspires to manage reserves so as to help Reserve management objectives achieve the goals of monetary policy efficiently, 561. According to the Central Bank Act, one of meet the requirements of debt service, and, at the the basic responsibilities of the National Bank of same time, try to optimize the return on the Hungary (NBH) is the management of foreign reserves without jeopardizing the above-mentioned exchange reserves. The primary purposes of man- goals. aging foreign exchange reserves, as for every central bank, are the following: Institutional framework • support for the monetary policy (interven- 563. The reserve management policy of the tion), NBH is defined by the Monetary Council (MC). The • transactional purposes (supporting debt MC decides on the currency composition of foreign management, controlling crisis situations), reserves, and interest and credit risk exposure. It approves the applied investment instruments and • wealth management objectives. the list of business partners. Furthermore, accord- 562. In the past couple of years, with the eco- ing to the investment guidelines and the return nomic development of the country and with the requirements, the MC determines the benchmark improvement of credit ratings and debt service portfolio. The MC monitors the results of the ratios, the direct transaction objectives—such as reserve management activity on a quarterly basis. supporting the repayment of debt—have been 564. While the MC is a strategic decision-making gradually losing their weight. At the same time, sup- body, the Asset and Liability Committee (ALCO) is port of the monetary policy has become the princi- responsible for tactical decisions related to reserve pal reserve management objective. One way to management. The ALCO holds a meeting at least ensure the credibility of the exchange rate system is once a month. The ALCO makes decisions on the to hold an adequate level of reserves that can sup- deviation from the strategic benchmark and on the port the inflation targeting system in the form of modification of operational limits. The ALCO also intervention, if needed. Although the cost of hold- monitors closely the activity of the reserve manage- ing reserves has significantly decreased with the ment unit in charge of the implementation of daily country’s improving credit ratings, the NBH still investment and liquidity management operations.

113 114 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT

Figure 7. Hungary’s Five-Year Credit Spread reserves via foreign exchange market operations. over Bund, 1994 –2002 In addition, the costs of holding foreign exchange reserves (spread between borrowing and invest- Spread over Bund (in basis points) ment rates) are, although decreasing, still negative. 300 These facts must be taken into consideration when 250 determining the adequate size of reserves. 569. Around 30 percent of the state debt is in 200 foreign currency. The primary source of the annual EUR 2–3 billion debt service is the NBH’s 150 foreign exchange reserves. Hence, the size and 100 currency structure of the debt service are an important input to set the reserves management 50 policy. 570. The country’s primary objective is to join 0 1994 96 98 2000 02 the European Union and then the Economic and Monetary Union. The NBH is already running a quasi-ERM-II exchange rate regime with no capital 565. An independent risk management unit is controls. The currency is pegged to the euro with a responsible for the evaluation of daily business plus/minus 15 percent fluctuation band. In order activities and monitors compliance with the opera- to give credibility to the band, the NBH must have tional limits. This unit is in charge of the elabora- adequate reserves in the current “quasi” and later tion of the risk management policy and the in the real ERM-II system. reporting systems the senior management. The unit also sets up and maintains the benchmark Optimal currency structure indices for the portfolio managers. 571. Prior to 1999, the NBH was responsible for the foreign currency borrowing of the country. Determinants of reserve management policy So taking the gross currency structure first, we 566. There are four special country character- match the foreign currency liabilities of our bal- istics that guide Hungary’s reserve management ance sheet. This means we hold EUR, US$, and JPY policy: in our foreign exchange reserves. 572. In taking the net open currency position • small open economy against the domestic currency, the Hungarian • emerging/converging country Forint, we take into consideration the following factors: • relatively high foreign currency debt • currency of intervention; • quasi-ERM-II exchange rate regime with no capital controls • HUF basket; 567. Hungary is a small open economy with an • orientation of external trade; and export/GDP ratio above 60 percent. This means • macro level asset-liability considerations. that exchange rate developments have substantial influence on inflation. Hence, to run a successful 573. As stated above, Hungary is running a exchange rate policy, Hungary must have sufficient quasi-ERM-II system, where the central parity of foreign exchange reserves. the HUF is 100 percent pegged to the euro. As a 568. Hungary is an emerging/converging consequence, more than 80 percent of the inter- country, with fast developing but still less liquid bank HUF/foreign currency spot market turnover domestic financial markets. This means that the is against the euro. This means that the natural central bank cannot easily build up and down intervention currency is the euro. 9 • Hungary 115

574. Hungary is becoming increasingly inte- one-year liabilities of the whole country. Also, the grated into the European Union. Hence, the cur- level of reserves must be at least as high as the mon- rency structure of external trade, especially in the etary base. Behind this, one can find the argument competitive sector, is more denominated in euros. that to defend the currency, the system could be at This is also true for foreign direct investments and any time theoretically converted into a currency portfolio investments. board. 575. The currency benchmark for foreign cur- 579. To keep the level of reserves in a desirable rency debt of the government, managed by the range, we try to quantify the foreseeable and State Debt Management Office, is 100 percent potential cash flows. Debt principal and interest euro. To provide a hedge on a macro level, we take payments account for the biggest part of foresee- this fact into consideration when determining the able outflows, amounting to $2–3 billion in the first optimal net currency structure to the extent it does part of this decade and falling sharply in later not conflict with other objectives of holding years. The government’s foreign currency borrow- reserves. ings are the biggest potential inflows. The NBH 576. To summarize, the euro has a dominant coordinates closely with the authorities responsible part in the foreign exchange reserves. The domi- for debt management in order to harmonize poli- nance of the euro is justified by the fact that the cies. Privatization revenues are another possible Hungarian forint is 100 percent pegged to the source of inflows. These were considerable in the euro, the objective of the country is to join the EU 1990s, but, looking ahead, NBH does not expect as soon as possible, the currency composition of huge amounts from this source. government debt denominated in foreign 580. Stress tests are performed to see how exchange, and the fact that the intervention cur- external or internal shocks can affect the size of rency in the domestic market is the euro. reserves in a three- to six-month horizon. We monitor nonresidents’ holdings of government securities and equities, the open foreign exchange positions Adequate size of reserves of the domestic commercial banks, the liquidity of 577. In setting the adequate size of reserves, we the domestic interbank foreign exchange market, take the following into consideration: etc. Using our own and international historical evidence during currency crises (like the 1998 Russian • nature of present and future foreign ex- crisis and the 2001 Argentine crisis) we estimate the change regime; potential outflow in a three- to six-month period, a • Guidotti rule; period during which internal policy adjustments • ratios to monetary aggregates; can be executed, or after which foreign capital markets can be accessed again. • foreseeable and potential future cash flows; 581. Rarely is the central bank entirely free in • hot money potentially leaving the country in setting the exact level of reserves. Even in the case 3–6 months; of an efficient foreign exchange market of the domestic currency, the central bank can purchase • access to foreign exchange markets; or sell domestic currency for reserve level adjust- • access to foreign capital markets; ment purposes under normal market conditions. • cost of holding reserves; and In the case of Hungary, it was only in 2001, after full foreign exchange liberalization, that the liq- • international comparison. uidity of the HUF spot market reached a level 578. The level of reserves should be sufficiently where the NBH could purchase foreign currency high to support the current quasi-ERM-II, and the purely for foreign exchange reserve management future real ERM-II foreign exchange regime. To purposes (to cover interest payments on the for- perform this task, the reserves must meet the eign state debt), without effectively affecting HUF Guidotti rule, i.e., the reserves should cover the market exchange rates. To minimize the impact on 116 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT

Figure 8. Size of Official Foreign Exchange 584. Finally, to verify actual levels of reserves we Reserves regularly carry out international comparisons. (1990–2002; in billions of U.S. dollars) Taking a longer period we look at figures like import coverage, ratios to monetary aggregates, 14 reserves to GDP, etc. Concentrating mainly on countries with similar features as Hungary, we 12 examine how successfully different countries run 10 monetary and exchange rate policies with different levels of reserves. 8

6 Investment policy

4 585. With respect to the classical investment 2 triad (return-liquidity-safety), the investment philosophy of the NBH is to achieve maximum return 0 1991 93 95 97 99 2001 on reserves while maintaining the highest attainable liquidity and safety. Appropriate safety in this case relates to the obligation of the central bank to preserve the value of reserves held on behalf of the the exchange rate, it was executed in a transparent country. Concerning this special responsibility, way, in equal, market-conform preannounced reserve management is supposed to consider the amounts (EUR 2.9 million a day, total EUR 374 mil- appropriate risk level that allows a minimum prob- lion). Independent of this positive experience, ability of loss of capital in a certain given year. when planning the future course of reserve levels, Liquidity requirement means the ability to provide we conservatively do not take into account foreign an adequate amount of funds for a possible imme- market sales or purchases. diate foreign exchange market intervention. The 582. As the rating of the country is improving, adequate amount of funds has to be available with access to international capital markets is getting the lowest attainable cost and capital loss. The relatively easier and easier. It means the necessary objective of maximizing returns ought to be con- size of reserves can be lower than before, since the sidered only if all the liquidity and safety require- NBH does not have to build high precautionary ments are met. Developing this approach in the buffers. The NBH has a formal agreement with the investment policy allows us to favor active against Ministry of Finance that for reserve replenishment passive portfolio management. purposes, the government is ready to execute bor- 586. In the process of developing the invest- rowing transactions any time the central bank ment guidelines, the main objective of the NBH requests it. Moreover, in the future, other sources has been to adopt the best practices of central such as automatic borrowing facilities in the ERM- banks of developed countries. Like all central II system will be available. banks in the world, NBH has conservative guide- 583. Looking at the cost of holding reserves lines that try to avoid instruments with high volatil- (see Figure 8. where, as a proxy, we used the rele- ity and not permit investment in equities. The vant credit spread), there is a clear tendency maximum time to maturity of bonds in the portfo- toward lower costs. Nevertheless, it is still negative; lio is ten years and the required rating is AA-AAA so, as in the past, the NBH does not intend to hold (by the big rating agencies). Our liquidity require- higher reserves than necessary. The lower cost of ments with the mentioned maturity and rating con- holding only means that the NBH can tolerate big- siderations determine the available instruments in ger swings in the size of reserves. Going forward the bond market. Therefore, NBH holds mainly until the prospective EMU-entry, we expect the cost government, supranational and government of holding to approach zero. agency issues of developed countries. The suffi- 9 • Hungary 117 ciently high level of reserves and the development • system of partner, issuer, and sectoral limits; of bond markets in the last ten years allowed us to • restrictions concerning eligible assets and trans- gradually increase the size of AA rated securities actions; and with excellent liquidity features in the bond portfolio. This part of the portfolio bears higher yield • internal two-stage benchmark procedure— without adding significant risk. allowing for a certain range of permitted deviation—concerning sectoral allocation, duration, and currency composition. Transparency and accountability

587. In 1999 and 2000, IMF addressed these Investment instruments issues in several proposals. The NBH joined the Fund’s Special Data Dissemination Standard among 590. Authorized investment instruments are the first central banks. According to the current • bonds (authorized embedded options: put, practice, the NBH discloses the size and internal call, cap, floor); structure of its reserves monthly with a 20-day lag • minimum AA rated sovereign; using IMF’s Data Template on International Reserves and Foreign Currency Liquidity. • supranationals (incl. BIS); 588. The management of our bank partici- • AAA agency papers; pated in meetings in Basel and Washington, D.C., • AAA Pfandbrief; where the framework of the Guidelines for Foreign Exchange Reserve Management was negotiated. • min. AA corporate bonds; Together with other central banks, we considered • min. AA commercial papers; the proposed Guidelines in full detail and pro- • min. AA or tri-party repos, buy-sell-back, and vided our bank’s 10–15 years of experience con- sell-buy-back agreements; cerning this issue. Since the approval of these proposals, the National Bank of Hungary has • AAA unsubordinated tranches of asset- adopted most parts of it. backed securities; • “plain vanilla” OTC bond options (put/call, long/short); Establishing a Capacity to Assess and Manage Risk • interest rate futures and IRF options; • interest rate swaps, currency swaps; and Risks incurred by the NBH • money market depos, rating: min. AA with 589. Risks incurred by the NBH in managing certain exemptions. foreign exchange reserves are primarily of a credit, 591. Among the derivative instruments, only liquidity, and market nature. Within credit risks, we plain vanilla structures are permitted. (The mini- can distinguish counterparty and spread risks. mum criterion to be a plain vanilla instrument is Concerning market risks, we put the emphasis on that we can price and analyze an instrument in the currency and the interest rate (yield curve) expo- our internal position-keeping and risk manage- sures. There is a framework in place for identifying ment system.) The primary condition for deriva- and managing these risks on an integrated and tive deals is the existence of ISDA Master centralized basis in line with best homologue35 and Agreement and mark-to-market agreement with market practices, building on four key elements: our counterparties. • system of partner and issuer ratings; Portfolio structure

35With special attention to the ECB and the connected 592. Similar to the practice of other central European NCBs. banks, the NBH distinguishes a liquidity and an 118 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT investment portfolio. The liquidity part is held to 594. Tactical benchmarks, set by the ALCO, may satisfy daily foreign exchange cash-flow needs, such deviate from the strategic ones within predefined as interest and principal payments of government ranges. Empirical evidence shows that ALCO devi- debt, interventions, special transactions, and trans- ated from the strategic benchmark only in case of fers. The term structure of these cash flows is partly major trend reversals (i.e., 1–2 times a year). This predetermined (by interest and principal pay- means the ALCO does not alter the benchmark in ments) and partly uncertain (foreign exchange periods of normal business conditions. intervention needs). Since the investment horizon 595. In line with the tactical portfolio bench- of this portfolio is very short, the NBH avoids the marks, a separate Risk Management Department risk of interest rate movements in this segment. maintains internal model portfolios that serve as oper- The other stable part of our portfolio has longer ational guidelines for portfolio managers. Portfolio investment horizons and higher return require- managers may deviate from the benchmark within ments. The fact that the probability of liquidation the predefined ranges so as to take advantage of of this part of the portfolio is low allows our bank favorable market conditions. Model portfolios are to hold bonds with longer time-to-maturity charac- updated and investment portfolios are evaluated teristics as long as the market movements and the against the appropriate benchmarks and model shape of the yield curve justify this. According to portfolios on a monthly basis. The bonuses of port- the result of our optimization process, we hold folio managers are linked to performance vis-à-vis around 20 percent of the whole amount of reserves the benchmark. in the liquidity portfolio and the rest in the investment portfolio. Use of external managers 596. In the second part of the 1980s and the Benchmarking first part of the 1990s, the NBH used external 593. NBH implemented a two-stage benchmark- portfolio managers. The altogether rather mixed ing system. The benchmarking policy, the actual experience showed that the services of external strategic benchmarks concerning currency, interest managers are most useful when building up rate, and credit structure of the investment portfo- reserve management activity (i.e., to learn) or lio, as well as the permitted deviations from these when they can provide facilities a central bank can- benchmarks, is set by the Monetary Policy not easily establish. Currently, the NBH uses exter- Committee (MPC) in the annual Risk Management nal portfolio managers only for its securities Policy Guidelines. lending programs. 10 India

Introduction billion as of end-March 1991 to $54.1 billion as of end-March 2002 and further to $62.1 billion as of 597. The Indian approach to determining ade- September 6, 2002. quacy of foreign exchange reserves has evolved over the past few years. Various factors, ranging from the pioneering Report of the High Level Developing a Sound Governance and Committee on Balance of Payments (Chairman: Institutional Framework Dr. C. Rangarajan) to Governor Jalan’s exposition Reserve management objectives of the combination of global uncertainties, domestic economy, and national security considerations 600. India’s objectives of holding reserves, in in determining liquidity at risk and thus assessing broader terms are: reserve adequacy (Paragraphs 23 and 24 of • maintaining confidence in monetary and Statement on Monetary and Credit Policy, April 29, exchange rate policies; 2002), have contributed toward the process of • enhancing capacity to intervene in foreign development of such an approach. exchange markets; 598. The three components of India’s foreign exchange reserves include Gold, Special Drawing • limiting external vulnerability by maintain- Rights (SDRs), and Foreign Currency Assets ing foreign currency liquidity to absorb (FCAs). The last item, however, accounts for the shocks during times of crisis; major portion. As of September 6, 2002, out of the • providing confidence to the markets, espe- US$62.1 billion of total reserves, India’s FCAs cially credit rating agencies, to the effect that stood at $58.8 billion; gold accounted for about external obligations can always be met, thus $3.2 billion, the rest being SDRs. In July 1991, as a reducing the overall costs to the economy or part of reserve management policy, and as a means the market participants; and of raising resources, the Reserve Bank of India • adding to the comfort of the market partici- (RBI) temporarily pledged gold to raise loans. The pants, by demonstrating the backing of gold holdings thus played a crucial role in reserve domestic currency by external assets. management at a time of external crisis. Since then, gold has played a passive role. 601. At a formal level, the objective of reserve 599. In quantitative terms, the level of foreign management in India could be found in the exchange reserves has steadily increased from $5.8 Reserve Bank of India Act, where the relevant part

119 120 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT of the Preamble reads, “to use the currency system (iv) Other instruments/institutions as ap- to the country’s advantage and with a view to secur- proved by the Central Board of Directors ing monetary stability.” Monetary stability, in this of the central bank. statement, may be interpreted as internal as well as external stability, implying a stable exchange rate Institutional framework as one of the overall objectives of the reserve management policy. While internal stability implies that 605. The decisions on currency composition reserve management cannot be isolated from and asset allocations are taken by the Reserve domestic macroeconomic stability and economic Bank in consultation with Government of India. growth, the phrase “to use the currency system to Within the RBI, while the major decisions relating the country’s advantage” implies that maximum to currency/investment are made by a Strategy gains for the country as a whole, or the economy in Committee headed by the Governor/Deputy general, could be derived in the process of reserve Governor in charge of foreign exchange reserve management. This warrants taking a very dynamic management, the Department of External view on the country’s requirements of reserves and Investments and Operations is given some flexibil- how best to meet such requirements. ity with regard to currency composition to take advantage of market trends. Further, within the RBI, a “Financial Markets Committee,” comprising Legal framework heads of departments responsible for domestic 602. In India, the RBI Act of 1934 contains the debt management, reserve management, and enabling provisions for the RBI to act as the custo- monetary policies, facilitates day-to-day coordi- dian of foreign exchange reserves, and manage nated administering of policies. reserves within the defined objectives. The powers available to the RBI as custodian of foreign exchange reserves are enshrined in the Preamble Transparency and accountability to the Act. The “reserves” refer to both foreign 606. On public disclosure, the RBI has been exchange reserves in the form of gold and foreign constantly endeavoring to ensure compliance with securities and domestic reserves in the form of best standards of transparency, in line with major “bank reserves.” The RBI Act also broadly indicates international central banks/reserve management the desirable composition of reserves, minimum authorities. Within the broader framework of mon- reserve requirements, and the instruments in etary, fiscal, and financial policies, areas relating to which the country’s reserves could be deployed. transparency and disclosure constitute important 603. Specifically, subsections 17(12), 17(12A), aspects of reserve management. The policy on 17(13), and 33(1) of the RBI Act of 1934 define the reserve management as well as all relevant infor- scope of investment of foreign exchange reserves. mation are articulated through a variety of means The provisions, by way of severe restrictions on the from time to time, the most significant being the credit quality of counterparties/securities in the half-yearly Monetary and Credit Policy Statements Act, reflect the RBI’s utmost concern about the by the Governor of the RBI. The speeches of the safety of foreign exchange reserves. Governor and Deputy Governors are important 604. In brief, the law broadly permits the fol- sources of policy analysis, actions, and intentions. lowing investment categories: The Annual Reports of the RBI provide an authen- (i) Deposits with other central banks and the tic version of RBI’s perspective as approved by its Bank for International Settlements (BIS). Board. Periodical publications, Press Releases, and Discussion Papers of the RBI provide additional (ii) Deposits with foreign commercial banks. important sources of information. (iii) Debt instruments representing sovereign/ 607. The RBI has also been providing, on a reg- sovereign-guaranteed liability (with resid- ular basis, appropriate data relating to foreign ual maturity not exceeding 10 years). exchange market operations. The RBI publishes 10 • India 121 daily data on exchange rates, forward premiums, sions when foreign exchange is made available from and foreign exchange turnover and on a weekly reserves for identified users, as part of a strategy of basis the movement in foreign exchange reserves, meeting lumpy demand for foreign exchange. The in the Weekly Statistical Supplement (WSS) of the net effect of purchases and sales of foreign currency RBI Bulletin. Data on nominal effective exchange is the major determinant of the level of foreign rate (NEER) and real effective exchange rate exchange reserves. The sales or purchases also (REER), RBI’s purchases and sales in the foreign include those in forward markets, although such exchange market, along with outstanding forward transactions are of a very small magnitude. positions, are published in the RBI Bulletin with a 611. Decisions involving currency composition time lag of one month. and the maturity pattern of the investments are 608. The RBI has all along been ahead of cen- driven by broad parameters of safety, liquidity, and tral banks of many developing and industrial coun- profitability. The choice of the highest possible qual- tries in regard to publishing details on the size of ity investment instruments and explicit constraints its gross foreign exchange market intervention on critical portfolio variables, such as limits on vari- (purchase and sale) and its net forward position. ous securities, currencies, counterparties, and The daily reference rate of U.S. dollars and euros sovereigns form the basic elements of reserve man- as well as the middle rates for four major curren- agement. Transactions are put through with coun- cies, namely, U.S. dollars, pounds sterling, euros, terparties, approved for the purpose. Counter- and Japanese yen are made available by the RBI parties could be banks, subsidiaries of banks, or website. security houses. Such counterparties are approved 609. As a part of the Special Data Dissemination by the RBI, taking into account their international Standards (SDDS), the IMF has prescribed a data reputation and track record apart from factors such template for disclosure of international reserves and as size, capital, rating, financial position, and service foreign currency liquidity of countries that have sub- provided by them. While investments in securities scribed to SDDS. India is among the 49 countries are restricted to sovereign and sovereign-guaranteed that have adopted the SDDS template for publica- instruments, the residual maturity of these instru- tion of detailed data on foreign exchange reserves. ments cannot exceed 10 years. A good percentage of The data template provides information on a num- reserves is invested in the money market, including ber of parameters, including currency composition deposits with top-notch international commercial (SDR and other currencies), deployment of foreign banks. Investments in new products/markets are exchange reserves, and forward position. These data deliberated upon within the Department of are made available on a monthly basis, since External Investments and Operations, by its October 2001, both through the RBI and IMF “Investment Committee,” which meets at the start of (SDDS) websites. every week before appropriate approvals are sought. 612. In practice, holdings of gold have been Principles, Policies, and Practices of virtually unchanged and gold reserves are man- Reserve Management aged passively.

Reserve management operations Evolution of reserve management 610. Currently, accretion to foreign currency policy in India reserves arises mainly out of purchases by the RBI from Authorized Dealers. In addition, there is 613. India’s approach to reserve management, income from deployment of foreign exchange assets until the balance of payments crisis of 1991, was held in the portfolio of the RBI. Aid receipts on gov- essentially based on the traditional approach, i.e., ernment accounts also flow into reserves. Outflow of to maintain an appropriate level of import cover reserves arises mainly on account of sale of foreign defined in terms of number of months of imports currency to Authorized Dealers. There are occa- equivalent to reserves. For example, the RBI’s 122 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT

Annual Report 1990–91 stated that the import maintain the reserves so that the cost of carrying liq- cover of reserves shrank to 3 weeks of imports by uidity is minimal.” (Paragraph 6.4) the end of December 1990. Thus, the emphasis on 616. As mentioned in the RBI’s Annual Report, import cover constituted the primary concern, say, 1995–96, with the introduction of the market- until 1993–94. determined exchange rate, a further change in the 614. The approach to reserve management as approach to reserve management was warranted part of exchange rate management and, indeed, and the emphasis on import cover was supple- external sector policy underwent changes with the mented by the objective of smoothing out the adoption of the recommendations of the High volatility in the exchange rate. Level Committee on Balance of Payments 617. Against the backdrop of currency crises in (Chairman: Dr. C. Rangarajan) in 1992. The focus East Asian countries in 1997 and in light of country in deciding on the level of reserves was in fact experiences of volatile cross-border capital flows, it shifted to ensuring a reasonable level of confi- was felt that there was need to take into considera- dence in the international financial and trading tion a host of factors, including the shift in the pat- communities in general and a plethora of factors tern of leads and lags in payments/receipts during that contribute to such confidence in particular. exchange market uncertainties. The RBI Annual The extract given below provides evidence of this Report, 1997–98, emphasized that besides the size shift in the approach. of reserves, the quality of reserves also assumed “It has traditionally been the practice to view importance. Thus, unencumbered reserve assets the level of desirable reserves as a percentage of the (defined as reserve assets net of encumbrances annual imports—say reserves to meet three months such as forward commitments, lines of credit to imports or four months imports. However, this domestic entities, guarantees, and other contin- approach would be inadequate when a large num- gent liabilities) were required to be available at any ber of transactions and payment liabilities arise in point of time to the authorities for fulfilling various areas other than import of commodities. Thus, lia- objectives assigned to reserves. bilities may arise either for discharging short-term 618. As regards management of external liabil- debt obligations or servicing of medium-term debt, both interest and principal. The Committee recom- ities, the policy of the RBI to keep forward liabili- mends that while determining the target level of ties at a relatively low level as a proportion of gross reserve, due attention should be paid to the pay- reserves and the emphasis on prudent reserve ment obligations in addition to the level of imports. management were highlighted in the RBI’s Annual The Committee recommends that the foreign Report, 1998–99. exchange reserves targets be fixed in such a way that 619. The overall approach to management of they are generally in a position to accommodate India’s foreign exchange reserves had undergone imports of three months.” (Paragraph 6.3) a further change during 1999–2000, reflecting the 615. In the view of the Committee: changing composition of balance of payments and liquidity risks associated with different types of “The factors that are to be taken into consider- flows as elaborated in the RBI Annual Report, ation in determining the desirable level of reserves 1999–2000. This is evident from the extract as are the need to ensure a reasonable level of confi- below: dence in the international financial and trading communities about the capacity of the country to “The policy for reserve management is built honor its obligations and maintain trade and finan- upon a host of identifiable factors and other contin- cial flows; the need to take care of the seasonal fac- gencies, including, inter alia, the size of the current tors in any balance of payments transaction with account deficit and short-term liabilities (including reference to the possible uncertainties in the mon- current repayment obligations on long-term loans), soon conditions of India; the amount of foreign cur- the possible variability in portfolio investment, and rency reserves required to counter speculative other types of capital flows, the unanticipated pres- tendencies or anticipatory actions amongst players sures on the balance of payments arising out of in the foreign exchange market; and the capacity to external shocks and movements in repatriable for- 10 • India 123

eign currency deposits of non-resident Indians.” cover (defined in terms of reserves in (Paragraph 6.30) months of imports). While India’s foreign 620. In recent years, while focusing on prudent exchange reserves could cover only 3 weeks’ management of foreign exchange reserves, there of imports as of end-December 1990, the has been an emphasis on “liquidity risk” associated position improved to about 11.5 months as of with different types of flows. In this context, the tra- end-March 2002; ditional approach of assessing adequacy of reserves • In terms of money-based indicators, the pro- in terms of import cover has been broadened to portion of net foreign exchange assets of RBI include a number of parameters that take into to currency with the public sharply increased account the size, composition, and risk profiles of from 15 percent in 1991 to 109 percent as of various types of capital flows, as well as external end-March 2002 and the proportion of net shocks to which the economy is vulnerable. foreign assets (NFA) to broad money (M3) 621. Governor Jalan’s statement on Monetary increased more than six-fold, from 3 percent and Credit Policy (April 29, 2002) provides an up- to 18 percent, during the same period; to-date and comprehensive view on the approach to reserve management: • Debt-based indicators of reserve adequacy showed remarkable improvement in the “A sufficiently high level of reserves is necessary 1990s and the proportion of short-term debt to ensure that even if there is prolonged uncer- (i.e., debt obligations with an original matu- tainty, reserves can cover the ‘liquidity at risk’ on all rity up to one year) to foreign exchange accounts over a fairly long period. Taking these considerations into account, India’s foreign exchange reserves substantially declined from 147 per- reserves are now very comfortable.” (Paragraph 23). cent as of end-March 1991 to 8 percent as of . . . “the prevalent national security environment end-March 2001, whereas the proportion of further underscores the need for strong reserves. volatile capital flows (defined to include We must continue to ensure that, leaving aside cumulative portfolio inflows and short-term short-term variations in reserves level, the quantum debt) to reserves decreased from 147 percent of reserves in the long-run is in line with the growth in 1991 to 58.5 percent as of end-March 2001. of the economy, the size of risk-adjusted capital Further, as part of sustainable external debt flows and national security requirements. This will position, the short-term debt component provide us with greater security against unfavorable decreased from 10 percent as of end-March or unanticipated developments, which can occur 1991 to 3 percent as of end-March 2001. quite suddenly.” (Paragraph 24) Similarly, the size of debt service payments 622. The above discussion points to evolving relative to current receipts decreased from 35 considerations and indeed a paradigm shift in percent in 1991 to 16 percent in 2001. India’s approach to reserve management. The shift has been from a single indicator to a multiple indicators approach.36 Establishing a Capacity to Assess and 623. Adequacy of India’s foreign exchange Manage Risk reserves at present could, however, be broadly assessed in terms of various indicators as described Risk management below: 624. The RBI has in place sound systems to • In terms of the traditional trade-based indi- identify, measure, monitor, and control various cator of reserve adequacy, i.e., the import types of risk involved in reserve management. Broadly, risk management involves establishing 36For a subsequent substantive discussion on the issue, refer to parameters for: the Mid-Term Review of Monetary and Credit Policy for 2002–2003 (paragraphs 30–34), RBI Bulletin, November 2002, (i) desirable currency mix and limits to facil- available on the RBI website, www.rbi.org.in. itate availability of convertible currencies; 124 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT

(ii) permissible range of investment instru- interest rate sensitivity of the reserves port- ments that meet liquidity and safety folio is measured and managed in terms of requirements; and benchmark duration and permitted leeway from the benchmark. The emphasis is to (iii) maturity or duration requirements to keep the duration short, which is in tune address interest rate or price risks. with the approach to remain risk averse and 625. The risks attendant on deployment of keep a liquid portfolio. The benchmark reserves, namely, credit risk, market risk, liquidity duration and the leeway are suitably altered risk, and operational risk are detailed in the fol- keeping in view the market dynamics. lowing paragraphs. Liquidity risk: The choice of instruments deter- Credit risk: Credit risk refers to risk arising out mines the liquidity of the portfolio. While of default or delay in payment of obligations. bonds and treasury bills of AAA rated Credit risk is addressed by putting in place a sovereigns are highly liquid, BIS Fixbis/ framework under which investment is made in Discount fixbis can be liquidated at any time to financial instruments issued by sovereigns, meet the liquidity needs. With the increasing banks, and supranationals conforming to a focus of central banks, academics, and market minimum rating. For example, investments are participants worldwide on the adequacy of invariably made in papers issued by AAA rated reserves, the Department of External Invest- sovereigns and supranationals apart from ments and Operations has been undertaking those with BIS. As stated earlier a careful pro- exercises based on stochastic models in order to cess of selection of counterparties and fixation estimate “Liquidity at Risk (LaR)” of reserves. of limits for each category of transactions is also in place. Ratings given by international Operational risk: Internally there is a total sep- rating agencies and various other financial aration of the front and back office functions. parameters are considered before grading and The internal control systems ensure several fixing limits regarding each counterparty. The checks at the stages of deal capture, deal pro- day-to-day developments regarding the coun- cessing, and settlement. The middle office is terparties are closely monitored. responsible for risk measurement and monitoring, performance evaluation, and concur- Market risk: Market risk comprises currency rent audit. The deal processing and settlement risk and interest rate risk. system is also subject to internal control guide- (a) Currency risk: Currency risk arises due to lines based on the principle of one point data uncertainty in exchange rates. Foreign cur- entry, and powers are delegated to officers at rency reserves are invested in multicur- various levels for generation of payment rency, multimarket portfolios. In tune with instructions. To hold the dealers to a high international trends, RBI follows the prac- degree of integrity, a code of conduct has been tice of expressing foreign exchange prescribed for them and an annual undertak- reserves in U.S. dollar terms. The senior ing is obtained from each of them to ensure management is kept informed of the cur- that they abide by the code of conduct. rency composition of reserves through the Custodial risk: A major portion of the securities weekly Management Information System are held by the central banks. While all U.S. (MIS) report. Government securities are held with the Federal (b) Interest rate risk: The central aspect of the Reserve, all gilts and Japanese Government management of interest rate risk for a cen- Bonds (JGBs) are with the Bank of England and tral bank is to protect the value of the invest- Bank of Japan, respectively. All primary cash ments as much as possible from the adverse accounts are with the central banks in their impact of interest rate movements. The respective countries. BIS provides both custo- 10 • India 125

dial and investment services and accordingly ties subdivide their reserves portfolio into they are also the custodians for investments with “tranches,” namely, liquidity tranche and invest- them. A small portion of other euro securities ment tranche according to liquidity and invest- and assets managed by external asset managers ment objectives and policy requirements. In the are placed with carefully selected global custo- case of the RBI, a system that creates an explicit dians. The custodial arrangements are reviewed division of the reserves of this kind is not in place. from time to time and the developments relat- However, the RBI has two broad portfolios with ing to the custodians are tracked regularly to independent risk parameters, namely, the money ensure that the risk is kept to the minimum. market portfolio and the bonds portfolio. The money market portfolio comprises instruments Audit and Management Information with maturity of less than one year and it is pre- dominantly guided by transaction and interven- System (MIS) tion needs. By its very nature (because of low 626. There is a system of concurrent audit in duration), the money market portfolio runs a the Department of External Investments and lower market risk (in relation to interest rate Operations for monitoring compliance with all the movements). In contrast, the bonds portfolio con- internal control guidelines, independent of the sists of long-term holdings (up to a maximum of process flows. Reconciliation of nostro accounts is 10-year residual maturity) of triple-A rated done on a daily basis for major currencies. sovereigns and supranationals. 627. In addition to the annual inspection by the Inspection Department of the RBI and statu- External asset managers tory audit by external auditors, there is a system of appointing a special external auditor to audit deal- 630. A small portion of the reserves has been ing room operations. The main objective of the assigned to external asset managers with the objec- special audit is to ensure that risk management sys- tives of gaining access to and deriving benefit from tems and internal control guidelines are adhered their market research. It also helps to take advan- to by the Department. tage of the technology available with asset man- 628. A sound management information system agers while utilizing the relationship to obtain the (MIS) exists in the Department of External required training/exposure for the central bank’s Investments and Operations for comprehensive personnel dealing with foreign exchange reserve reporting to senior management on all significant management. The asset managers are carefully areas of activity. Reports are provided to senior selected from among the internationally known management, with their frequency depending on asset management companies. They have been the type and sensitivity of information. given clear investment guidelines and benchmarks and their performance is evaluated at periodic intervals by a separate unit within the middle Division of reserves into tranches office. External asset managers’ views and out- 629. The guidelines for foreign exchange look on international bond and currency markets reserve management developed by the IMF indi- are examined and taken as input by operational cate that a number of reserve management enti- personnel. 11 Israel

Background exchange-rate regime is now defined by a band for the value of the sheqel against a basket of curren- 631. Israel’s foreign-exchange reserves are cies, with the lower bound fixed, while the upper owned and controlled by the central bank, Bank of bound increases by 6 percent per year. As of early Israel (the Bank), which is therefore the “reserve 2002, the width of the band, relative to its midpoint, management entity,” as defined by Guidelines. was around 45 percent. The Bank has declared a Within the Bank, the Foreign Currency Department policy of nonintervention within the band, but is (Department) is responsible for performing the committed to defending the band’s limits until such reserve management function, under the direction time as it is formally abolished. The past decade was of the Governor of the Bank. also witness to a substantial increase in the size of the 632. The size and role of Israel’s foreign- reserves, which tripled in dollar value from 1994 to exchange reserves have evolved over the 17 years 1998, while the ratios of the reserves to various other since the 1985 Stabilization Program, which marked aggregates increased by lesser degrees. This increase a watershed in the country’s economic history. The was primarily due to intervention by the Bank in the early years of this period were characterized by a local foreign exchange market, to defend the limit fixed exchange rate, which served as a nominal on sheqel appreciation set by the band. anchor for the price-level and a target for monetary policy, accompanied by a strict currency-control regime and the absence of significant interbank Governance and Institutional trading in foreign currency. In this environment, the Framework reserves portfolio served as a “buffer” for capital flows, with the Bank intervening in the market on a Objectives, scope, and coordination of Israel’s daily basis. reserves management 633. Over the last decade or so, the focus of Objectives monetary policy moved from exchange-rate targeting to inflation-targeting, the exchange-rate regime 634. In conjunction with the evolution of eco- was gradually liberalized, foreign-currency controls nomic policies and circumstances described above, were all but eliminated (with the last restrictions due the Bank’s understanding of the purposes served to be lifted at the end of 2002), and an active inter- by the foreign-exchange reserves has changed and bank foreign-exchange market, in which the Bank developed, a process that remains ongoing. Based has not intervened for several years, developed. The on the experience of other countries and the rele-

126 11 • Israel 127 vant academic literature, the Bank has identified changing circumstances. Though not formally four principal goals that are served by holding the adopted in this language, the Bank’s investment pol- reserves portfolio: icy has been developed on the basis of the following objectives for reserves portfolio management: • Reducing the probability of a crisis in the local foreign-exchange market. Although, as • Preserving the real foreign purchasing power noted, the Bank’s stated policy is not to inter- of the reserves. This goal finds expression in vene within the limits of the band, the knowl- the currency composition of the reserves, the edge that it has access to substantial reserves management of their interest-rate risk, and of foreign currency serves to reassure both the limitations on credit risk. residents and foreign investors, on the one • Maintaining a high degree of liquidity. This hand, while deterring speculative attacks on goal is met mainly via limits on the types of the other. However, it should be emphasized assets that may be included in the reserves that the importance of the reserves in this portfolio. regard is secondary to that of sound and credible macroeconomic policies that sup- • Subject to meeting the first two objectives, port economic and financial stability. earning a reasonable rate of return on the portfolio. This goal has influence on the • Providing a strategic reserve of liquidity, for choice of portfolio duration, the level of use in a market crisis—should one neverthe- credit risk accepted, and the decision to less develop—together with other tools, such employ active management. as the interest rate, or for use in a national emergency. In such situations, a high level of 636. A further objective of the reserves man- reserves improves the resilience of the econ- agement process, though one clearly subordinate omy and expands the range of options avail- to the three listed above, is the accumulation of able to policymakers. information and expertise that can be of value to • Improving the standing of the country in other core functions of the Bank, such as the for- international capital markets, where many of mulation of monetary policy or exchange-rate pol- the players view the level of a country’s for- icy (as noted in Guidelines, Sec. I, Par. 2.). eign-exchange reserves as an important indicator of its financial stability. Scope and coordination • Providing the government with a degree of 637. Management of the foreign-exchange flexibility in managing the composition of reserves is closely linked with the formulation and public-sector debt. Since the government can conduct of exchange-rate intervention policy, with buy foreign currency from the Bank at will, it a number of individuals at various levels having could choose to fund part of its foreign-cur- involvement in both.37 As noted above, the reserves rency expenditures (debt service or other management process also provides valuable infor- expenses) from local-currency sources (taxes mation resources to the makers of domestic mone- or borrowing) rather than from income or tary policy. new borrowing in foreign currency. However, 638. Under current policy, the Bank is not excessive use of this option could impair the involved in liability management,38 nor are the ability of the reserves to serve the other goals reserves managed with a view to hedging the inter- listed.

635. In contrast with the evolving state of the 37However, under the Bank’s current policy of noninterven- Bank’s purposes for holding reserves, the Bank’s tion, “conduct” of intervention policy is limited to informa- objectives in managing the reserves have remained tion-gathering activities, so long as the exchange rate is within fairly stable over the years, although the means of the band. 38Other than the use of short-term repurchase agreements for achieving them have been refined and adapted to tactical liquidity management. 128 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT est-rate exposure of Israel’s foreign-currency liabil- parameters of the Bank’s investment policy that the ities. Israel’s foreign-currency borrowing is man- Department wishes to propose. aged by the Ministry of Finance. Traditionally, the 641. Investment decisions of the Department, maintenance of a “Chinese wall” between the within the boundaries set by the Foreign Currency reserve manager and the liability manager has Committee but beyond the leeway allowed to indi- been seen as an important safeguard for the vidual portfolio managers, are discussed in the reserves’ unencumbered status, the value of which Investments Committee, which is chaired by the outweighed any advantages that might be obtained Director of the Department and attended by staff from coordination between the Bank and the members of the front and middle offices and by Finance Ministry. (This issue is currently being back-office managerial staff. The Investments reexamined.) However, the currency composition Committee meets weekly to review market devel- of Israel’s short-term debt service is a factor in set- opments and front-office positions, as well as to ting the currency composition of the reserves (see consider investment decisions within its purview paragraph 649 below). and recommendations to the Foreign Currency Committee. It should be noted that the role of both the Institutional framework Investments Committee and the Foreign Currency Committee is advisory, rather than authoritative, since Legal foundation and structure of internal responsibility for their decisions is ultimately borne by the governance officers chairing them (the Director of the Department and 639. The Bank of Israel’s authority to own and the Governor, respectively). manage the foreign-exchange reserves of the coun- 642. Investment decisions within the boundaries try is based on The Bank of Israel Law, 5714–1954, set by the Investments Committee are made by port- and on the legal interpretations that have been folio managers, with the approval of the head of the developed around it over the course of the years. It front office (which is normally always given). Senior should be noted that the law and its interpretations portfolio managers are responsible for one or more primarily address the types of foreign-currency nonoverlapping portfolios, typically defined by cur- assets that the Bank may own and the counterpar- rency and range of maturities. They are assisted in ties with whom it may transact.39 Thus, many this by junior portfolio managers, who may be given aspects of the Bank’s investment policy and gover- responsibility for part of a portfolio, and by trader- nance framework for the reserves are matters of analysts (see below). No organizational separation is internal Bank policy. made between trading and portfolio management 640. The main directives regarding manage- activities. The application of the above principles to ment of the reserves portfolio in its various aspects, active management of the reserve portfolio is dis- and the degree of leeway allowed to the Department cussed further in paragraph 662, below. in each aspect, are set by the Foreign Currency Committee, which is chaired by the Governor and Staff includes senior managers from various departments 643. As stated in the Guidelines (Sec. IV, Par. of the Bank. The Department reports to the Foreign 36), “appropriately qualified and well-trained Currency Committee on current developments in staff, following sound business practices” are an international markets, on the performance of the essential element of the framework for reserve portfolio and the various investment decisions made management. The Department’s personnel policy by the Department, and on any alterations in the in recent years has been based on the following principles: 39In brief, the Bank is permitted—within the framework of the reserves—to own gold, foreign currency, and securities that • The Department’s goal is to employ tenured, are issued or fully guaranteed by a foreign government, to long-term employees who become known invest in bank deposits and CDs, and to utilize derivatives such well. Thus, staff members of the front, mid- as futures and options, provided the underlying asset is of a type that the Bank is permitted to own. dle, and back offices are regular employees 11 • Israel 129

of the Bank, governed by the same collective- ational risk, and it strives constantly to maintain bargaining agreements as staff members of high standards of practice in this area, consistent other departments. with the norms of the financial services industry in • When vacancies occur in the front office, the developed world and with reasonable cost-ben- they are normally filled by probationary efit trade-offs. Among the most important aspects employees who are recent MA-level honors of the Bank’s control procedures are the following: graduates in economics or finance, without • The organization of the Foreign Currency prior financial market experience. Practical Department and its established work prac- training as a trader-analyst thus takes place tices. These have been designed to reduce the on a tabula rasa, and is oriented toward the possibility of loss due either to human error specific needs of the Bank. A combination of or to intentional misconduct. Standard work- internal and external training is employed. ing procedures, which are documented and Needless to say, all employees must be eligi- enforced, include routine verification and ble for appropriate security clearances. authorization procedures. The use of com- • At the end of a four- to five-year probationary puter systems, which include automated con- period, trader-analysts who show exceptional trols procedures, is extensive. And there is an ability are offered permanent employment as almost absolute division of authority and portfolio managers. Those who are not responsibility, on both an organizational and offered permanent appointments typically personal level, in the Department’s primary find that the experience gained in reserve tasks—transacting trades, processing trades, management is well respected by potential sending payment instructions, accounting, employers in the private financial-services and auditing—so that a single individual does industry. A similar employment cycle applies not have the ability to process a trade, send to the middle office. payment instructions, or alter records. • Compensation is on the same pay scales as • Control functions carried out by various professional staff with graduate training in units within the Department. In addition to other departments of the Bank. As a matter the back office, which performs a number of policy, there are no direct incentives to of checks in the regular course of process- employees based on trade performance. ing trades, and the Department’s auditing section, which reconciles all transactions • Front and middle office staff members with after settlement, there is a staff member— permanent appointments generally remain in the System Controller—who follows all their positions on the order of a decade (with transactions processing on a real-time basis, quite substantial variation around this mean). and who reports directly to Department Rotation to posts in other departments of the management. Bank (including managerial positions) is an option for those who come to desire a change • Monitoring by authorities outside the Depart- or suffer professional burnout. In past years, ment. These include the Comptroller’s front and middle office “alumni” have also Department, which prepares the Bank’s daily moved on to senior economic posts in other financial statements, checks accounts, and branches of the public sector. authorizes the proper accounting scheme in the general ledger; the Bank’s Internal Transparency and accountability in the Auditor, who performs regular comprehen- reserves management process sive examinations of specific topics within the Foreign Currency Department, reporting to Operational risk management management of the Department and the 644. As a manager of public funds, the Bank is Bank; and the public accounting firm particularly sensitive to issues of security and oper- employed as External Auditor by the Bank, 130 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT

which audits the Department’s activities once Assessing and Managing Risk a year and reports its findings in writing to the Governor of the Bank. Investment policy and benchmark portfolio • Management’s follow-up. Every irregular 646. The Bank of Israel’s investment policy occurrence in the operational process is comprises the standards and procedures adopted documented, with instructions for correc- by the Foreign Currency Committee, which ensure tive action to prevent a recurrence. Once a that management of the reserves is in accord with year, a general overview of control proce- the Bank’s long-term preferences, objectives, and dures is undertaken. Needless to say, any strategies. It provides for conservative limits on the recommendations of the external and inter- portfolio’s exposure to various financial risks, the nal auditors are also given the most serious main ones being currency risk, interest-rate risk, consideration. and credit risk. (There are additional risks, such as liquidity risk (paragraphs 667–669) and operational • Codes of conduct. All Foreign Currency risk (paragraph 644).) The Bank’s investment pol- Department employees are subject to the icy defines a risk-neutral benchmark portfolio for Bank’s rules of conduct, which include spe- the reserves, and limits the deviations of the actual cial rules on conflict-of-interest for staff with portfolio from the benchmark in terms of the vari- market contact. Such staff members are also ous financial risk factors. These deviations may be required to be familiar with, and to follow, the result of active management, or may be due to the ethical codes of the markets in which the operational limitations of transacting in finan- they trade. The Department is currently cial markets. The limits on each risk factor are studying this issue, with a view to drawing up applied independently; synergistic risk measures a Departmental Code that would incorporate such as Value at Risk (VaR) are monitored, but cur- all the existing rules and possibly extend rently have no formal role in the investment policy. them. The Department investigates new risk measures as they are developed; measures examined in recent Disclosure years include partial duration and spread duration (not adopted) and option-adjusted duration 645. For many years it was the Bank’s practice (adopted for mortgage-backed securities). for the Department to prepare an Annual Report 647. The sections that follow give a brief intro- for use within the Bank, which was submitted to the duction to some aspects of the Bank’s investment Governor and members of the Foreign Currency policy. More complete information may be found Committee (see paragraph 640), with a very brief by consulting the sources listed above in para- summary included in the Bank’s Annual Report. In graph 645. 2001, the Department’s Annual Report was published separately, and in 2002 it was included in full in the Bank’s Annual Report. These documents Neutral currency composition provide the public with extensive information on 648. The neutral currency composition of the the Bank’s objectives, investment policy (not reserves is known as the numeraire. It is defined by including precise currency composition), and fixed percentages of various currencies, with the investment performance in absolute terms and rel- number of units of each one allowed to vary as ative to benchmark. They can be viewed on the exchange rates change (in contrast to a currency Bank’s website, at http://www.bankisrael.gov.il/ basket, such as the SDR, in which the number of publeng/publeng.htm. Up-to-date monthly data units is constant from day to day while the percent- on the foreign-exchange reserves, in the form pre- ages vary). The composition of the numeraire is scribed by the IMF Template, can also be found reviewed at least once a year. there, at http://www.bankisrael.gov.il/deptdata/ 649. When first adopted, the composition of mth/imf/imfdata.htm. the numeraire was based on the geographical dis- 11 • Israel 131 tribution of goods and services imports. This com- threshold and confidence level set by the portfolio position was considered to preserve the real for- manager, on the basis of his inclinations and risk eign purchasing power of the reserves, since aversion, together with the assumed distribution of imports constitute the foreign currency compo- yields to maturity in the market, determine the nent of Israel’s total final uses of funds.40 A few maximum allowable portfolio duration, or shortfall years later, another element was added to the com- duration. position of the numeraire, namely, the currency 653. Unfortunately, for a given threshold and composition of external debt service for the com- confidence level, the shortfall duration can vary ing year. A further consideration in determining significantly from month to month, as the yield the currencies included in the numeraire has been curve shifts. In order to find a duration that would that they are “reserve currencies,” that is, those of have acceptable characteristics in various financial countries with a tradition of economic stability and climates, staff of the middle office conducted the responsible policies in various fields. following study: For each month of the period 650. The currency composition of the from January 1984, to June 1998, the shortfall numeraire described here has changed over time duration was calculated, using a confidence level of only moderately, and it bears a reasonable resem- 95 percent and a minimum threshold equal to one- blance to the currency composition of the total half the yield on a risk-free asset. For U.S. dollars, reserves held by official institutions. Nevertheless, this was defined as a three-month Treasury bill and over the past several years the Bank has reexam- for other currencies as the one-month LIBID inter- ined the definition of the numeraire from time to est rate. The resulting series of monthly shortfall time. To date, there has been no change in it, inter durations was then examined, and a value selected alia because the other systems reviewed yielded that is lower than 95 percent of them. This gives a currency compositions that could change radically duration that, 95 percent of the time, would have from year to year, making them very difficult and given an ex ante probability of at least 95 percent of expensive to implement. earning no less than one-half the risk-free rate. 654. After doing this calculation separately in each currency, and after further minor technical Neutral duration adjustments, a single neutral duration was set for 651. The interest-rate risk of a portfolio in a the currency portfolios comprising the reserves. particular currency is defined by its duration, and This duration is 16 months. by the distribution of that duration along the yield curve. The Bank of Israel has defined a neutral Formulation of neutral benchmarks duration for each currency in the numeraire by using a modified shortfall approach. 655. The core element of the Bank’s invest- 652. Under the shortfall method, a portfolio ment policy is the neutral benchmark of the manager sets a minimum threshold for acceptable reserves portfolio. Control of currency risk and holding-period yields. Since the future course of interest-rate risk (and, to a limited extent, credit yields-to-maturity in the market is uncertain, it is risk) is exercised via limits on the allowable devia- impossible to rule out capital losses with absolute tions of the actual portfolio from its neutral bench- certainty (unless one invests in zero-duration assets mark (see paragraph 662), and it constitutes a such as cash), but only with a certain probability, risk-free portfolio for the Department, when it known as the confidence level. The minimum does not wish to have open positions, and provides a criterion for assessment of the Department’s performance (paragraphs 664–666). 40This system was based on the 1979 study by A. Ben-Bassat, 656. The overall neutral benchmark is con- The Management of Foreign Exchange Reserves, Israel’s Experience, structed on the basis of benchmark portfolios in Research Department, Bank of Israel (Hebrew), an abridged English version of which was published in the May 1981 Bank the various currencies of the numeraire, each one of Israel Economic Review. being represented in proportion to its numeraire 132 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT weighting. Each of these component currency ing credit risk, the desire to avoid having to seek benchmark portfolios has a neutral duration (see legal redress in the courts of a foreign country, and above), and is composed of assets that are charac- the fact that credit risk is “optional” (in that it terized by low risk and high liquidity, features that could be almost completely eliminated by investing reflect the Bank’s long-term investment strategy. only in the securities of sovereign states in their Each currency benchmark portfolio is based on local currencies), while other risk factors are not. two components: the first, having a short duration, 659. Investment of the reserves portfolio includes assets of up to one year to maturity, while causes it to be exposed to the credit risk of various the second, which has a longer duration, includes types of institutions—governments, international assets of between one and five years to maturity. organizations, clearing systems, commercial banks, The weights of the two components are then set and broker-dealers. Investment in the securities of such that the total duration of the currency bench- a foreign government creates exposure to the issu- mark portfolio is neutral. The assets included in ing country, while investments in bank deposits, the currency benchmark portfolio are government time differentials in the settlement process, and bonds of the currency’s country. However, in cur- trades involving delayed settlement (e.g., currency rencies where the market for government securi- forwards) create exposure both to private firms ties maturing up to one year is not liquid, the and to the countries in which they operate. The short-term component contains indices that reflect Bank’s willingness to assume exposure falls as the the interest paid by the Bank for International risk of experiencing a loss increases (i.e., as credit Settlements (BIS). quality declines), as the time over which the risk 657. Although the Bank’s use of active man- extends increases, and as the type of entity to which agement (paragraph 662) implies that there is usu- the exposure pertains is thought to be less resilient ally a gap between the yield of the reserves (e.g., banks vs. governments). portfolio and that of the benchmark, this differ- 660. The Bank uses a variety of tools to manage ence is generally small. This means that the the credit risk of the reserves portfolio. Of these, expected profit on the reserves portfolio is deter- the most important is the System of Limits and mined primarily by the composition of the bench- Quotas, which defines for each institution (bank, mark portfolio, rather than by the quality of the country, etc.) the maximum quantity of various Bank’s active management. Therefore, periodic types of credit exposure that may be assumed. It adjustment of the benchmark portfolio to ongoing sets the minimum levels of credit quality for indi- changes in the global financial environment is a vidual institutions of various types and also ensures necessary process, and is one of the major chal- appropriate diversification across firms and coun- lenges confronting the Bank. tries, in line with their relative size and credit quality. Additional tools for control of credit risk include: a ceiling on the total exposure of the Limitation of credit risk reserves portfolio to the world banking system, lim- 658. As is true of many official institutions, the its on the permitted quantity of investment in Bank of Israel’s sensitivity to credit risk is greater “spread assets,” such as Eurobonds, and limits on than its sensitivity to other financial risks. This is the maximum time for which certain types of expo- primarily due to the judgment that its ability to use sure can be assumed (e.g., on the term-to-maturity diversification to limit the scope of losses is more of bank deposits). limited in this area than it is vis-à-vis other types of 661. Once a year, the System of Limits and risk, such as interest-rate risk. Additional reasons Quotas is updated by the Department and submit- for heightened sensitivity would include: the possi- ted to the Foreign Currency Committee for bility of correlation between losses due to credit approval. If an institution’s quota is added or risk in the portfolio and the need to make use of enlarged during the course of the year, the change the reserves (e.g., in a global financial crisis), the must be approved by the Foreign Currency limitations of currently available tools for quantify- Committee. However, the Department may cancel 11 • Israel 133 or reduce a quota on its own initiative at any time, • The neutral duration for all currencies is set if changes in the institution’s status warrant doing by the Foreign Currency Committee, and a so. It should also be noted that the Bank’s relations deviation from it by the Department is con- with financial institutions are anchored in legal sidered a position. The Department is autho- agreements, most of which have been signed in the rized to open positions of limited scope past few years. vis-à-vis the neutral duration in the various currency portfolios. The range of permitted durations is asymmetrical, as the Department Scope for active management41 is allowed greater leeway in reducing dura- 662. In investing the foreign exchange reserves, tion than in increasing it. Within this bound- the Department is authorized to use active manage- ary, the front office is permitted very limited ment or position-taking, that is, to decide to depart positions around the duration set by the from the overall benchmark portfolio, in terms of Investments Committee. currency composition, duration, kinds of assets, • The distribution of assets along the yield and their distribution along the yield curve, with curve is also a source of interest-rate risk, the goal of earning a higher yield than that of the together with duration. The neutral distribu- benchmark portfolio. The leeway allowed for active tion is that of the benchmark portfolio, while management is defined separately for each type of differences from it in the reserves portfolio exposure, and is based on the principle of limited represent positions. This type of position is delegation of authority and responsibility in the normally decided on by the front office and investment decision-making process from each level monitored by the Investments Committee. to the level below. In managing any type of position, it is customary to impose a maximum potential loss • Decisions on asset allocation may also create (“stop-loss”), with the position being closed if the positions, as part of the reserves may be cumulative loss on it reaches the limit. In recent invested in types of assets that are not repre- years, the main focus of active management has sented in the benchmark portfolio, such as been on asset allocation and security selection, Eurobonds, bank deposits, mortgage-backed which have formed an important part of the total securities, etc. Asset allocation decisions are contribution from active management. normally made by the front office. However, • In the area of currency risk, the numeraire is in the case of asset allocation positions that viewed as a risk-free portfolio, and any devia- are of unusually large scope, or that are of a tion from it is defined as a position. Currency long-term nature, responsibility for the posi- positions of more than limited scope must be tion may be taken by the Investments authorized by the Foreign Currency Committee. Committee; however, the Foreign Currency • Finally, decisions on security selection—the Committee has not utilized this authority in actual choice from among several alternative recent years. The Department may decide on debt instruments to fulfill a specific role in limited positions around the currency compo- the portfolio—of course are made through- sition determined by the Foreign Currency out each workday by the staff of the front Committee; within this boundary, the front office, constituting an important component office is permitted very limited positions of active management. around the currency composition set by the Investments Committee. 663. The decision to employ active management is based on a number of considerations. First, and most importantly, the cumulative experience of the past fifteen years or so suggests that the Bank’s

41This section should be read in conjunction with paragraphs use of active management has made a modest but 639–642, above. statistically significant positive contribution to over- 134 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT all portfolio return. In addition, active management that asset class with a component portfolio of the requires those involved in it to be constantly up-to- benchmark. date as regards market developments. This incentive 666. The returns on portfolios are normally helps to ensure that the Department’s focus does available to management and to the front and mid- not, over time, become too narrow, and it hones the dle offices on command. An exception to the rule skills needed for periodic adjustment of the bench- outlined above is the excess return on certain types mark portfolio and for other tasks, such as the for- of spread assets (e.g., bank deposits). Due to tech- mulation of intervention policy. Finally, the use of nical limitations, this is calculated only after the active management helps the Department to create fact; however, the principles by which it is calcu- an interesting and challenging work environment lated are similar. Certain elements of yield curve for front- and middle-office staff, assisting it to positioning and security selection are necessarily attract and retain highly qualified professionals. calculated as the residual of other contributing factors and the total difference in return, but the middle office seeks to minimize the scope of this factor Performance attribution as far as possible. 664. The contribution of various investment decisions to the overall difference in yield between The role of efficient markets the reserves portfolio and the neutral benchmark 667. As noted, an important goal of the Bank over a given period is measured by the middle in managing the foreign exchange reserves is that office, using the capabilities of the recently they should have a high overall level of liquidity, acquired portfolio management information sys- defined as the ability to realize assets without delay tem (paragraphs 670–677) together with a data- and without diminishing their value. The liquidity warehouse system developed in-house. (For a of the various markets in which the assets compris- description of how performance attribution was ing the reserves are traded is regularly assessed by done before the implementation of this system, see the middle office, based on two criteria. The first is Box 1.6 of the Department’s Annual Report for the width of the “bid-ask” spread between buying 2000, at the address given in paragraph 645.) The and selling prices; a narrow spread implies low system is used to maintain portfolios that reflect transaction costs, relative to the midpoint price. the components of the neutral benchmark and The second is the ability to transact in large vol- portfolios that match the Bank’s actual holdings, umes without affecting the market price. In an classified by maturity and asset type, including illiquid market, an investor’s attempt to buy or sell “leverage” portfolios, which are used to track the in large volumes will cause the spread to widen and profit or loss of certain types of positions. the midpoint price to move in a direction unfavor- Portfolios can be aggregated in hierarchies, so that able for the investor; thus, assets can only be sold in the aggregate of actual holdings can be compared quantity at an average price lower than the one with the aggregate benchmark. that prevailed before the investor began to sell. 665. Leverage portfolios include long and short 668. Based on these criteria, the Bank classifies positions (though in its actual holdings the Bank the assets of the reserves portfolio into four groups: never sells short a security). For example, the profit and loss on a currency position would typically be 1. Highly liquid, including securities with a tracked using a leverage portfolio that includes a spread of 0–2 basis points or 0–2 cents and short position in cash in one of the currencies of various demand deposits. the numeraire and a long position in cash in 2. Liquid, including securities with a spread of another currency (which may or may not be in the 3–5 basis points or 4–6 cents. numeraire). By contrast, the performance of a par- 3. Short maturity, including securities, ticular asset class (e.g., inflation-linked securities) deposits, and repurchase agreements with would be calculated by comparing the yield on a terms of less than a month. portfolio including all the Bank’s holdings in 11 • Israel 135

4. All others, most of which are tradable and • Variation in the quality and maintenance of can be realized, however. This group has systems developed by end-users without pro- included, among others, GNMA mortgage- fessional IT training and responsibility. backed securities, TIPS (U.S. inflation-linked • Blurring appropriate separation of responsi- securities), and some types of Eurobonds. bility, as, for example, when front-office staff, 669. During the years 1999–2001, the first who were the only people with the expertise group has typically accounted for no less than 20 and access to data feeds required, built ad percent of the reserves, and the first three groups hoc systems to implement new compliance together for 75–90 percent of the reserves. rules.

672. One bright spot was that the problems Portfolio management information were found to be concentrated in the front and system middle offices, with the situation of the back office judged quite acceptable. 670. Without doubt, the Bank’s most signifi- 673. Defining the needs of the Department, in cant move in recent years to enhance the quality of a very detailed way, based on the gap between the its reserve management and to improve trans- current state of affairs and the desired one, was the parency and accountability was its decision to next stage. This was done by an interdepartmental acquire a new portfolio management information team chaired by the head of the front office and system. Although space limitations do not allow a including senior people from the front and middle full description of this project, which extended offices and the IT Department. The high profes- over more than three years and involved direct and sional level of this team proved essential to the suc- indirect costs of well over US$1 million, the main cess of the project. The team’s analysis served as a aspects of it can be briefly sketched. guide for the general RFI (Request For 671. Recognizing the existence of a problem Information) and the more detailed RFP (Request was the first task, and probably the hardest. Even For Proposal), which were written at a later stage. in ideal conditions, computer systems are often in 674. Buy or build was the next decision to be flux, as front, middle, and back offices adapt to made, and it was not an easy one. Building a com- changing financial-market conditions. How, then, plex customized system “in-house” would have does one identify the transition point from rou- meant recruiting or contracting for substantial tine imperfection to a fundamental problem additional personnel in the IT area for a very requiring a more radical solution? One important lengthy project, with no guarantee that it would warning sign was the proliferation of ad hoc solu- result in an ideal solution. On the other hand, tions, often developed by end-users, to track risk experience to date suggested that most of the “off measures and the profit and loss of positions. the shelf” systems in the market would not meet When the staff assigned to examine this problem the Bank’s needs. In the end, the team recom- formally mapped the Department’s workflow, and mended that the possibility of purchasing a system counted between five and ten distinct manual entries should first be thoroughly explored, and only if a to these independently maintained programs that detailed examination of the available systems were required for a single trade, it was clear that the showed they were inadequate should the option of risks had become unacceptably large. Among building in-house be revisited. them, 675. Searching for systems, sending out the • Substantial increase in the probability of Request For Information (RFI) letter, and com- human error, which could remain undiscov- posing a short list based on the responses were the ered for a considerable time. subsequent stages of the project. The project team • Inconsistency in the meaning of data across identified possible candidates through discussions multiple systems, which sometimes were with market participants and companies, and by based on different concepts. searching the Internet and industry publications. 136 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT

The RFI letter included a general description of chase of goods or services by public sector bodies the Bank’s needs and the framework of reserve such as the Bank, was issued to the three candi- management, the layout of the IT systems in use, dates that participated in the simulation. The ten- and a list of 12 questions that summarized the der was very detailed with regard to the contractual requirements of end-users and IT staff. Vendors terms of purchase (including warranty and main- were strongly encouraged not to limit themselves tenance issues), as well as the criteria for choosing to just answering the questions, but rather to send a system and the future milestones of project publications, documentation, or other written implementation. An integral and important part of material regarding the relevant modules of their the tender was the Specification Matrix, consisting systems, as well as information on pricing, training, of about 500 specification line items regarding the and support. During this period, the Bank did not quality and functionality of the system. In their honor vendor requests to demonstrate their sys- replies, the vendors were expected to define the tems, and also found it necessary to decline various extent of their systems’ capabilities by entering pre- offers by companies to serve as consultants or defined codes for each line item (Supported, Not implementation subcontractors. Based on the writ- Supported, etc.). Where relevant, they could also ten responses to the RFI, a short list of candidate add free-form comments. This detailed list helped firms was drawn up. Interviews with two current to rank the proposals, and served as the basis for clients of each short listed candidate were then the implementation of the chosen system later on. conducted by conference call, based on a list of The final choice of system was made based on con- questions faxed to them in advance, without the siderations defined in the tender documents, with participation of the vendors’ firms. the weight of each component set prior to the 676. Following these interviews, each candidate review of the proposals. These included, among was invited to demonstrate its system, using a others, the quality of the system and its suitability detailed simulation of initial portfolios, bench- for the Bank’s intended uses, its price, warranty marks, and a (fictional) day of trading activities pro- terms, and reputation. vided by the Bank. Throughout the simulated day, cash flow, holdings, risks, and performance were Conclusion measured. The simulations took place at the Bank’s premises, with each vendor receiving three days in 678. The preceding sections have not attempted which to conduct its presentation. The program of to provide a comprehensive description of the Bank three days was divided into carefully defined ses- of Israel’s reserve management process, but only to sions, with each session relating to one of the main throw light on a few aspects of it that may be of par- issues (e.g., markets, compliance, performance ticular interest to other official institutions. The measurement, etc.). Each vendor was required to Bank continues to explore numerous issues influ- install its system at the bank for the occasion, so that encing reserve management. Some of these have the entire simulation was performed and demon- been noted in the text; others include aspects of strated on each system. The simulation was of criti- legal risk, operational risk, definition of the universe cal importance to the process. It gave the vendors of permissible assets, and the process of benchmark greatly improved insight into our needs and the specification. It should be emphasized that the suitability of their systems to meet them. As a result, Bank’s approach to reserve management was not two companies realized that their systems were established in its present form all at once, but is the unable to perform the simulation, thereby reduc- result of a long-term process of growth and developing the short list. The simulation also enabled the ment. In this regard, and bearing in mind that every project team and management to have the closest institution’s needs are unique to it, leading to vari- look possible at the suitability of each system to the ous approaches, it is worthwhile to mention some of Bank’s requirements. the fundamental conditions that underlay the devel- 677. The competitive tender or Request for opment of reserves management at the Bank of Proposal (RFP), required by Israeli law for pur- Israel: 11 • Israel 137

• An absolute commitment, at all levels of the • A commitment on the part of both staff and organization, to maintaining the highest management to the professional develop- standards of integrity and professionalism. ment and continuing education of members • An organizational culture that encourages of the organization. creativity and does not penalize those who 679. An institution that is able to nurture these question the “conventional wisdom.” values will most likely enjoy excellent prospects for • A collegial working environment, encourag- successful fulfillment of its responsibilities, ing full discussion of major decisions before whether or not the specific solutions it arrives at their implementation. are similar to those described above. 12 Korea, Republic of

Developing a Sound Governance Scope of reserves management activity, and and Institutional Framework coordination with monetary and external debt policy Reserve management objectives 683. The foreign reserves that the BOK cur- 680. The Bank of Korea (BOK) holds foreign rently manages are the portion of government and exchange reserves to maintain a capacity for inter- BOK assets that are readily available for foreign vention in the foreign exchange market, to cope payments, and consist of foreign-currency- with internal and external shocks, and to preserve denominated fixed income instruments, deposits, the value of the national wealth. Therefore, the gold, and SDRs (see Table 20). BOK puts the focus on safety and liquidity, while 684. The BOK manages its foreign reserves in also endeavoring to generate high returns. a manner so as not to hinder domestic monetary 681. Subsequent to the Asian financial crisis in policy. When the BOK intervenes in the foreign 1997, the foreign exchange regime in Korea exchange market, it observes the domestic interest moved from a market average exchange rate sys- rate and currency flows carefully so as to be in har- tem to a free-floating rate system, and this reduced mony with the open market operations. the central bank’s need to intervene in the foreign 685. The currency composition of the BOK’s exchange market. However, it became imperative and the Government’s foreign debt and its dura- to increase the volume of foreign reserves, since tion are taken into consideration when determin- they play an important role in alleviating shock in ing the currency composition and target duration times of financial crisis and can also enhance of the foreign reserves, so that foreign exchange Korea’s national credibility. rate and interest rate risk can be reduced. 682. Although the current level of foreign reserves is sufficient to make any necessary foreign payments, such as for short-term foreign debt Institutional framework redemption or for withdrawal of foreign investment 686. As outlined in the pertinent laws, Korea’s funds from the equity market, we believe that it is foreign reserves are comprised of funds from the desirable to increase the amount of our foreign BOK and the Government (Foreign Exchange reserves even more, considering the efforts being Stability Fund). put into improving the Korean financial system as well as our developing relationship with North • The BOK’s authority to hold and manage Korea. the foreign reserves is outlined in the Bank

138 12 • Korea, Republic of 139

Table 20. Reserves and Foreign Exchange Rates

End of End of End of End of End of End of 1996 1997 1998 1999 2000 2001

Foreign reserves (in billions of U.S. dollars) 33.2 20.4 52.0 74.1 96.2 102.8 US$/KRW 844.9 1,695.0 1,204.0 1,138.5 1,264.5 1,313.5

of Korea Act and the Foreign Exchange benchmark, and determines the currency Transaction Act, which are open to the composition and range of investment public. products. • In accordance with the Foreign Exchange • The Risk Management Team establishes the Transaction Act and the Budget and Account risk limits on the commercial financial insti- Act, the Government maintains the Foreign tutions, monitors various types of risk, and Exchange Stability Fund in order to stabilize carries out performance analysis. the foreign exchange rate, and has entrusted • Reserves Management Teams 1, 2, and 3 the fund to the BOK to manage. manage the portfolio in accordance with the • Hence, the BOK, founded in June 1950, has investment guidelines and benchmark. been the sole reserves management entity for • The Settlement and System Service Team Korea’s foreign reserves. carries out settlement and accounting and 687. On the other hand, the BOK works closely looks after the IT systems. with the Government on issues pertaining to policy 690. Some of the major responsibilities of the decisions such as intervention in the foreign International Department include the monitoring exchange market and monitoring foreign debt, in of foreign exchange transactions and of supply and accordance with the Foreign Exchange Transaction demand, intervention in the foreign exchange Act. market, and reviewing the volume of foreign 688. In accordance with the regulations set reserves and reporting on this to the public. forth by the Monetary Policy Committee, the highest decision-making body in the BOK, the Reserves Management Department (RMD) and Accountability and transparency the International Department of the Bank are 691. To minimize the investment risk and responsible for foreign exchange management- achieve greater investment efficiency, the BOK related tasks. One Assistant Governor oversees assigns responsibilities in a hierarchical manner, in both Departments (see Figure 9). accordance with the BOK’s internal regulations set 689. The RMD oversees all aspects of reserves forth by the Governor. management, including benchmark selection, investment guidelines establishment, risk manage- • The Governor determines the investment ment, portfolio management, accounting, and per- guidelines and the benchmark, including the formance attribution. The department is currency mix and range of investment prod- structured based on the three major functions ucts, and approves the annual management (front, middle, and back office), and is divided plans. into 6 teams. • The Assistant Governor establishes the quar- • The Reserves Management Planning Team terly management plans within the parame- formulates investment guidelines and the ters approved by the Governor. He also 140 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT

Figure 9. Organizational Chart

Coordination Government Bank of Korea

Monetary Policy Committee*

Governor*

Deputy Governor Auditor*

Assistant Governor

International Reserves Management Audit Department Department Department

Front Office Middle Office Back Office - Reserves Management Team 1 - Reserves Management Planning Team - Settlement and System - Reserves Management Team 2 - Risk Management Team Service Team - Reserves Management Team 3

*Appointed by the nation’s president.

mediates to harmonize the foreign reserves procedures are performed in accordance with management plan and the foreign exchange the “Code of Foreign Reserves Management policy that the International Department is Procedures” set forth by the Director of the RMD. responsible for. 693. The segregation of the accountabilities is achieved through defining the responsibilities of • The Director of the Reserves Management each function clearly, as described above. Department and the heads of the three Moreover, strict firewalls have been established reserves management teams set and execute between each function, and each team has an inde- the weekly and daily investment plans. pendent reporting line. • The Benchmark and Management Plans are 694. The Risk Management Team prepares the established after approval of the Reserves risk management reports and submits them to the Management Committee and the Investment Assistant Governor on a monthly basis and reports Committee. the detailed management transactions and performance to the top management on a quarterly basis. 692. The major tasks of foreign reserve man- 695. The auditing of Reserve Management agement are carried out in accordance with the activities is performed in two different ways, by “Regulation on Foreign Reserves Management” means of internal audit and by external audits as determined by the Governor, and the detailed follows: 12 • Korea, Republic of 141

• The internal audit is performed by the Retaining qualified staff Risk Management Team and the Audit 699. Staff are selected from among the existing Department. The Risk Management Team BOK staff based on the BOK’s general human reviews reserves management details on a resources guidelines, and trained. No external pro- daily basis to check for any breach of the fessionals are hired. investment guidelines or excess of risk limit, 700. The staff selected are encouraged to and ensures that the accounting is per- remain in the department long-term, in order to formed properly. In addition, it also mea- strengthen their expertise. They are also encour- sures the VaR numbers. The team reports the aged to participate actively in the training pro- results to the Director. grams sponsored by various domestic and foreign • The Audit Department of the BOK reviews institutions. the management details daily, through the 701. The BOK has not adopted a perfor- Bank’s internal IT network, and performs an mance-based compensation system. Therefore, audit annually. The department is operated the professionals in the foreign reserves manage- independently under the supervision of the ment teams are subject to the same compensation Auditor appointed by the President, and the and promotion system as other staff members of results of the annual audit are reported to the Bank. the Governor and the Monetary Policy Committee as well as to other Government bodies. Establishing a Capacity to Assess and Manage Risk • An external audit is performed at least once a year by the Board of Audit and Inspection, Risk management which is directly responsible to the President. Its purpose is to review both the accounting 702. To monitor the different types of risk asso- procedures and the foreign reserves manage- ciated with foreign reserves management, the BOK ment. The National Assembly also audits the has the following procedures in place: foreign reserves management annually • Credit Risk: Investment is only permitted in through the national audit. instruments with credit ratings of AA or above, and the trading counterparties are 696. The BOK calculates the size of the selected based on strict criteria. nation’s foreign reserves daily and reports on this to top management and the Monetary Policy • Liquidity Risk: The size of the liquidity Committee on an ad hoc basis. In compliance with tranche is maintained at an appropriate level the IMF’s SDDS, the BOK discloses the size of its at all times, and all investments are made in foreign reserves twice a month, to the public as well liquid and marketable securities such as as the IMF. sovereign bonds. 697. The general investment philosophy and • Market Risk: The criteria for the currency direction are disclosed to the public through mix and target duration and the permitted annual reports. However, we do not disclose deviation range are determined in advance details such as our benchmark, currency mix, and monitored closely on an ongoing basis. portfolio composition, or portfolio returns, as to The VaR system is also utilized to track and do so might adversely affect our foreign reserves monitor the greatest possible loss at a certain management. confidence level. 698. The BOK publishes an annual financial statement expressed in the domestic currency; 703. Since 1997, the BOK has separated its however, this statement does not include the com- reserves into three different tranches and estab- ments of the external auditors. lished different benchmarks for each tranche. 142 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT

• The liquidity tranche is managed to meet the Investment instruments ad hoc foreign payment demand using U.S. 706. In accordance with the BOK’s internal dollar-denominated money market instru- regulations, investment in deposits and marketable ments. The optimal size of the liquidity securities are permitted for reserves management tranche is determined quarterly based on the as follows: statistical analysis of the foreign reserves cash flow. • For marketable securities, investment is limited to securities with AA or above credit rat- • The investment tranche is managed for the ings—sovereign bonds, agencies, supra- purpose of enhancing returns, and its assets nationals, and financial debentures. Stocks, are usually invested in mid- to long-term corporate bonds, ABSs, and MBSs are not fixed income instruments. permitted. • The trust tranche is the assets outsourced to • With regard to deposits, they may be made internationally recognized asset manage- only with financial institutions having credit ment companies for the purpose of transfer ratings of A or above. of investment knowledge or know-how as well as enhancement of returns. • However, outsourced assets are allowed to be invested in corporate bonds, ABSs, and 704. The currency composition of each tranche MBSs, provided that their crediting ratings is determined based on the following principles: are AA or above.

• The entire liquidity tranche is composed of a 707. Although strategically the BOK adopts a single currency, the U.S. dollar, as most of passive investment strategy that usually does not the foreign exchange transactions are settled deviate much from the benchmark, active strate- in U.S. dollars, and the U.S. money market is gies are undertaken occasionally depending on very well developed. market conditions. 708. To facilitate such active investment • The investment tranche is determined con- strategies, the deviation range of the benchmark sidering (1) the currency composition of the is determined in advance for the currency Government’s and the BOK’s foreign debt, composition and duration, and sufficient range (2) the currency composition of the current is permitted for achieving the optimal active account payments, and (3) the size of the strategies. global sovereign bond market. In addition, 709 In addition, the BOK measures and moni- other central banks’ currency compositions tors absolute VaR and relative VaR numbers on a are also used for reference. daily basis, as a complementary tool for more effective risk management. • The trust tranche maintains the same currency compositions as the market index benchmarks employed for the respective Recent trends and challenges investment strategies. 710. The globalization of the securities mar- 705. The BOK does not hedge its currency ket has deepened the coupling effect of interest exposure, following the generally accepted princi- rate risk, resulting in a diminished diversification ple that currency exposure is neutral if the cur- effect in bond investments. Portfolio managers rency composition is maintained as determined in aspire to maximize diversification through care- advance. The BOK employs a strategic currency ful analysis of the correlations between bond management strategy on a long-term basis for the markets. purpose of rebalancing (adjusting) the portfolio, 711. The BOK employs the book value system rather than engaging in short-term (tactical) cur- as part of its accounting standards, but perfor- rency trading. mance and risk management are measured using 12 • Korea, Republic of 143 the daily market prices. Therefore, we do not 716. In addition, the transaction details are foresee any problem even if the accounting received from the custodian banks and fund standard is changed to the market price valuation management companies and reconciled daily, to system. monitor risk as well as any breach of investment guidelines. Benchmark selection Management information systems 712. The BOK uses different benchmarks for different tranches, and they are determined by the 717. The daily risk reports are submitted to the Governor. Director of the RMD and the monthly risk reports are submitted to the Assistant Governor. The quar- • For the liquidity tranche, we have developed terly performance reports to top management a benchmark composed of deposits and include some of the risk-related indexes such as short-term U.S. treasuries. currency composition, duration, VaR numbers, • For our investment tranche, we have modi- and risk adjustment measurement index, as well as fied the JP Morgan Government Bond Index the performance figures. to suit our investment guidelines. 718. The BOK conducts stress tests and measures the changes in asset value of the foreign • For our trust tranche, the Lehman Brothers reserves daily using scenarios in which historical Global Aggregate Index and Lehman events that had significant impact on the market Brothers U.S. Intermediate Government/ (e.g., Black Monday, the Asian financial crisis, and Corporate Index are employed. the September 11 terrorist attacks) recur, or hypo- 713. The benchmarks are reviewed annually in thetical scenarios in which market conditions consideration of changes in the market environ- change dramatically (such as the yield on U.S. trea- ment. However, we try to keep the strategic bench- suries goes up by 50 basis points). The results are mark stable, unless the market environment submitted to top management regularly through changes are significant. risk reports. 719. To reduce operational risk, the BOK has established strict firewalls between functions, Assessment of performance which provides a system of checks and balances 714. The performance of our reserve man- among the teams. In addition, all dialogues over agement activities is measured using market valu- the phone are recorded. ation and compared to the performance of the 720. The custodians and counterparties are benchmark. Starting in 2002, the information selected based on strict guidelines, and their credit ratio is used to measure risk-adjusted returns. ratings and corporate governance are closely mon- Performance is evaluated quarterly. The itored and reported to the Director of the Reserves performance evaluation is reported to the Management Department. Assistant Governor quarterly and to the Governor annually. Efficient markets 721. In order to maintain the liquidity of the External management foreign reserves, the BOK trades in the markets 715. Along with a benchmark, the BOK pro- where large-sized transactions can be executed vides very strict investment guidelines to the fund without severe price distortions. The BOK trades management institutions to manage the risk. in the regional markets located in the same time Separating the fund management bodies and the zone—Tokyo, Hong Kong SAR, Singapore—and custodian banks also helps to reduce the opera- in some of the European markets such as London tional risk. and Frankfurt that have time zones that over- 144 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT lap with Korea. For the New York market, which 722. The BOK’s investment instruments are is in a different time zone, the BOK’s New York restricted to high-investment-grade bonds that are representative office just executes the orders usually very liquid and marketable, and therefore from the headquarters, in the name of the head traded actively in all major international financial office. centers. 13 Latvia

Governance and Institutional 725. On the one hand, automatic interven- Framework tions at relatively tight intervention bands would necessitate the need for highly liquid reserves. On Reserve management objectives and the other, it is highly unlikely that we would ever coordination see interventions of such size that would entail the sale of the entire money base; and therefore, it 723. Reserves at the Bank of Latvia are man- would appear that we have a good deal of reserves aged according to three primary requirements: that would not be necessary for intervention pur- stability, liquidity, and income. Clearly, there are poses, that could be invested with a higher degree trade-offs between income versus stability (or cap- of risk, in exchange for increased expected ital protection) and liquidity. In practice, the Bank returns. of Latvia has set an investment benchmark that 726. The use of reserves in Latvia is generally represents and communicates the Board of restricted to maintaining the defense of the foreign Governors’ views on these three conflicting goals. exchange policy, and generating income for the The specific aspects of this strategy will be dis- central bank and the State Budget (through exist- cussed later; but it is important to note at the out- ing profit retention arrangements). Since Latvia set that the Bank of Latvia puts relatively has a vibrant banking sector with a large amount of significant emphasis on the income portion of international business, official reserves are rarely reserves management. needed for current account needs or to provide 724. Any analysis of appropriate risk/return foreign exchange for local enterprises. The trade-offs for central bank reserves management amount of foreign exchange in local bank balance needs to incorporate reserves adequacy and sheets is more than enough to satisfy the needs of potential intervention needs. Latvia’s foreign importers, exporters, and other financial institu- exchange and monetary regime is a quasi- tions. All of these factors have been analyzed at the currency board. The bank pursues a fixed Bank of Latvia, and influence the specific reserves exchange rate target (vs. the SDR), with a ±1 per- management practices, which will be discussed cent intervention band. Latvia is a quasi-currency later. board because we also have and use a number of 727. As stated in the law on the Bank of Latvia, open market instruments to manage domestic liq- the central bank has the sole mandate to manage uidity, which wouldn’t be the case in a traditional the foreign exchange reserves of the country (the currency board. mandate also permits us to engage external man-

145 146 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT agers to manage a portion of the reserves). As a intranet. The central bank is currently installing a quasi-currency board, the size of the reserves is new treasury system, which will provide more entirely dependent on automatic intervention detailed management information. The system operations, and therefore coordination with mon- should be live by year-end 2002. Furthermore, the etary policy is not much of an issue. The Bank of Governor of the Bank of Latvia and the Latvia has, at times, offered foreign exchange swap Chairperson of the Executive Board are members products to the local market, and these operations of the bank’s Investment Committee (along with are always coordinated with monetary policy. members of the Foreign Exchange Department), 728. The Bank of Latvia works closely with the which meets weekly. Therefore, the highest levels State Treasury and Finance Ministry to coordinate of management are always informed of any devel- debt policy, but reserves management is not influ- opments positively or negatively affecting the enced by the currency composition or maturity of reserves portfolio. the government’s external debt. Each institution is responsible for managing its foreign exchange and Transparency and accountability interest rate positions. The Bank of Latvia is the fiscal agent for the State Treasury and Finance 730. Foreign exchange reserves operations are Ministry, however, and frequently manages money audited by external auditors and the State Control on behalf of these institutions, but these funds are annually and by internal auditors more frequently. managed in separate portfolios and do not influ- Disclosure of performance and positions is quite ence the central bank’s reserves portfolio. Any transparent. The central bank’s published monthly non-reserve foreign exchange in the central bank’s financial statements will reflect all market value balance sheet (such as Finance Ministry money or changes in all portfolios, and the annual statements funds from foreign exchange swap operations) is are quite specific, offering detailed reports of cur- run on a matched-book basis, to minimize any rency position and also credit quality. While the adverse effects on the bank’s income statement. Bank of Latvia, like most central banks, does not While requiring the management of several portfo- publish results in accordance with International lios with different investment characteristics com- Accounting Standards, the amount of transparency plicates the foreign exchange management process is very high, with footnotes to the financial state- at the bank, this arrangement allows a very clear ments being very detailed, providing any reader of understanding of every risk taken on the balance the financial statements possessing a modest sheet from foreign exchange operations. amount of accounting knowledge with all the information necessary to analyze the true performance from reserves management. And while relative Organizational and decision-making structure performance numbers versus the benchmark are 729. Investment guidelines for reserves man- not specifically published, the benchmark itself is agement are set by the central bank’s Board of not confidential, and all of the data that would Governors. More specific guidelines (such as allow- be needed to make such an analysis are publicly able risk parameters for other portfolios, for exam- available. ple) are set by the Executive Board. All reserves management operations are undertaken in the Foreign Exchange Department. Great care is taken Capacity to Assess and Manage Risk to ensure that all levels of management are aware Risk management and benchmark portfolio of the results of reserves management operations. Monthly performance reports are given to the 731. As the Bank of Latvia uses reserves to Executive Board. The Board of Governors analyzes defend a fixed exchange rate target (against the the effects of reserves management on the bank’s SDR), the neutral currency composition mirrors budget at its meetings, and all management has this target. Specifically, the reserves benchmark access to daily accounting reports on the bank’s consists of the components of the SDR currency 13 • Latvia 147 basket, weighted as in the SDR. When the reserves its from expected rate moves. The long-term strate- portfolio is invested according to the neutral cur- gic benchmark is set by the Board of Governors, and rency weights, then there are no valuation fluctua- the Investment Committee (comprised of Foreign tions due to currency movements. Exchange Department staff, the Chairperson of the 732. Regarding interest rate risk, the bench- Executive Board, and the Governor of the Bank) mark consists of the 1–3 year government bond meets weekly to set tactical benchmarks. The index in each component currency. This maturity Investment Committee also holds a quarterly sector was chosen for various reasons. First, extend- meeting to discuss strategic themes. Individual port- ing duration, and having a market, not cash, folio managers are free to trade instruments in a benchmark, markedly increases the return on range around the tactical benchmark set by the reserves over the long run. Obviously, increasing Investment Committee. expected return leads to an increase in expected volatility. However, the 1–3 year sector was chosen Instruments to mirror the risk tolerance of the Board of Governors of the Bank of Latvia. The 1–3 year sec- 735. The central bank uses futures, options, tor offers notable return enhancement, but volatil- swaps, and other derivatives in the management of ity is limited—during the time periods available in currency, interest rate, and credit risks. Derivatives most financial databases, the 1–3 year maturity sec- can be used for hedging purposes, to quickly and tor has never ended a 12-month period with a neg- efficiently restructure the risk parameters of the ative return. Clearly, sub-zero returns can be portfolio, and for taking active positions. Leverage observed in shorter time periods. limits are set by the Board of Governors’ invest- 733. Liquidity is, of course, a primary concern. ment guidelines. The Bank of Latvia has several liquidity constraints 736. A certain portion of reserves tends to be in its reserve management guidelines, which result invested in “spread product”—agency and supra- in the purchase of instruments that can be realized national paper, corporate bonds, mortgage-backed in times of market stress. Unlike other central and asset-backed securities, commercial paper, and banks, however, the Bank of Latvia does not main- similar products. Our studies have shown that tain separate liquidity and investment tranches in greater long-term risk-adjusted expected return its reserves portfolio. We have found that the addi- can be gained from “moving down the credit tion of extremely liquid short-term instruments for curve,” than by adding duration, or taking active a liquidity portfolio is not economically justified in currency positions. Our investment guidelines our case. The instruments we hold in longer-term limit the amount of credit risk allowable in the maturities are more than liquid enough to satisfy portfolio, and limit liquidity and concentration risk any intervention (or even working capital) needs, as well. With a minimum allowable long-term rat- and any perceived negative effects from increased ing of A-, all of the instruments the Bank of Latvia transaction costs from liquidating market instru- purchases for its reserves portfolio are safely in the ments in times of stress are more than offset by “investment grade” category. increased long-term returns. Maintaining separate liquidity and investment tranches in effect puts the Staff reserves portfolio in a “barbell” strategy. And while such a strategy offers increased portfolio convexity, 737. The management of a portfolio with such convexity has a price, and such a portfolio will be diverse products requires front, middle, and back suboptimal in the long term, as it will not outper- office staff that can understand, measure, and form a duration-neutral “bullet” strategy. manage the various risks involved. The Bank of 734. Within limits set by the Board of Governors Latvia has been able to attract and maintain and the Executive Board of the Bank of Latvia, the extremely competent staff; turnover in the reserves portfolio managers are allowed to take active posi- management department has been limited. The tions away from the benchmarks, in the aim of prof- central bank is able to offer its reserve manage- 148 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT ment staff sufficient salaries—while not necessarily ment guidelines and limits as our internal man- exceeding those available in the private sector, agers, and every external manager transaction is also salaries are at least competitive. It is also possible entered into our in-house information systems. for reserves management staff in some cases to As a result, the managers provide good external earn higher salaries than senior management benchmarks for our internal managers, and every- members, or department heads in other bank one’s performance is measured using the same data areas. Furthermore, we have found that allowing and methodology. We have found our external man- more complicated investments tends to keep ager program to be quite successful—at first, the reserves management staff interested and moti- managers provided valuable technical assistance and vated—it would be much harder to retain our best training; now, besides providing external bench- specialists if the reserves portfolio were limited to, mark data, they can be used to discuss investment say, only government paper. strategies and ideas. Since every manager has the 738. To maintain a high standard of profession- same goals, in trying to outperform the same bench- alism in the reserves management staff, every single mark, these discussions can be more fruitful than member of the front and middle offices (and the with some sell-side counterparties that may not department head), as well as some back office staff, know our specific needs at best, or may be trying to are enrolled in, or have completed, the Association sell their specific inventory at worst. for Investment Management and Research’s 741. Compliance with limits and guidelines is (AIMR) Chartered Financial Analyst (CFA) pro- monitored constantly, for both internal and exter- gram. This program is a series of annual exams nal manager portfolios. Exception reporting is (three years’ minimum) that cover all aspects of the automatic; in the case of a limit breach, the depart- investment process, including accounting, taxes, ment head, Chairperson of the Executive Board, corporate finance, fixed income, equity manage- and Governor are notified electronically. Daily ment, derivatives, portfolio management, ethics, asset mix reports, which show various deviations financial analysis, etc. All AIMR members also from strategic and tactical benchmarks (within per- adhere to a Code of Conduct regarding conflicts of missible limits), are also distributed electronically. interest in asset management and analysis, and 742. Portfolio performance is measured on an annually sign professional conduct statements. absolute basis (for accounting purposes), and relative to the benchmark (for investment management purposes). Our performance attribution system dis- Risk and performance measurement aggregates composite returns into returns from spe- 739. Information systems are also crucial to the cific strategies, and these reports are always available management of these risks. The Bank of Latvia cur- online in our information systems, and e-mailed rently has specialized systems covering position weekly to reserves management staff, the Governor, management, risk analysis, performance attribu- and Chairperson of the Executive Board. tion, exception reporting, and accounting require- 743. Operational risk and legal risk are con- ments for all reserves management operations. stantly managed, and also addressed in several Obviously, these systems are capable of processing department and Executive Board procedures doc- all the allowable instruments in the bank’s reserves uments. All reserves management operations and other foreign exchange portfolios. The central undergo an annual external audit, and specific bank is currently installing a new bank-wide trea- aspects are audited more frequently by the Bank’s sury system, which will further integrate these pro- Internal Audit department. cesses, and a new risk management package will further supplement our existing risk management Conclusion efforts. 740. The Bank of Latvia employs external asset 744. The Bank of Latvia places a focus on the managers to manage portions of the reserves port- return aspect of reserves management, which folio. These managers are subject to the same invest- necessitates excellent staff, excellent systems, and 13 • Latvia 149 the willingness of senior management to under- and our performance to date has tended to justify stand and sanction relatively higher risk levels. We this attitude. The nature of reserves management is feel the systems and staff at the Bank of Latvia are always evolving, and the Bank of Latvia will con- more than capable of managing the assumed risks, tinue to invest resources in staff and systems. 14 Mexico

Developing a Sound Governance and Assets and Liabilities on a monthly basis in the Institutional Framework Data Template on International Reserves (foreign currencies). Reserve management objectives and 748. However, with respect to a more detailed coordination disclosure, the Bank considers the effort required 745. The main objective for Banco de Mexico to explain the technical issues related with reserve (the Bank) in the management of its reserves is the management to the public to be very costly. maximization of returns subject to liquidity needs Instead, that effort should be placed in addressing and constraints. With the implementation of a float- more important topics of national interest. ing exchange regime in 1995, the Bank has been 749. External audits are performed once a year increasing the weight that it places on return and the results are delivered only to the Congress enhancement, while also placing high attention on and the President.42 other risks involved in its investment decisions. 750. Internally, the audit department monitors 746. There is no explicit coordination between operations on a daily basis to verify if the bank monetary policy decisions and external debt man- norms are being met. However, the middle office is agement. However, in the past, when the Bank had responsible for monitoring whether investments liabilities with the IMF, reserves were split to allow comply with the guidelines set by the Board of the synthetic purchase of an SDR-denominated port- Governors on a daily basis as there are degrees of folio in order to hedge the currency risk. freedom that allow some deviations from the Additionally, the Bank, as a financial agent for the benchmarks. These deviations are limited using a Federal Government, has a mandate to invest and Value-at-Risk approach. manage the resources that were pledged as collateral 751. The Bank keeps formal documentation of in the Federal Reserve Bank after the 1989 negotia- every topic approved by the Board of Governors. tions of the Mexican Brady Bonds; in performing The General Direction of Central Banking these duties, the Bank must observe restrictions Operations also gives authorizations in writing. imposed under the “Collateral Pledge Agreement.” 42 Chapter VII, Article 51, subindex III of Banco de Mexico’s Law (BDML) states: “In April of each year, a report on the Transparency and accountability implementation of monetary policy during the second semester of the previous year and, in general, on the activities 747. The Bank publishes its Reserves on a of the Bank throughout said year, within the context of the weekly basis in its Summarized Balance, and its domestic and international economic situation.”

150 14 • Mexico 151

Finally, both the General Director and the Director held to evaluate and decide on the investment of Operations are constantly informed of every strategy to be followed by headquarters-based staff. investment strategy put in place, and of the perfor- 758. External fund managers act indepen- mance generated against the benchmarks on a dently based on the same guidelines placed by the daily basis. Board for internal operations. There are no prede- 752. Recruiting employees with high business termined proportions on the amount of reserves ethics and high professional skills is the way to that can be placed with external managers; ensure sound management of internal operations. although currently approximately 5 percent of Due to the confidential nature of the work within total reserves are delegated to five different institu- the Direction of Operations, a particular effort is tions. These institutions provide a list of all the taken in selecting personnel. Training the staff by operations executed on a daily basis, and deliver a sponsoring them to graduate studies, as well as performance report on a monthly basis. sending them to highly recognized Central Bank 759. In addition to the Investment Working Seminars, are ways of confronting the difficulty of Group, a Risk Management Unit, which is inde- retaining high-quality staff. In the end, however, pendent from the Operations Department, super- the most efficient tools to avoid this situation have vises to ensure that risks and limits in the been a challenging work environment and an management of reserves are met on a daily basis by increased level of responsibility. both the external managers and the Operations Department. Within the Operations Department, foreign exchange dealing operations are executed Institutional framework independently from the investment reserves man- 753. The Constitution of Mexico gives total agement activities. autonomy to the central bank and defines the con- 760. A Counterpart Working Group that trol of inflation as its main objective. assembles every six months, led by the General 754. According to Banco de Mexico’s Law Director of Operations and formed by the (BDML), reserves are wholly owned by the Bank in Operations Department and the Risk Management order to facilitate the accomplishment of the objec- Unit, is responsible for evaluating and approving tive mentioned above. the addition or deletion of counterparts from a 755. The BDML also gives power to the Bank’s predefined authorized list. Board of Governors to define policies and standards in order to perform its duties, including the management of reserves. The types of operations, Establishing a Capacity to Assess and the definition of reserves, and the authorized Manage Risk assets in which to invest are defined in BDML Articles 7, 19, and 20, respectively (see Box 1). Risk management 756. Even though the “Exchange Rate 761. The main risks that the Bank faces are liq- Commission” (composed of members from the uidity, credit, currency, and interest rate risks. To Ministry of Finance and Banco de Mexico) is the deal with all of them the Bank has a specific highest decision authority on exchange rate policy approach. The Board of Governors defines the and the management of foreign reserves, in prac- strategic asset allocation embodied in two bench- tice, it is the Bank’s Governing Board that autho- mark portfolios: one for the investment portfolio rizes the main investment guidelines. The and the other for the foreign exchange diversifica- Governing Board is informed semiannually of the tion of reserves. Once the benchmarks have been investment performance; nevertheless, reports are defined, the Board sets the guidelines that will available daily at their request. apply to the active management of the interna- 757. An Investment Working Group formed by tional reserves. senior operating staff is responsible for the over- 762. The investment benchmark has been sight of ongoing operations. Weekly meetings are modified several times; currently it is composed of 152 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT

Box 1. Banco de Mexico’s Law

BDML ARTICLE 7 states, among other things, that received from the sale of domestic currency Banco de Mexico shall be entitled to perform activi- will not be taken into consideration; and the ties such as: Bank’s liabilities in foreign currency and gold, except for those liabilities with maturities over I. Deal with securities; six months and those corresponding to the II. Make deposits in either domestic or foreign financing referred to in Section III of this arti- credit institutions or security depository insti- cle, will be deducted. tutions; BDML ARTICLE 20 states that reserve investments III. Purchase those securities provided for in must be made in securities, deposits, or other obliga- Article 20, Section II, issued by international tions issued by highly rated foreign institutions. financial institutions or legal entities with for- Pursuant to this Law, the term foreign currency eign domiciles; includes foreign bank notes and metallic coins, bank IV. Carry out transactions involving foreign cur- deposits, negotiable instruments, securities, and all rency, gold, and silver, including repurchase types of credit documents payable abroad and agreements. denominated in foreign currency, as well as interna- BDML ARTICLE 19 states: The reserve provided tional means of payment in general. The foreign cur- for in the previous article shall be composed of: rency qualified to be part of the reserve is only the following: I. The foreign currency and gold, property of the Central Bank, that are free of all lien and I. Foreign bank notes and metallic coins; whose availability is not subject to any restric- II. Deposits, negotiable instruments, securities, tion; and other liabilities payable outside national II. The amounts resulting from the difference territory that are considered to be first rate in between Mexico’s participation in the Inter- international markets, denominated in foreign national Monetary Fund and the balance of currency, and payable by international financial unpaid contributions to said institution that institutions, foreign entities, and governments are payable by the Bank, when this balance is other than the Mexican Government, provided less than the aforementioned participation; they are highly liquid or redeemable within a and term no longer than six months; III. The foreign currency procured through III. Credits payable by central banks, redeemable financing obtained for exchange regulatory within a term no longer than six months, and purposes from the legal entities referred to in which are current; and Article 3, Section VI. To determine the amount IV. The special drawing rights issued by the of the reserve, the foreign currency not yet International Monetary Fund.

U.S. Treasury instruments (65 percent), U.S. agen- 12 percent in other G-7 currencies and Swiss cies debt (32.5 percent), and AAA credit card ABS francs, but historically the average has been 90 per- (2.5 percent), and is of a 1.25 year duration. cent dollars vs. 10 percent non-dollars. The use of Securities lending is permitted and is executed derivatives is authorized as part of the foreign through three securities lending agents (that hap- exchange active management. pen to be three of the Bank’s custodians) and the 764. For both benchmarks Value-at-Risk (VaR) income generated is considered part of the return methodology is used to estimate on a daily basis the that is compared against the performance of the portfolios’ exposure to market risk. VaR is esti- benchmark. mated for a one-month horizon period with a 95 763. The foreign exchange benchmark is nor- percent confidence interval. The maximum mally modified on a yearly basis, and currently it is amount of risk allowed is equivalent to 0.25 per- composed of 88 percent dollars and the remaining cent of the difference portfolio VaR. Additionally if 14 • Mexico 153 the maximum cumulative underperformance in ment in AAA credit card asset-backed securi- any calendar year, or any part of a calendar year, ties is allowed. Ratings are reviewed semi- reaches 50 basis points (or more) below the return annually as well as limits for individual bank of the fixed income benchmark (or 100 million exposure. These limits are based on their dollars (or more) worse than the foreign exchange relative credit rating against the rest of benchmark) the portfolio will be managed pas- authorized bank institutions and also based sively thereafter so as to replicate the benchmark on their market competitiveness. for the remainder of the calendar year. For both • Currency risk: Due to the nature of the benchmarks, the middle office marks to market Bank’s Balance expressed in Mexican pesos, the positions daily in order to verify that invest- foreign exchange movements in the peso- ments comply with the guidelines set by the Board dollar market have a direct impact on the of Governors. Bank’s results. In the internal management 765. In relation to liquidity, credit, currency, of international reserves, however, currency and interest rate risk: risks arise from deviations against the foreign • Liquidity risk: The Board has chosen G-7 cur- exchange benchmark. rencies and Swiss francs for foreign exchange • Interest rate risk: The exposure to interest operations and as those that constitute the rate risk arises from deviations against the Central Bank Forex Benchmark. For invest- investment benchmark, even though in this ment decisions the Board has chosen assets particular portfolio the use of derivatives is with deep secondary markets and high credit not allowed. The Value-at-Risk methodology quality (such as U.S. treasury instruments, described above is used to monitor and con- agencies, and industrialized country debt). trol risk. Additionally, the investment staff is Additionally the Bank splits its reserves into not authorized to buy more than 10 percent several tranches. Out of the 88 percent of the of any individual security and the maximum international reserves that are held in U.S. maturity investment is 10 years. dollars, 6 percent are in a liquidity portfolio with a very short duration.43 • Credit risk: The investment guidelines do Operations in efficient markets not allow the purchase of sovereign securi- 766. The Bank agrees that undertaking trans- ties lower than Aa2 as rated by S&P in their actions in deep and well-established markets long-term debt, placements with foreign ensures that reserve-related transactions can be banks must be in A2, P2 institutions as rated easily absorbed at market-determined prices with- by S&P and Moody’s, respectively, in their out undue distortions or adverse impacts on the short-term debt, and the total exposure to level and availability of foreign exchange reserves. bank risk cannot exceed 50 percent of the That is why the currencies and assets used by the international reserves. Finally, the invest- Bank comply with this requirement. Nevertheless, the Bank recognizes that there could be extreme situations such as LTCM or September 11 events 43 The liquidity portfolio considers investments with maximum that can cause liquidity to disappear at any time, maturities of three months (although investments in instruments such as U.S. treasuries and U.S. agencies can be made making it impossible to avoid these distortions for liquid on a same-day basis). the management of international reserves. 15 New Zealand

767. This report outlines the framework for • Meet the immediate liquidity needs for any managing foreign reserves in New Zealand. We foreign exchange market intervention. cover matters raised in the IMF’s guidelines on • Maximize risk-adjusted net returns (or mini- reserves management under two broad themes: mize risk-adjusted net costs), subject to the developing a sound governance and institutional first objective. framework and establishing a capacity to assess and manage risk. • Develop and maintain a broad skill base in foreign securities and foreign exchange dealing to support the Bank’s capability for conduct- Developing a Sound Governance and ing foreign currency market intervention or Institutional Framework responding to other crises, and to enhance 768. The responsibility for foreign reserves the Bank’s general understanding of financial management rests with the central bank—Reserve markets, instruments, and practices. Bank of New Zealand (the Bank). Two major bene- 771. These objectives are long-standing—they fits arise from this arrangement. First, synergistic were first developed in the late 1980s. The objec- benefits arise with a single organization taking tives have been subject to review since then, but responsibility for monetary policy, financial system have remained substantially the same because the oversight, and foreign reserves management. principles that underlie them have remained rele- Second, the Bank’s independence from the govern- vant through time. These principles are that the ment means that the management of foreign Bank should: reserves is undertaken at arm’s length from the • have both the funds and expertise to be able political process. to intervene effectively in times of extreme 769. The Minister of Finance has important market disorder; and roles in setting the range within which the Bank must maintain foreign reserves and can direct the • manage public assets prudently and cost- Bank to intervene in the foreign exchange market. effectively. 772. These underlying principles are reflected Objectives and strategies in the reserves management objectives in the fol- 770. The Bank’s reserve management objec- lowing ways. First, the primary objective for tives are to actively manage the foreign reserves reserves management is to maintain liquid assets so portfolio to: that even in the event of extreme market disorder

154 15 • New Zealand 155 in both the foreign exchange market and global 776. The level of reserves also reflects our bond market the Bank has the capacity to under- intervention strategy. We hold reserves to preserve take effective foreign exchange intervention. the functioning of the market for NZDs in time of 773. Second, the Bank actively manages for- crisis—i.e., when the market ceases to make a two- eign reserves. It does so because it believes that way price (bid and offer) for NZDs. If price-makers active management: exit the NZD market, the Bank may enter the mar- • generates positive returns (in excess of com- ket as a temporary “price-maker of last resort.” The pensation for risk and of active management aim would be to facilitate early reentry of price- overheads) and so reduces the costs of hold- makers, by taking on foreign exchange risks that ing reserves; and arise in price making in times of heightened foreign exchange or financial market uncertainty, • encourages the dealers to actively participate until a new price-clearing level for the NZD is in a wider range of instruments and markets determined. The Bank would maintain control than would otherwise be the case and so over the transaction sizes used to determine a mar- improves the Bank’s market intelligence and ket clearing price. The Bank has not had to inter- contacts, knowledge of market practices, and vene in the foreign exchange market since the foreign exchange intervention and risk man- NZD was floated in March 1985. agement skills. The skills and experience 777. Our base-line level of reserves was first gained from reserves management have been approved in the late 1980s. Much has happened of value to the Bank in the context of its other since then, including the Asian crisis and a greater roles too. For instance, foreign reserves deal- understanding internationally of factors influenc- ers were able to provide valuable input when ing macro-financial stability. The Bank is embark- the Bank, in the context of its financial system ing on a review of reserves levels with these lessons oversight responsibilities, was managing the in mind. sale of a derivatives portfolio of a failed financial institution. It is not possible to be precise about how much added value is obtained Funding reserves from active management but, in times of 778. The Bank funds its foreign reserves by way crises, extensive market knowledge, contacts, of foreign currency borrowing. The benefit of this and experience become invaluable. strategy is that the Bank is not as exposed to signifi- 774. The key strategic issues arising from New cant foreign exchange risk as it would have been Zealand’s reserves management center around two had it funded reserves from NZD liabilities (includ- issues: the level of reserves and the funding of ing notes and coins).44 This assists the Bank in main- reserves. taining its independence as it is less exposed to political risks that arise (rightly or wrongly) when a government or public sector entity reports large Level of reserves losses from risk positions. A strategic issue for the 775. The Bank manages reserves at a level Bank to consider in the future is whether costs of agreed with the Minister of Finance—currently this holding reserves could be reduced by financing is SDR 1.5b–SDR 1.8b. The level of reserves is reserves from notes and coins and/or fixed rate bor- determined in the context of our exchange rowing in the local market (where the rate/monetary policy implementation strategy and Government’s AAA rating gives it a competitive foreign exchange intervention strategy. New

Zealand operates a free-floating exchange rate 44This funding arrangement requires the Bank to spread its regime—the Bank does not enter the New Zealand borrowing requirements to minimize its exposure to refinanc- dollar (NZD) market to support a level or range for ing risk—i.e., minimize the risk that the Bank has to finance a the NZD that it may consider appropriate in the substantial portion of reserves at a time when an extreme event in international markets has a significant adverse effect context of monetary policy. on borrowing (refinancing) costs. 156 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT advantage). The Bank would enter into a currency ducts back-office operations (e.g., settlements, swap to continue to hedge its foreign exchange risk. treasury, and financial accounting) and some middle-office operations (e.g., compliance monitoring, risk and exposure reporting, risk system Institutional framework maintenance). 779. As noted at the outset, the Bank is the 783. Other departments and committees also entity responsible for foreign reserves manage- play important roles in the management of foreign ment; however, it has a working relationship with reserves. The Risk Assessment and Assurance the Treasury and in particular the Treasury’s Debt Department (RAA) participates in high-level strate- Management Office (DMO) in two respects. We gic reserves management issues, acting as the discuss this relationship and then outline the insti- Governor’s advisor on risk frameworks and archi- tutional arrangements within the Bank. tecture. This department also contains the internal audit function. The Reserves Oversight Committee (ROC) comprises Governors and senior managers The Bank and Treasury and reviews the appropriateness of the portfolio 780. The relationship with the Treasury arises in structure, approves new business initiatives two contexts. First, the Minister of Finance has the (including new financial instruments), and moni- power to direct the Bank to intervene in the foreign tors active management and passive benchmark exchange market. It is anticipated that in a foreign performance. The Risk Management Committee exchange crisis, the Bank will be intervening with (RMC) comprises Governors and senior managers the approval of the Minister of Finance, although and reviews the risk management arrangements the Bank has the power to intervene in the foreign with respect to all the Bank’s operations, including exchange market of its own accord, if required. reserves management. 781. The Bank also has a close working relationship with the DMO in the context of funding reserves (among other functions—e.g., govern- Accountability through governance and ment cash management and bond tendering). The transparency Bank decides on the timing and nature of reserves 784. Accountability for the cost-effective man- funding (i.e., fixed or floating rate, maturity, cur- agement of reserves in accordance with perfor- rency), consistent with its reserves management mance expectations and risk tolerances is achieved strategy, but it is the DMO that raises the funds through formal governance arrangements and (borrowing is undertaken in the Government/ transparent reporting of results and processes. Crown name). The proceeds of the borrowing are passed to the Bank by way of loans from the DMO to the Bank and in this way the risks arising from Governance the reserve assets and liabilities are managed by the 785. The Bank’s powers, authorities, and Bank. accountabilities are contained in the Reserve Bank of New Zealand Act 1989 (the Act). The Bank’s powers and authorities are vested with the Governor, Arrangements within the Bank who delegates appropriate authorities to relevant 782. Foreign reserves management is carried staff. The Bank conducts its foreign reserves opera- out across two departments. The Financial Markets tions in accordance with a mandate from the Department conducts front-office operations (e.g., Governor. The Mandate for the Management of the dealing, portfolio and asset/liability management, Foreign Reserves Portfolio (the Mandate) contains counterparty relationship management) and some the purpose, objectives, reserves level, performance middle-office operations (e.g., risk management expectations, risk management policies, and key policy, contract maintenance, counterparty credit management responsibilities and delegations with rating reviews). The Financial Services Group con- respect to reserves management. The Mandate, 15 • New Zealand 157 which was implemented in September 2000, was Markets Department and Financial Services Group designed to avoid any misdirection of focus toward are subject to both internal and external audit. detailed and immaterial risk and procedural issues. It was felt that a succinct, high-level mandate mod- Transparency eled along funds management industry lines would emphasize high-level, strategic focus on risk and 788. The Bank publishes an annual report that return issues with respect to the foreign reserves lays out the governance arrangements, reports on management function. Based on the experience of the key performance indicators with respect to its two years of operations, the Mandate appears to be functions (including reserves management), con- serving its purpose. tains a report from the non-executive directors, 786. The Bank’s Board of Directors45 (which and includes audited financial statements pre- comprises a majority of independent directors) has pared in accordance with New Zealand generally responsibility for, among other matters, keeping accepted accounting practice (GAAP). New under constant review the performance of the Bank Zealand GAAP requires compliance with New in carrying out its functions. Unlike boards of most Zealand accounting standards, which are at least as entities, which have a capacity to direct and influ- rigorous as international accounting standards. In ence the entity’s functions and operations, the addition, the Bank applies relevant financial risk Bank’s board may only advise the Governor with disclosures recommended by the Basel Committee respect to matters relating to the Bank’s functions on Banking Supervision. The key financial report- and exercise of its powers. However, if the board ing implications of these policies are: considers that the Bank is not adequately carrying • Foreign reserve assets and foreign currency out its functions, it may recommend to the Minister liabilities funding those assets are valued in of Finance that the Governor be removed from the Statement of Financial Position (Balance office. Senior managers report to the Board Sheet) on a marked-to-market basis with monthly on the financial results of foreign reserves gains and losses booked to the Statement of management. The Board’s Audit Committee also Financial Performance (Profit and Loss). meets regularly to monitor the audit function within This fair value methodology is employed the Bank, receive reports from the Bank’s external because we regard the reserves as available auditor, review the Bank’s financial statements, and for sale (intervention). Liabilities are valued advise the Board on the Bank’s accounts. using the same methodology as the assets so 787. The Head of Financial Markets, who that the financial statements capture the reports to the Governor, is accountable for reserves effects of the quality of our financial risk management performance and compliance with management—gains/losses from unhedged risk management arrangements. The ROC assists risk positions are booked to P&L. the Governor in monitoring performance and port- • Extensive disclosures are provided in the folio structures at a high level. The Chief Financial notes to the accounts on a range of reserve Officer (who heads the Financial Services Group management matters—e.g., risk management and reports to the Deputy Governor) is accountable policies, quantitative risk exposures (includ- for, among other matters, settlement operations, ing credit risk and market risk losses, includ- reserves accounting/financial reporting, and moni- ing from tail (extreme) events), net reserves toring the Financial Markets Department’s compli- management income (active management ance. Reserves operations in both the Financial performance and passive or risk neutral performance are separately identified).46

45The Bank’s Board is about to undergo a restructuring—a non-executive director will replace the Governor as Chair of 46Note, the effect of translating reserves management perfor- the Board, and Deputy Governors will no longer hold Board mance back into NZD is not material (but is separately dis- positions. This follows an independent review of the operation closed) because foreign reserves are funded by foreign of monetary policy in New Zealand. currency liabilities. 158 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT

Establishing a Capacity to Assess and the liquid reserves must be held in Government Manage Risk securities and no more than a third of the liquid reserves can be held in CD/CPs. The investment of Benchmark portfolio and instruments a significant proportion of reserves in CD/CPs 789. The Bank’s framework for managing all instead of Government securities significantly risks arising from foreign reserves management is reduces the cost of holding reserves (the CD/CP documented in the Risk Management Document. investment yield is close to the funding costs), with- The main risks the Bank faces from this activity are out significantly reducing credit quality (given the business risk, liquidity risk, credit risk, market risk credit rating criteria we apply and the short matu- (interest rate and foreign exchange risk), and rity of the instruments) or materially altering our operational risk (including custodial risk). The key liquidity (since our holdings represent a small pro- elements of the strategy for managing these risks portion of turnover and amount on issue). are outlined below. This section concludes with a 793. The currency composition of reserves is discussion of active management performance determined by the intervention strategy and risk monitoring and controls. preferences. The U.S. dollar is our intervention currency so the majority of our liquid assets are denominated in this currency. The proportion of Business risk reserves held in other major currencies varies 790. This encapsulates the political and infra- depending on prevailing risk conditions and net structural risks arising from the markets in which, borrowing costs. Depending on local market con- and instruments with which, we manage reserves. ditions we may hold reserves in only one currency We aim to minimize reputational risk by limiting other than the U.S. dollar. Currently, we hold liq- authorized instruments to “plain-vanilla” fixed uid reserves in U.S.dollar- and euro-denominated income instruments and derivatives. The deriva- assets. tives activities encompass only futures and swaps. 794. The instrument composition of reserves is We do not invest in non-fixed income instruments reviewed periodically in the context of liquidity risk such as equities. Nor do we invest in options or stress scenarios—e.g., widening of credit spreads fixed income securities with material option risk and bid/offer spreads. The Risk Management such as mortgage-backed securities. Committee reviews underlying assumptions about 791. The markets in which we operate are in extreme market conditions, our intervention strat- essence restricted to those of well-developed coun- egy under those conditions, and the financial cost tries (mainly the U.S. and Germany although we of liquidating reserves under such conditions. have scope to participate in G-10). We do not oper- Based on this analysis, the instrument composition ate in emerging markets. of liquid assets is determined.

Liquidity risk Credit risk 792. Reserves are not divided into tranches to 795. The risk of loss from counterparty default meet different objectives per se. However, reserves is managed by way of individual counterparty and are actively managed within the overriding con- aggregate credit risk limits. Individual counter- straints that reserves must be liquid and diversified party limits are determined in accordance with the primarily across the U.S. and Germany. This means Governor’s strategic tolerance for loss—the loss that the base level of reserves must be invested in from default of a non-sovereign counterparty specified classes of liquid assets in these markets— should not exceed the Bank’s capital. In practice, i.e., Government securities (including central bank this means we set the counterparty limit for deposits), reverse repos (with Government security AAA/AA+ rated entities at a level just below Bank collateral), and CD/CPs (primarily by issuers rated capital. Limits for counterparties with a lower rat- AA- or better). In broad terms, at least a third of ing are assigned a proportionately lower limit 15 • New Zealand 159 based on the relative default rate for entities with in instruments that are highly liquid (even in that lower rating. For instance, if the probability of extreme/stress scenarios) we believe it is appropri- default of a single-A rated entity was three times ate to measure market risk (including tail-event higher than that of an AA+ rated entity, the limit market risk) with only a one-day holding period. for the single-A rated entity would be one third the 799. Actual daily P&L results are compared limit of the AA+ rated entity. We do not permit with estimated gains and losses from the VAR credit exposures to entities rated lower than A-. model each month. The results of the “back- 796. Concentration of credit risk is controlled testing” analysis are reported to the Reserves by aggregate credit limits—primarily country limits Oversight Committee quarterly. and, in some cases, bank or corporate sector limits 800. The VAR-based framework for managing within countries. The thresholds for aggregate market risk has been in operation since 1998. It is a credit limits are set on the basis of judgments about considerable improvement over our in-house dura- political risks arising from losses in the event of section and convexity market risk model, which it tor or country crises. We are in the process of sup- replaced, because VAR captures spread risk and FX plementing these judgments with a quantitative risk. We have found VAR a very useful “common analysis of counterparty default correlation. Our ruler” for measuring market risk on a range of dif- aggregate credit limits also include a cap on the ferent instruments and positions and most helpful aggregate amount of credit exposure we have to all in communicating to senior management about the single-A rated counterparties to ensure that the quantum of risk (under normal market condi- credit quality on the reserves portfolio is main- tions). VAR presents challenges for us in terms of tained at a high level. understanding where our market risk exposures lie 797. Credit exposures relative to limits are gen- and what are our key risk factors (nature of and erally reported on a gross basis—exposures are changes in interest rate and exchange rate volatili- only reported on a net basis where there is a legally ties and correlations). We are in the process of enforceable netting contract. developing management reports to get better insights into our risks that lie behind VAR. Senior management are aware of market risks that lie Market risk beyond VAR—the results of the annual tail-event 798. The market risks the Bank is exposed to analysis are reported to them and estimates of are interest rate risk and foreign exchange risk. extreme losses are published in the annual report. Both these risks are controlled by the same market We also find (parametric) VAR less useful for cap- risk limit framework. The (parametric) Value-at- turing the risks over time on the passive portion of Risk (VAR) methodology is used to measure and reserves because the main market risk on this por- control market risk. The VAR limits are set well tion of reserves—credit spreads—is mean-reverting. within the Governor’s stated tolerance for market This means scaling parametric VAR by time over- risk losses in a year to allow for both accumulated states risk. VAR derived from historical simulation is market risk losses over a year under normal market our preference for the future, but system and conditions and losses from extreme movements in database management issues constrain our desire to market prices or “tail-events.” The accumulated move in this direction in the foreseeable future. losses over a year allow for poor active management performance and (mark to market) losses on the passive portion of reserves due to adverse inter- Operational risk est rate trends (narrowing credit spreads). The 801. Minimizing operational risks in the man- allowance for tail-events is based on an analysis of agement of reserves is of critical importance in two simulated worst single day losses on a diversified respects: portfolio over the 1990s, scaled up to allow for unobserved tail-events. This simulation/stress test • Maintaining a continuous intervention capac- analysis is conducted annually. Given that we invest ity; and 160 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT

• Minimizing financial loss and reputation clearly outlines the performance expectations that damage from fraud. must be met to continue this activity. Active man- 802. In order to maintain a continuous inter- agement takes the form of interest rate and cur- vention capacity the Bank sets internal controls rency trading over short-term (ranging from and processes with respect to system and data intraday to up to three months) and medium-term integrity (e.g., data reconciliation), disaster recov- (three to 24 months) horizons. Positions are ery planning (including maintaining an off-site entered into at the discretion of dealers and on the capacity and crisis procedures and contacts), and basis of rule-based analytics. Given the rather lim- key-person risk (including succession planning, ited range of instruments and markets in which we mentoring, knowledge sharing, and information can operate, we strive for diversification by trading dissemination). The Bank is also dependent on its with different investment horizons and by using securities custodians effectively managing their different decision processes (dealer discretion and operational risk. We review custodians’ controls rule-based analytics). before we place securities with them and, on an 805. Active management returns and risks are ongoing basis, test their systems (with their coop- measured against a benchmark (comprising both eration) by executing securities transfers instruc- assets and corresponding liabilities), which is con- tions from time to time to simulate cash raising in structed within the Bank, independently of the time of intervention. In addition, we have a policy front office, to reflect the composition of reserves of diversifying our security holdings across a few and funding under passive management—the risk- custodians so that our intervention capacity is not neutral position. The benchmark is managed entirely exposed to operational risks or disaster sce- within broad risk parameters defined by the narios with respect to a single custodian. Governor and with the objective of minimizing costs, consistent with a passive management strat- Fraud egy. Portfolio managers must actively manage reserves in a manner that adds value—i.e., gener- 803. The Bank has in place a number of operates a return that exceeds the benchmark and cov- ational controls to minimize financial and reputa- ers charges for additional risks from active tional damage from fraud. These include management as well as additional costs arising from separation of front- and back-office operations, active management. Performance is measured on a logged dealer phones, tracking of deal tickets, rolling three-year basis, but attention is also paid to transaction and position reconciliation across P&L performance in a financial year to monitor the and risk reporting, and confirmation and settle- Bank’s political risk exposure that may arise when it ment instruction matching with counterparties. publishes results of operations in the annual report. The Bank also places considerable importance on Active management performance is also monitored front-, middle-, and back-office operations having a relative to that of comparable (external) fund man- good understanding of the nature of, and risks aris- agers, six monthly. Information ratios are used for ing from, the instruments in which we deal, so this purpose. This enriches our understanding of transactions will be subject to reasonableness our portfolio managers’ performance; however, it is checks along the process chain. The aim here is to not the relative performance of portfolio managers not rely too heavily on any one person (particularly that determines whether we continue with this in the front office) for advice on appropriate pro- activity; it is their absolute performance—they must cessing of transactions. This widespread under- add value (as defined above). standing of appropriate processes is an objective 806. Active management risks are controlled we are continually striving to achieve. using the same framework used to control the risks on the entire reserves (active and passive Active management reserves), as outlined above. Market risk is the 804. As noted above, the Mandate includes only area where we have separate active manage- provisions for active management of reserves and ment limits. VAR and stop-loss limits are applied 15 • New Zealand 161 at the portfolio and aggregate (all portfolios com- activity to entities that operate in markets at night bined) level. in New Zealand. 807. The Bank does not currently use external fund managers as we believe that this would constrain our capacity to meet the objective of reserves Conclusions management to increase the Bank’s knowledge of instruments and market practice and maintain 810. The Bank’s management of foreign market contact; divert scarce resources to manag- reserves is continually evolving. There are a num- ing the relationship; and not significantly increase ber of strategic issues that underlie reserves returns if the managers were subject to the same arrangement and it is the Bank’s (and govern- risk constraints as our portfolio managers. ment’s) practice to review these issues periodically. 808. However, we would consider using external Reserves management in New Zealand also evolves fund managers if there were markets or instruments in light of market developments in financial instru- in which we wished to participate but did not have ments and risk management practices, and of our the expertise to do so directly. In these circum- own experiences and lessons. We recognize that stances, we would expect that external fund man- our practices differ in many significant respects agers would not only improve active management from the practices in other countries (there are risk-adjusted performance, but also provide a means also significant similarities too). We believe that by which we could learn from their activities. this is appropriate because, while there are core 809. We do make use of overseas investment principles underlying reserves management, the banks’ bond lending services. The Bank under- practices adopted in meeting those core principles takes this activity itself, but time zone differences should vary according to countries’ public policy, mean that it is economical for us to outsource this institutional frameworks, skills, and resources. 16 Norway

Background • the long-term portfolio or investment portfolio (NKr 106 billion/$12 billion), which should 811. At the end of 2001, Norway’s central bank, also be available for market operations, but the Norges Bank (the Bank), managed funds worth should be invested on the basis of more long- NKr 795 billion (US$88 billion) in the international term considerations; capital markets. The bulk of this capital was the • the immunization portfolio (NKr 6 billion/$1 Government Petroleum Fund (NKr 613 billion/ billion), which is equivalent to government $68 billion), which is managed on behalf of the foreign currency debt and is intended to Ministry of Finance, and the Bank’s international neutralize foreign exchange and interest rate reserves (NKr 170 billion/$19 billion). Norges risk associated with this debt; and Bank’s international reserves comprise the foreign exchange reserves, gold reserves, and claims on the • the Petroleum Fund buffer portfolio (NKr 7 bil- IMF. In addition, the Bank manages the lion/$1 billion), which receives capital daily, Government Petroleum Insurance Fund (NKr 11 and is transferred to the Government billion/$1 billion) on behalf of the Ministry of Petroleum Fund on a monthly basis. 47 Petroleum and Energy. 813. The liquidity portfolio is managed by 812. The foreign exchange reserves (NKr 157 Norges Bank Monetary Policy (NBMP) by the billion/$17 billion) are split into four sub- Market Operations Department (MOD). All other portfolios; funds/portfolios are managed by Norges Bank • the liquidity portfolio (NKr 37 billion/$4 bil- Investment Management (NBIM), which was estab- lion), which is to be used in connection with lished as a separate wing in January 1998 to meet the conduct of monetary policy (for poten- the Bank’s challenges of having been delegated the tial foreign exchange interventions and to responsibility for managing the Petroleum Fund. influence liquidity and interest rates in the NBIM’s sole purpose is to function as investment Norwegian money market); manager and thereby take advantage of the benefits inherent in being a large institutional investor. Economies of scale made it natural to assign NBIM the responsibility for handling a large part of the 47Guidelines and performance reports for the foreign foreign exchange reserves. To prevent duplication exchange reserves and various funds managed by the Bank and invested in the international capital markets are pre- of internal resources, NBIM delivers settlement sented on Norges Bank’s website (www.norges-bank.no). and IT services to NBMP/MOD.

162 16 • Norway 163

814. In addition to being responsible for the Finance’s management of government foreign management of the liquidity portfolio, NBMP/ debt. The way this is carried out is that a small part MOD also carries out the purchases of foreign of the reserves—the immunization portfolio—has exchange to the buffer portfolio. This ensures that been set aside to be equivalent to government for- these responsibilities are viewed in conjunction eign currency debt. In 2004, the existing govern- with the department’s activities in implementing ment foreign debt (worth only NKr 6 billion at monetary policy. end-2001) will be settled in its entirety. 815. The way the Bank carries out the mission 820. One may therefore conclude that objec- of managing the Petroleum Fund has also con- tives (i) and (iii) mentioned above have become tributed to a more professional management of the less important over time and (ii) more important. foreign exchange reserves with more focus on performance, and has influenced the investment strat- Institutional framework egy of the long-term portfolio (as compared to the old strategy back in 1998, equities are now 821. Pursuant to the Norges Bank Act, Norges included, the number of markets is larger, and the Bank shall invest the official foreign exchange duration of the fixed income portfolio is higher). reserves with a view to maintain the foreign exchange policy that has been established. The King in council may issue rules concerning the Developing a Sound Governance and investment of the official foreign exchange Institutional Framework reserves. In practice, however, Norges Bank’s Executive Board has laid down guidelines for the Reserve management objectives and investment of reserves. coordination

816. The objectives of reserves management Transparency and accountability are: (i) funding intervention, (ii) managing national wealth (high return), and (iii) immuniza- 822. There is a clear division of responsibilities, tion of government foreign currency debt. which is reflected in the organizational setup and 817. In the monetary policy, a formal inflation well documented in written guidelines, mandates, target was adopted in March 2001. The interest and job instructions. The overall responsibility for rate is the main monetary policy instrument, but operations rests with the Executive Board, which interventions may be considered in special circum- sets the overall strategic guidelines (including stances. Measured in months of imports, Norway major risk limits) and receives quarterly manage- has quite large reserves. Both the size of the ment reports.48 The Board has delegated to the reserves and the change in the monetary policy Governor to set supplementary guidelines. The imply that it is more appropriate with a longer Governor has in turn delegated further specifica- investment horizon. tions to the responsible manager (wing leader). 818. The Executive Board of the Norges Bank 823. Instrumental to the establishment of a establishes guidelines for the management of the clear distribution of roles and responsibility is the foreign exchange reserves. The aim of the man- division between strategy formulation on the one agement is to maximize the return within the con- hand and operational management with a clear straints specified in the guidelines. From 2001 responsibility for performance on the other. A sepa- onwards, a part of the long-term portfolio (20 per- rate unit within the Governor’s staff has been given cent) has been invested in equities. The Executive Board has decided to further increase the equity share, and to include nongovernment securities in 48Until 2000 the Executive Board delegated to the Governor the bond portfolio. to define the benchmark portfolios and the limits for relative risk (tracking error), as well as credit risk (minimum rating 819. The management of the foreign exchange level). These fundamental limits are now placed with the reserves is coordinated with the Ministry of Board itself. 164 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT the responsibility for preparing advice on the strate- 826. In NBMP/MOD, risk control and return gic guidelines and benchmark portfolios of the measurement are carried out in a separate unit reserves and the Petroleum Fund.49 The leader of independent of the front unit. The middle office the respective wing has responsibility for the perfor- unit reports to the head of MOD. mance results of the portfolio(s) under manage- 827. Outside NBMP/MOD and NBIM, the ment. This principle of decentralized management Governor of Norges Bank has a staff to supervise is an important characteristic of Norges Bank’s gen- and monitor compliance and, as mentioned, to for- eral management model. This may contrast with var- mulate strategy. Previously the Governor also had a ious other central banks where investment special advisory committee from departments other management decisions may be based (more or less) than NBIM, NBMP/MOD, and the Governor’s staff on investment committees with members from dif- to assist the Governor in this work. Recognizing that ferent parts of the organization. Responsibility for the work of the advisory committee was overlapping internal control lies with the wing as part of the line- with the work of the Governor’s staff, the commit- based management model. tee was removed in 2001. 824. NBIM is a separate management unit that 828. External auditing is performed by Norges does not have access to market-sensitive central Bank’s separate Audit Unit, the Central Bank bank information (“Chinese walls”). The manager Audit, which reports to the Bank’s Supervisory reports directly to the Governor, like the other wing Council, which is appointed by the Parliament. leaders. Within NBIM, there is a sharp line between The Central Bank Audit is responsible for the oper- the departments that make decisions regarding ational auditing of investment management, as investment, and the Investment Support Depart- well as the statutory financial audit of the Bank’s ment, which takes charge of transaction settlement, accounts. In its mandate the Central Bank Audit is risk measurement, return measurement, and also asked to do work that is ordinarily considered accounts. Responsibility for control rests with the the responsibility of an internal auditor. The audit front office departments. These constantly monitor is carried out in accordance with recognized audit- the internal and external management. Independ- ing standards in Norway, which are based on inter- ent control of market and credit risk is carried out national auditing standards. in the Investment Support Department. The Legal 829. The Supervisory Council is responsible and Compliance Department oversees the internal for ensuring that the rules for the Bank’s activities control functions, and is a primus motor in compli- are observed, including general monitoring and ance work. follow-up of the Executive Board. The Executive 825. NBIM’s most important objective is to Board and the Supervisory Council receive a quar- achieve the highest possible return pursuant to terly report on the management of the reserves applicable mandates and limits. It is easy for the consisting of detailed reports on each of the sub- delegating authorities and other observers to assess portfolios and a concentrated report extracting the whether the performance targets are attained. most relevant information in the sub-reports (see Assignments are clearly defined in written man- below). It may also be pointed out that the dates, and NBIM’s results can be compared with Governor receives a monthly report from NBIM on defined benchmark portfolios. The establishment the performance of all NBIM portfolios. The of NBIM as an independent unit in Norges Bank Governor also has a special monthly follow-up makes its responsibility for performance more meeting with NBIM, where performance and other transparent. topics relevant for the Governor in evaluating NBIM are addressed. 830. Detailed accounts of the foreign exchange 49For the reserves, the guidelines prepared by the Governor’s reserves are presented in the Bank’s annual report, staff are set by the Executive Board or the Governor. For the including book value (i.e., market value) and Petroleum Fund the guidelines are given by the Ministry of return in Norwegian kroner (NKr) of the total Finance, except supplementary guidelines for credit risk, which are set by the Governor. reserves and the different sub-portfolios, as well as 16 • Norway 165 the currency composition of the total foreign 833. Part of the salary of employees with exchange reserves. The annual report also con- responsibility for the results of investment deci- tains a separate chapter describing investment sions is based on performance. In 2001, this was management in Norges Bank, including the the case for more than one third of the NBIM percentage return attained on each of the sub- employees. This pay system has been extended to portfolios and compared with the benchmark key personnel in investment support functions. return. 834. To a lesser degree, NBMP/MOD has 831. Since 2001 Norges Bank has, via the implemented a payment structure where payment Internet, extended to the public information partly is based on performance (on a broad basis). about the reserves.50 The reason for the change in 835. It is part of the IT strategy that top skills policy is that the Norwegian Government applies a are bought where they are found, whether by own principle of transparency to the Bank’s manage- employees or outsourcing. All technical support ment of the Petroleum Fund. The foreign and a large part of systems development and appli- exchange reserves may also be considered as part cations support are performed by external suppli- of public funds subject to openness. The new infor- ers, both outside and inside Norges Bank’s mation includes guidelines for the investment of premises. NBIM has defined the type of core com- foreign reserves issued by the Executive Board, as petence the unit would like to have. Other func- well as supplementary guidelines set by the tions will be outsourced if possible. Governor. In addition, the quarterly concentrated management report mentioned above is presented on the web as of 2000/Q4. This report displays size Establishing a Capacity to Assess and and return of the different sub-portfolios (and rel- Manage Risk ative return compared to the benchmark portfolio) as well as actual asset class and currency Benchmark portfolio composition, and portfolio risk exposure com- 836. The level of risk derived from the invest- pared with limits. Returns are measured both in ment strategy comes from two sources: the long- the currency basket of the benchmark portfolio term strategy specified by the benchmark portfolio and in NKr. The more detailed management and the short-term strategy or the permissible devi- reports for each of the sub-portfolios in the ations from the benchmark. By far the most impor- reserves are not made public. tant is the benchmark portfolio. The level of risk in 832. Norges Bank is aware that managing the the benchmark is determined by the currency dis- Government Petroleum Fund and the foreign tribution, asset classes (equities, bonds), type of exchange reserves requires active use of salary and securities, and duration of bonds. The benchmark personnel policy incentives. The market for perfor the liquidity portfolio reflects that the portfolio sons with experience in financial and investment is to be used for interventions: high liquidity, short management is characterized by a high salary level duration. The benchmark for the long-term port- with an element of performance-related pay in folio reflects the intention of managing wealth combination with extraordinary demands for (high return): bonds and equities, global diversifi- focused work. The Bank’s success in achieving cation. Risk is also affected by the maximum allow- good management results will depend very able deviations from the benchmark. This is strongly on its ability to recruit, develop, and retain handled in the strategic guidelines by specifying highly qualified personnel from this market. The limits for tracking error, asset class mix, currency Bank is very conscious of developing the compe- and market distribution, duration, and minimum tence of its own employees. level of ratings, etc. See our website for the detailed benchmarks and limits. 837. The investment strategy for the long-term portfolio (which includes equities) is based on 50Most of the web pages are available in English. analysis of portfolio return and risk, using an in- 166 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT house simulation model. In the calculations esti- reserves. In addition, it must be ensured that there mates of expected portfolio return are based on is sufficient expertise in all areas of activity. historical data and, alternatively, on simplified sub- 841. Interest-bearing securities in the liquidity jective judgments. Risk is measured as the annual- portfolio shall be issued by nation states, enterprises ized standard deviation of the portfolio return, with government guarantees, or international orga- based on a covariance matrix of historical returns. nizations with a high credit rating. Investment is In addition, the probability of having a negative also permitted in bonds from other issuers related portfolio return in any single year is calculated. to the public sector, which may be included in the The analysis showed that including a small part of Lehman Global Aggregate Government Index. equity exposure would enhance the portfolio Permissible interest-bearing securities in the long- return without significantly increasing the risk. term portfolio are bonds that may be included in 838. The asset weights of the benchmark port- the Lehman Global Aggregate Index (investment folio float with the market prices, and rebalancing grade), including corporate bonds, mortgage- the benchmark weights means that managers will backed, and asset-backed bonds. Bond issuers and incur transaction costs in the actual portfolio. A counterparts in bank deposits etc. are subject to a specific risk analysis has therefore been performed minimum rating level. Equities in the long-term to determine optimal rules for rebalancing the portfolio must be listed on a stock exchange in one benchmark. of the countries listed by the Board. 839. The liquidity portfolio is to be used in 842. Before trading in a new instrument com- connection with the conduct of monetary policy. It mences, documentation must be available that iden- is important that the portfolio is invested in liquid tifies the various types of risk associated with use of currencies. The euro is the most relevant currency the instrument, and that confirms that provision has for interventions and the U.S. dollar is the most been made for adequate expertise, risk systems, and relevant currency for operations in currency swaps control routines. Derivatives may be used to the to influence liquidity and interest rates in the extent that the ensuing financial exposure does not Norwegian money market. Currency swaps are exceed the exposure that would have resulted from only a supplementary instrument in domestic liq- investing directly in the underlying instruments. uidity operations. Because of diversification pur- Overall risk management is to be undertaken in poses the liquidity portfolio is also invested in which the exposure in derivatives is integrated with sterling and Japanese yen. The distribution of the the exposure from underlying instruments. liquidity portfolio is as follows: 50 percent in euros, 843. In practice it will be up to the leader of 25 percent in U.S. dollars, 20 percent in pounds the respective wing to specify a list of allowable sterling, and 5 percent in Japanese yen. The man- instruments. aging wealth motive of the long-term portfolio 844. Both interest rate and equity derivatives means more emphasis is placed on global diversifi- have been used extensively to attain desired posi- cation, with eight currencies in the fixed income tions in a cost-effective manner. In the transition in benchmark and 12 currencies (22 markets) in the 2001 from 0 to 20 percent equities within the long- equity benchmark. term portfolio, equity index futures were applied before converting the equity exposure to physical shares. Interest rate derivatives include bond Instruments futures, LIBOR futures, options on futures, and 840. The guidelines set by the Executive Board interest rate swaps. Activity in derivatives must obey specify the allowable asset classes for each portfo- the rules mentioned above. lio. Within the asset classes there is no list of allowable instruments, given that certain general Risk and performance measurement requirements are fulfilled: Sound risk systems and control routines must exist for the instruments 845. As mentioned, the objectives of holding used in the management of the foreign exchange reserves are multiple. Therefore the reserves are 16 • Norway 167 divided into four different sub-portfolios, and sep- 851. Possible criteria for choice of an index are arate guidelines are drawn for each portfolio. ease of access, transparency, clarity of selection cri- 846. Market risk is calculated as the expected teria, investibility, breadth of coverage, quality of annual standard deviation of the portfolio returns data, availability of historical data, customer based on portfolio holdings and time series of his- service/support, quality of analytics, and ability to torical market prices. Credit risk is primarily mea- customize. sured by the ratings from the leading rating 852. The Executive Board has stipulated that agencies. management of the foreign exchange reserves 847. Interest rate risk is measured by modified shall be aimed at achieving the highest possible duration. The liquidity portfolio has a short dura- return within the limits set out in the guidelines. tion (about 1.5 years). The level of duration for the Far the most important factor influencing returns long-term portfolio (approximately 5.5 years) mir- is the benchmark portfolio. There are two reasons rors the duration of the market (indices), and for allowing deviations from the benchmark port- reflects both the long-term investment horizon and folio. One is cost-effective management (index- the fact that in some bond markets empirical stud- related). The other is active management. ies indicate that the maturity premium has been 853. An upper limit has been set for the actual positive and rising for durations up to 2–3 years, portfolio’s deviation from the benchmark. This with the rise in premium slowing thereafter and limit is a measure of relative risk (tracking error). even stabilizing. In practice, this means that the difference in 848. The reserve portfolios are, as mentioned, returns on the actual portfolio and the benchmark split between two different wing leaders, and the will normally be small. The upper limit for responsibility for managing risk in Norges Bank is expected tracking error is 0.5 percentage point for with the wing leader. Therefore we do not quantify the liquidity portfolio and 1 percentage point for the expected return and risk for the total reserves. the long-term portfolio.51 Instead, the Bank’s return/risk objectives are 854. In NBIM, internal fixed income manage- reflected in the way reserves are divided into dif- ment is divided into two main areas: indexing and ferent sub-portfolios and the way the separate other index-related management on the one hand, guidelines are designed. and active management on the other. Within these 849. The main strategic choices for both the two areas, activities are further divided into various liquidity and the long-term portfolio are defined by special functions. means of benchmark portfolios. These are con- 855. The objective of index management is to structed portfolios with a given country distribu- efficiently purchase the benchmark, while taking tion and specific securities from the various advantage of special pricing situations to achieve sub-markets. A benchmark portfolio is used to some excess return (enhanced indexing). The manage and monitor risk exposure, and also serves earnings potential of lending fixed income instru- as a point of reference for evaluating the actual ments from the portfolio is utilized. Another return achieved on the reserves. important task is to correct undesirable deviations 850. We use external benchmarks (Lehman from the benchmark in the most efficient way Brothers for bonds, FTSE for equities). For ease of possible. comparing portfolios the policy is to use the same 856. One objective of active management is to index provider for the various portfolios unless we take advantage of systematic price differences have good reason to deviate. Benchmarks for the between bonds with almost identical properties in liquidity portfolio and the long-term portfolio are order to achieve an excess return. Another strategy defined by the Executive Board and are to some extent made more precise by the Governor. The wing leaders are measured against the “official” 51In simplified terms, a tracking error of 1 percentage point benchmark, but they are free, of course, to apply means that the actual difference between the returns on the benchmark and the actual portfolio will be between –1 and +1 sub-benchmarks for their different sub-activities. percentage points in 2 out of 3 years on average. 168 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT for achieving an excess return is to take positions the reasons for this is that portfolio managers in that depend on future interest rate movements. An NBMP/MOD perform other tasks in addition to important objective of management is to ensure investment management. breadth in the active fixed income management 861. For the long-term portfolio the Governor positions so that the return will not be overly has set a target (in basis points) for the yearly dependent on individual explanatory variables. excess return above benchmark. When compared 857. The equity portfolio of the long-term with the target, the actual excess return is adjusted portfolio was established in 2001. The entire port- for taxes and transaction costs that may have folio has until March 2002 been managed inter- resulted from changes in investment strategy. In nally as an enhanced index portfolio, taking the management of the liquidity portfolio, a part of advantage of special pricing situations, as for exam- the narrow risk limit of 50 basis points is utilized. It ple in relation to the significant changes in the is set a target (internally) for yearly excess return FTSE-index that occurred in June 2001. As for that reflects the use of tracking error. fixed income the earnings potential of lending 862. In Norges Bank’s accounts, foreign equities is utilized. In March 2002 part of the exchange reserve items are valued based on their equity portfolio was converted to external equity “fair value,” i.e., their market value in Norwegian mandates. See below for a discussion of external kroner. The accounting profit/loss includes both management. unrealized and realized gains and losses (in NKr). 858. The total level of active risk within the This means changes in market prices of currencies, long-term portfolio has until now been quite mod- bonds, and equities will impact the Bank’s est, mostly within the interval 20–40 basis points as profit/loss account and the Bank’s own capital. measured by expected tracking error. In practice Though NKr is the relevant currency in the the liquidity portfolio has tracked the benchmark accounts, the return on the long-term portfolio portfolio very closely, around 10 basis points as and the liquidity portfolio is measured both in NKr measured by expected tracking error. and by local currency (weighted by the benchmark 859. Returns on the actual portfolio and the portfolio’s currency basket). The reason is that benchmark portfolio are calculated according to return measured in NKr is not relevant to an eval- the market value principle.52 For the long-term uation of developments in the international pur- portfolio multiple historical performance horizons chasing power of reserves, which is of particular are applied to measure the average excess return. interest for the long-term portfolio. Monthly data go back to the beginning of 1998 when NBIM was established. An information ratio External managers is calculated for the long-term portfolio.53 860. Management costs for the sum of the 863. According to the guidelines, external man- three reserve portfolios managed by NBIM are pre- agers may be used in the management of the long- sented in quarterly reports. The costs incurred by term portfolio. Such managers must have adequate NBIM’s management activities consist partly of fees internal ethical guidelines for their own activity. to external managers and custodian institutions, 864. In NBIM there was internal fixed income and partly by Norges Bank’s internal operating management from the start, while equity manage- costs. Similar calculations of the costs of managing ment on behalf of the Petroleum Fund was out- the liquidity portfolio have not been made. One of sourced to external managers. Subsequently, external managers have been assigned responsibility for portions of the fixed income management 52 The detailed methodology for calculating the returns on the (both on behalf of the Petroleum Fund and the various portfolios Norges Bank manages are described in the appendix of the Government Petroleum Fund quarterly long-term portfolio), while internal equity man- report. The report is accessible on our website. agement has been built up. Today NBIM manages 53We define “information ratio” as the average monthly excess equities internally on behalf of the Petroleum return over time divided by the standard deviation. This figure is annualized. Fund and the long-term portfolio. 16 • Norway 169

865. At the end of June 2002 about 10 and 47 (i) daily updated information on holdings and percent of the long-term portfolio’s fixed income prices in both internal and external portfolios; and equity portfolios, respectively, were managed (ii) daily measurement of performance relative to externally. These are all active mandates, except for benchmark; and (iii) daily/weekly monitoring of one enhanced index equity mandate. The reason for risk. Information on all internal and external using external managers in the reserves is to con- managed portfolios is updated daily in the central tribute to the objective of maximizing returns (above data warehouse. benchmark). It is natural to take advantage of the experience Norges Bank has gained in selection and Stress tests follow-up of external managers in the Petroleum Fund also in the management of the reserves. When 870. Apart from the quantitative analysis per- selecting individual managers Norges Bank applies formed when strategy is reviewed, we do not use the same general standards for the managers in the formal ongoing stress tests for the potential impact reserves as for the Petroleum Fund. of specific scenarios. If we judge that a change in 866. Requests for applicants are posted on the market conditions may have a negative impact on Internet. Manager selection is based on a four- the reserve portfolios, we are prepared to amend stage process: (1) screening of applicants by 10 cri- investment strategy to protect the reserves from teria (based on questionnaire one), which results potential losses. in a short list of candidates; (2) analysis and selection by four groups of criteria (based on question- Operational risks naire two and interviews) give a further reduction to the finalists; (3) optimization process to select 871. The degree of operational risk will the managers (by a manager combination tool); depend on the organizational structure chosen (as and (4) ongoing monitoring and control. described above), the procedures and technical 867. The external portfolios form an integral systems used, and the expertise in the organiza- part of the risk management of the long-term tion. Norges Bank places emphasis on managing portfolio, and are subject to the following princi- this type of risk by establishing sound internal con- ples of monitoring: (i) performance and risk posi- trol procedures, a sound organization of activities tions are monitored daily; (ii) all transactions are with clear authorizations and a clear distribution of monitored weekly; (iii) monthly analysis of risk responsibility, recruitment of specialists with prac- profile, value statistics, and earnings expectations; tical and theoretical qualifications, satisfactory (iv) monthly/quarterly transaction monitoring training of personnel, technical standby solutions, (trading, momentum, and liquidity risk); and and a sound set of legal agreements. (v) yearly due diligence. 872. Once a year each wing makes a special report to the Governor’s staff on the quality of the internal control. The objective is to detect major Management information systems risks that may potentially be an impediment to the 868. An integrated risk measurement system is wing in reaching its goals, and to ensure that man- used to assess and monitor relative and absolute agement is focused on managing those risks. An risk. Expected annualized tracking error is calcu- example of a risk that is given attention is NBIM’s lated weekly for the long-term portfolio and the liq- follow-up of external suppliers of various services. uidity portfolio, to keep risk exposure within the 873. Examples of measures established to limits. The system is also used to measure absolute reduce operational risks are routines for prevent- risk (standard deviation) of the actual portfolio ing unauthorized transfers and securities transac- and the benchmark portfolio, as well as the modi- tions, guidelines for staff involved in investment fied duration of the fixed income portfolio. management to restrict their personal affairs and 869. Important elements in the Norges Bank’s potential conflicts of interest, and contingency use of management information systems are: plans (e.g., in case activities at the head office in 170 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT

Oslo should be prevented, NBIM’s management 876. The equity part of the long-term portfolio office in New York is prepared to step in and is invested in 22 markets, which are all classified as undertake simplified management services). developed markets (i.e., they all meet some specified minimum standards related to settlement systems, legislative regulation, size, and liquidity). As Efficient markets for bonds, the liquidity of equity investments 874. The part of the reserves that is the first to depends both on the possibility of selling large be drawn upon in interventions—the liquidity amounts in a short time, and the possibility of portfolio—is invested only in the very liquid cur- using repo markets. The opportunity for selling rencies/markets: euro, pound sterling, U.S. dollar, shares on short notice without impacting prices and Japanese yen. The 50 percent weight in euros depends, inter alia, on the turnover in the sec- in the benchmark portfolio is split equally between ondary market. It is not easy to judge precisely the the liquid bond markets of Germany and France. liquidity of equities vs. bonds. Normally a diversi- 875. Liquidity is of less importance for the long- fied bond portfolio will be more liquid than a term portfolio, but even this portfolio should be diversified equity portfolio. A moderate proportion available for interventions. Compared to the liquid- of reserves invested in equities spread among many ity portfolio, the fixed income part of the long-term markets would not, to any substantial degree, portfolio has a few additional, minor currencies, weaken the possibility of raising liquidity when considered to have liquid bond markets. needed. 17 Oman

Governance and Institutional eign exchange reserves at around US$2.5 billion Framework provides import cover of about 4.5 months, which is considered adequate, given the fact that external Reserve management objectives and debt of Oman is very low and is declining. coordination 880. The scope of reserve management activity 877. The objectives of management of reserve is confined to achieving the objectives of liquidity are three-fold: and growth/current income. 881. For the Central Bank, the most important • Provide liquidity for intervention in the local monetary policy goal is to maintain the fixed peg foreign exchange market. of the rial Omani with the U.S. dollar. This is rec- • Earn reasonable rates of total return without ognized as such in reserve management policy. exposing the reserves to excessive credit and Moreover, reserve management operations take market risks. notice of domestic liquidity conditions and the position of government balance with the Central • Earn good current income so as to achieve Bank. Local banks are allowed short-term U.S. healthy accounting profit. dollar-rial Omani buy-sell swaps as a mechanism for 878. Oman is a small oil exporting country augmenting rial Omani liquidity, in case of need. with its currency pegged to the U.S. dollar. 882. The imperatives of the monetary policy Maintenance of the credibility of the fixed peg is of are reflected in the manner in which the foreign paramount importance for macroeconomic stabil- exchange reserves portfolio is structured. ity. The reserve management policy objectives have Currently, the external reserves are divided into been designed primarily with a view of optimizing four sub-portfolios or tranches: U.S. dollar resources to provide a credible cushion against current and capital account shocks, while at (i) Liquidity Tranche: This is an all U.S. dol- the same time clearing the local foreign exchange lar portfolio that is meant for providing market on a day-to-day basis. These objectives have liquid resources for market intervention. remained in place since the inception of the As such, this tranche is invested in very Central Bank of Oman (the Central Bank) over 25 short-term high-quality instruments, such years ago. as deposits and CDs of top-class banks and 879. The Central Bank does not target any par- U.S. Treasury Bills. All inflows/outflows ticular level of reserves. The current level of for- (which do not represent income/realized

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profit) with respect to the external from time to time, taking into account, among reserves take place in the Liquidity other things, fixed income and foreign exchange Tranche. markets outlook. (ii) Bridge Tranche: This is also an all U.S. dollar portfolio that is intended to pro- Institutional framework vide support to the Liquidity Tranche in 884. Reserve management activities of the case of need. The size of the Bridge Central Bank are carried out under the overarch- Tranche is generally kept within a maxi- ing provisions of the Banking Law, which also cov- mum of 25 percent of the external ers other activities of the Central Bank. The Law reserves, excluding gold and SDRs. This mandates a fixed par value for the rial Omani and tranche is invested in short- to medium- also stipulates maintenance of a minimum ratio term high-quality instruments, such as between external reserve and currency in circula- deposits and CDs of top-class banks and tion. This Law has specific provisions regarding eli- U.S. Treasury Bills as well as U.S. Treasury gible currencies and instruments for deployment notes with remaining maturity up to and of reserves. The Law also mandates that interna- including three years. tional accounting standards be applied for (iii) Income Tranche: This represents the sta- accounting purposes with respect to the external ble portion of the reserves, which is a reserve. The Board of Governors of the Central multicurrency portfolio, with the neutral Bank is the highest body for policy decisions with share of U.S. dollar at 75 percent. The respect to management of external reserves. The other permissible currencies are euros relevant provisions of the Banking Law with regard and pounds sterling. Until recently, the to the above are quoted below: Japanese yen was also a permissible currency for this tranche. However, effective Level of external reserves January 1, 2002, Japanese yen ceased to be a permissible currency in light of the 885. Article 31 states that the Central Bank continuing weakness of the Japanese shall at all times maintain a reserve of external economy. The permissible instruments assets that shall be related in value to the value of for the Income Tranche include bank currency notes and coins in circulation in such deposits, CDs, treasury bills, and dated ratio as may be prescribed from time to time by the securities representing debt obligations Board of Governors, subject to approval of His of top-quality sovereign and suprana- Majesty, The Sultan. tional institutions whose residual maturity does not exceed 10 years. Categories of external assets (iv) Bullion Tranche: This tranche contains 886. As per Article 32, the reserve of external the gold holdings of the Central Bank, assets may consist of any one or more of the fol- which currently constitute around 3 per- lowing, provided they adhere to all limits, classifi- cent of the external reserves. The gold, cations, constraints, restrictions, and qualifications which is located at an overseas center, is whatsoever laid down by the Board of Governors: placed in short-term lease (deposit) with top-quality banks. a. Gold or silver coins, which are legal tender. 883. There are performance benchmarks for b. Bullion of gold, silver, or such other pre- the Liquidity, Bridge, and Income Tranches, which cious metals as may, from time to time, be take into account investment objectives, liquidity utilized as a monetary asset and freely requirements, and constraints. The investment pol- traded on international exchanges. icy with respect to the external reserves is reviewed c. Foreign currencies or basket of currencies. 17 • Oman 173

d. Bank demand and time deposits, certificates rencies, provided, however, that any such of deposit, and acceptances denominated in determination shall be in accordance with freely convertible foreign currencies. the conditions of any international monetary agreement to which the Sultanate (of e. Treasury bills, commercial paper, and any Oman) is then a party. other short-term money market instrument denominated in freely convertible foreign 889. In Oman, foreign currency revenues of currencies and issued by foreign banks, for- the government, arising mainly out of export of oil eign governments, foreign public agencies, and gas with unit sales realization up to the price of or supranational organizations. oil and gas fixed annually for budget purpose (the budgeted price) are generally sold to the Central f. Floating rate notes denominated in freely Bank against rials Omani, which serve as inflows convertible foreign currencies and issued by into the reserves and are thus monetized. Any rev- foreign banks, foreign governments, foreign enue of the government in excess of the budgeted public agencies, or supranational organiza- prices of oil and gas are kept separately in a fund to tions. be utilized if there is a budget shortfall subse- g. Fixed interest securities and notes denomi- quently. This portion of the external reserve of the nated in freely convertible currencies and country is owned and managed directly by the gov- issues guaranteed by foreign banks, foreign ernment. The name of the fund is State General governments, foreign public agencies, and Reserve Fund (SGRF). There is an institutional supranational organizations. arrangement for consultation between the Central h. Any internationally recognized reserve Bank and the SGRF on various investment-related asset, including SDRs issued by the IMF. issues, such as composition of benchmark, portfolio performance, etc. 890. There is a well-defined organizational Accounting structure within the Central Bank for all decisions 887. Article 38 provides that the amount of regarding the external reserves. As mentioned ear- profits, losses, credits, debits, depreciation, funded lier, the Board of the Central Bank is empowered and unfunded reserves, and other financial analy- to make all decisions with regard to investment pol- sis . . . shall be determined according to the gener- icy and investment guidelines, including perfor- ally accepted principles of accounting, including mance benchmark, etc. the International Accounting Standards insofar as 891. The highest decision-making body for all they do not contradict any provisions of the Law, investment decisions, in terms of the policy/guide- agreed by the Auditors appointed pursuant to lines approved by the Board, is the Reserve Asset Article 18(c) of this Law and approved by the Management Committee (RAMC), which is Board of Governors. chaired by the Executive President (CEO of the Central Bank). The composition of this Committee is detailed in Table 21. Parity 892. The RAMC decides on all issues concern- 888. Article 41 specifies that: ing reserve management, including fixing of medium-term strategic (MTS) benchmarks with a. The par value of the rial Omani shall be regard to currency allocation and duration. determined from time to time by His 893. The responsibility of the Central Bank Majesty, The Sultan. with regard to management of external reserves b. The par value of the rial Omani, or any arises exclusively out of the provisions of the change thereof, shall be declared in terms Banking Law. The external reserves are owned by of gold, units of SDR, a foreign currency, the Central Bank and as such there is no agency or a basket of currencies or an interna- arrangement between the government and the tionally recognized unit of account for cur- Central Bank for this purpose. 174 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT

Table 21. Committee Composition periodic intervals about all important

Executive President Chairman aspects of reserve management, including portfolio performance vis-à-vis benchmark. Senior Vice President (In charge of Treasury, Investment, and Settlement (ii) There is an internal audit system that peri- Departments) odically examines the operations at the Manager (In charge of Treasury and front office and the back office and reports Investment Department) to the CEO. Compliance with audit obser- Senior Manager (In charge of Financial vations within a time frame is ensured. Management Department, which is responsible for 897. Financial accounts of the Central Bank, maintenance of accounts for the Central Bank) including accounts relating to reserve management, are audited by external auditors at least Senior Manager (In charge of Systems, Procedure, and Operations once a year. Effective January 1, 2002, the Central Department, which performs Bank has implemented the provisions of management service functions) International Accounting Standards 39 with Investment Expert In-house consultant on reserve respect to all its financial assets and liabilities, management which are in conformity with the Banking Law referred to earlier. The audited accounts and the findings of the external auditor are reported to the Board of Governors. The Central Bank’s pol- 894. The three main aspects relating to invest- icy and procedure with respect to internal control ment of external reserves, namely, guidelines, and audit are well documented. decision-making process, and procedure for opera- 898. Information on foreign exchange tions with respect to transactions in the front office reserves is provided in annual audited accounts and their follow-up at the back office, have been and reports of the Central Bank. The present pol- established and documented. There is a system for icy of the Central Bank does not envisage more dis- periodic review of these documents. closure with respect to reserve management. 895. There is a good deal of decentralization of 899. Staff involved in reserve management are decision-making power for risk decisions. The subject to a code of conduct and guidelines on Central Bank has adopted a document delineating conflict of interest regarding the management of the powers and responsibilities of officials at vari- their personal affairs. ous levels connected with decision making. The 900. The staff of the departments responsible delegation of power and the chain of authority are for reserve management are all well trained and well documented. experienced. New staff are taken on the basis 896. Internal control and audit systems for the of very strict criteria for academic qualification reserve management functions and operations and after thorough and comprehensive screen- have been designed on sound governance lines. ing. The Central Bank devotes considerable Major elements of the internal control systems are: resources to upgrading the knowledge and skill of (i) Management Information Reports with its personnel. The Central Bank has not found respect to transactions, risk exposure, and feasible the idea of offering a better compensa- exceptions (breach of guidelines, deletion package to reserve management personnel gated powers, and procedure for opera- in order to attract and retain reserve manage- tions) have been prescribed. These are ment specialists. The present policy of uniform intended to cause flow of critical informa- service rules and compensation packages for staff tion from the reserve management depart- of all the departments of the Central Bank is ments to the senior management working satisfactorily. (including CEO) on a regular basis. The 901. Retention of experienced staff has not Board of Governors is kept informed at been a problem so far, although some movement 17 • Oman 175 of staff, in search of better and well-paid jobs in the Duration private sector, has been noticed in recent years. 905. The neutral duration of investments in The present policy is to offer better career oppor- the Bridge Tranche shall be one year around which tunities in the Central Bank for the talented and a maximum deviation of plus or minus six months well-performing staff. will be permitted. The neutral or benchmark weighted-average duration of investment in the three approved currencies (in the Income Establishing a Capacity to Tranche) shall be as indicated in the table below: Manage Risk

902. The external reserves are exposed to currency, credit, liquidity, as well as interest rate risks. Benchmark Maximum Minimum Approved currencies (in years) (in years) (in years) The approach toward risk exposure has been shaped by the following elements: U.S. dollar 2.5 3.5 2 Euro 2.5 3.5 0 • Provisions of the Banking Law with regard Pound sterling 2.5 3.5 0 to currency diversification and choice of instruments.

• Low appetite for downside risk with regard to Credit risk currency revaluation, mark-to-market portfolio valuation, and income. 906. At the time of purchase, short-term money market instruments shall be rated not lower • An empirically observed fact with respect to than F3 and the issuing banks rated not less than C interest rate risk that the expected risk- (individual) and 3 (legal) by FITCH-IBCA or their adjusted return is optimal around a portfolio equivalent. At the time of purchase, long-term duration of 2.5 years for major markets. instruments shall not be rated lower than A by • Aversion to credit risk so as to keep the prob- Moody’s or its equivalent. ability of getting involved in any default to a 907. The current thinking with regard to the minimum. Income Tranche envisages a gradual elimination of diversification into non-U.S. dollar currencies and 903. The current investment guidelines embody non-U.S. markets over a period of time. This is the above approach with regard to prescriptions driven by a desire to stabilize earnings in U.S. dol- for the different types of risk exposures. The rele- lar terms, with low downside risk. vant provisions of the investment guidelines are as 908. Forward foreign exchange contracts are follows: the only permissible derivative instruments. Short sale is prohibited. Further, although repo is a per- Currency diversification mitted instrument, it has not been used so far. 904. In the Income Tranche, the proportion of However, in recent years bond lending activity has holdings in the approved currencies shall always been undertaken for a large portion of the exter- remain within the maximum and minimum limits nal reserves, including lending against cash collat- as indicated in the table below. eral for the U.S. Treasury portfolio. The objective here is to earn additional income, while keeping the risk exposure at a low level. The approach with Neutral Maximum Minimum regard to any new activity has been to first under- Approved currencies (percent) (percent) (percent) stand and internalize the risk characteristics, put in place the necessary IT systems and internal con- U.S. dollar 75 100 60 Euro 20 30 0 trols, and then undertake it. This has been fol- Pound sterling 5 10 0 lowed in the case of bond lending against cash collateral by ensuring that the risk on investment 176 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT of cash collateral is always at an acceptably low level independently by an external agency. Return cal- by prescribing suitable investment guidelines for culation is accompanied by full attribution analysis this purpose. once in a quarter to highlight the factors responsible for over/under-performance vis-à-vis the benchmark. Liquidity risk 913. Active risk taking for value addition vis-à-vis 909. Liquidity risk has been addressed by cre- passive configurations with respect to currency and ating a three-tranche structure, as described ear- duration is also undertaken. For this purpose, there lier. In creating this structure, historical are two levels of decision making. At the level of the inflow/outflow data were analyzed to find out the Reserve Asset Management Committee (RAMC), liquidity requirement for undertaking intervention monthly currency and duration benchmarks in the domestic market under a “worst-case” sce- (known as Medium-Term Strategic Benchmarks or nario. Further, to avoid issue concentration, which MTS) are set, which are intended to beat the neutral can have adverse liquidity implications, maximum performance benchmarks. At the level of the holdings for individual issues of debt securities Department, deviation from the MTS benchmarks is have been prescribed. permitted within prescribed limits in order to add value vis-à-vis the MTS. 914. Although the Central Bank is essentially a Benchmarks long-term investor, especially with respect to the 910. There are performance benchmarks for Income Tranche, the investment horizon for all Liquidity, Bridge, and Income Tranches. All of these intents and purposes is one year at a time, reflect- have been constructed on the basis of publicly avail- ing the accounting year (January to December). able market indices. For the Liquidity Tranche, the The broad accounting principles currently benchmark is the one-month U.S. Treasury Bill rate. applied in terms of IAS 39 with respect to the For the Bridge Tranche, as also for the Income Liquidity, Bridge, and Income Tranches are the Tranche, the performance benchmarks are a com- following: posite of market indexes, reflecting the neutral cur- • All coupon and discount earnings as well as rency and duration configurations. The criteria for realized profit/loss on sale of securities are selection of the performance benchmarks are the taken to the P/L. following: • All unrealized gain or loss on currency reval- • The benchmarks should correspond to the uation is booked under an equity head. passive or neutral risk profile. • All unrealized gain/loss on mark-to-market • The benchmarks should reflect the broad valuation of securities/outstanding forward pattern of investments. exchange contracts is booked under another • The benchmarks should not have any inher- equity head. ent bias for over/under performance. 915. Premiums/discount on bonds and 911. The performance benchmarks are pre- Treasury Bills at the time of purchase are amor- scribed in the investment guidelines for external tized following an effective interest rate method. reserves, which have been approved by the Board 916. Interest earnings on gold deposits and of Governors. realized gain/loss (against cost price) on the sale 912. For the purpose of calculation of rates of of gold are taken to the P/L. Unrealized gain/loss return, the U.S. dollar acts as the base/numeraire on revaluation of gold holdings is booked under currency. Calculation of return with respect to the the same equity head as for currency. investment portfolios and also the benchmark is 917. As the rial Omani is pegged to the U.S. outsourced at present. This is done primarily with dollar, rates of return in terms of domestic cur- a view to ensuring that the returns are calculated rency are similar to those in U.S. dollar terms. 17 • Oman 177

918. Gist of quarterly performance and attribu- • A monthly statement giving a stress test for tion analyses is reported to the Board of Governors. interest rate risk. 919. The Central Bank has a policy of engaging 921. There is a plan to set up an independent external managers for discretionary management Middle Office with well-defined responsibilities for of a small segment (there is a ceiling of 10 percent managing various risks with respect to external for this purpose) of the external reserves. The reserves. Also, steps have been taken to identify investment guidelines prescribed for the external operational risks for the Central Bank as a whole managers have been given higher duration and for setting up appropriate systems and mechanisms also different performance benchmarks. External for managing them. At present, custodial risks are managers can hold debt securities with remaining minimized by appointing only the most reputable maturity up to and including 30 years. This has institutions as custodians. been done on the basis of the fact that they have 922. For the purpose of undertaking buy/sell the requisite expertise and advantage of location to transactions in currencies and securities and for assume higher interest rate risk for the purpose of placement of deposits, etc., there are approved value addition. centers, most of which are in major OECD coun- 920. A management information system to tries. Also, there are concentration limits for expo- assess and monitor risks consists of the following: sure to banks located in different centers. • A daily statement showing the portfolio sum- Moreover, transactions in currencies and securities mary with respect to the three tranches, are required to be undertaken only with approved which provides details, such as duration and counterparties, which are selected on the basis of currency composition vis-à-vis their respec- their credit, reputation, market share, and relative neutral and MTS benchmarks, aggregate tionship with the Sultanate of Oman in general investment pattern, etc. and the Central Bank in particular. 18 Tunisia

Developing a Sound Governance and assets, and counterparts. In addition, an operating Institutional Framework control system is in place to monitor exposure limits for credit and market risks. Furthermore, the CBT Objectives and coordination has forbidden short position taking and financial 923. The strategic reserves management objec- instrument short sale practices. The use of derivatives of the Central Bank of Tunisia (CBT) are tives is only allowed for hedging needs. based on the following key points: • Guarantee of the external liquidity of the Return economy; 927. The CBT aims to maximize reserves port- • Preservation of the reserves holdings; and folio return subject to its liquidity and security con- • Maximization of return on reserves. straints. Investment policy focuses on a dynamic allocation of reserves, using permissible instru- Liquidity ments, in line with international capital markets outlook. 924. Liquidity of reserves is the main manage- 928. Tunisia has low foreign exchange inter- ment objective of the CBT. Liquidity is required to vention needs, given the floating managed ensure financing of external payments imbalances exchange rate regime of the Tunisian dinar and and to intervene in the local exchange market, in capital movement restrictions. This provides some order to avoid sharp adjustments of the Tunisian flexibility in reserves investment policy. Thus, the dinar exchange rate. CBT has stretched the upper limit on money mar- 925. The liquidity objective is met by targeting ket from three to six months and has extended appropriate investment instruments and currency investment activity to international bond markets. structure. The currency structure of reserves is set In an attempt to limit the exposure to bond market in accordance with the currency structure of the risks, especially with respect to the two primary settlement balance as well as CBT and government objectives of liquidity and security, the investment liabilities. scope has been limited to government and supranational bond markets with a deep and liquid sec- Security ondary market, which guarantee the highest level 926. In order to safeguard reserves, the CBT has of security (i.e., U.S., German, and French govern- implemented a rigorous selection policy of markets, ment bond markets).

178 18 • Tunisia 179

Institutional framework strategy, currency exposure, credit risk, dealing counterparties, custodian arrangements, permissi- 929. According to Tunisian law, management ble instruments, etc., have to be approved by senior of foreign reserves comes under the Tunisian managers and by the Governor, on proposals of the Central Bank’s purview. There is no other inde- concerned departments. pendent entity in charge of it. Governance, man- 932. The managers of the reserve management agement, and surveillance of the Central Bank department ensure that all operational guidelines of Tunisia are undertaken by the Governor are followed, and senior management is kept appointed by the President of the Republic, the informed of all deals done, on a daily basis. Board of Directors, and a censor who is appointed Portfolio position is communicated daily to senior by decree, respectively. The Governor sets the management, and weekly to the Governor. bank’s organization. The lastest administrative 933. There is an explicit separation among the chart gives the following configuration of the front office, back office, and the entity responsible reserves management department: for SWIFT and messages. Pursuance of Treasury Governor orders is immediately checked by the back office. Deputy Governor Observance of limits (credit limits, permissible General Manager of External Finance instruments, etc.) is checked through controls Deputy General Manager charged with Payments from the chief dealer, the back office, senior man- and Follow-Up agement, the banking relations department, and Manager of External Financing and Market Operations through frequent reporting to the Governing Deputy Manager of Market Operations Board. Department of International Market Operations Department of Domestic Market Operations Deputy Manager of External Financing Management of operational risk Department of Private Financing and and controls Specialized Organizations 934. Supervision of risks is conducted through Department of Public Financing Manager of International Relations and Treasury a system of formal limits and several controls. Deputy Manager of International Relations 935. First, dealing is centralized in a single Department of International Organizations location: the dealing room. Dealing risks are min- Department of Banking Relations and imized by a formal separation between the front Counterparts Follow-Up office, back office, and SWIFT and messages unit. Deputy Manager of Treasury Formal deposit limits are set for each counter- Back Office party in terms of amounts and maximum deposit Department of Treasury Projections periods. Settlement risk for bond operations is Manager of Payments and External Debt reduced through a systematic and immediate Deputy Manager of Current Payments checking of a counterparty’s confirmations (secu- Deputy Manager of External Debt rity type, accrued interest, nominal and net Manager of External Transactions Follow-Up amounts, value date), prompt processing, and Deputy Manager of External Payments Follow-Up settling through receive (or deliver) against pay- SWIFT and Messages Unit ment settlement procedures. Custodial risk is reduced by choosing good international clear- 930. Strategic decisions on overall objectives ing institutes (Federal Reserve Bank of New and principles of reserves management policy are York, Euroclear, Clearstream, Bank of Tokyo set by the Governor on proposal of the concerned Mitsubishi), and by undertaking a thorough cus- departments (currency distribution, asset classes, todian follow-up and systematic control of custo- limits, risk monitoring, etc.). dian statements. 931. The operational framework of the policies 936. Information technology risk is reduced by adopted, and all decisions regarding investment limiting access to data files and information system, 180 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT a daily backing up of data files, and similar precau- operations in international capital markets. The tions. Financial errors are minimized through system guarantees real-time transaction process- prompt transaction processing and recording, ing. It produces all the required statements to back office control measures, as well as accounting confirm and settle the transactions done by the checks on a daily basis. front office, updates the treasury statements, generates book entries, and manages formal limits. The system also produces a variety of report- Transparency and accountability ing statements for control and follow-up of the 937. To enhance the efficiency of reserves commitments. management policy and to trim down operating 941. The system also provides a large range of risks, the CBT has implemented an appropriate activity, treasury, and statistical reports. These operational system based on risk exposure limits, reports allow control of transactions processing, cautious and prompt settlement processing, con- and follow-up of risk and return management tools trol measures, and frequent reporting. This opera- such as limits, duration, and performance. tional system is managed by means of a computer 942. The system structure separates front and system. back office functions. At the front office level, 938. Regarding settlement processing, short- transactions done are booked into the system. term investment operations on the international The back office has the charge of checking the money market are generally settled the next day. deal’s accuracy and entries before the final valida- Long-term deposits and foreign exchange transaction of the transaction. The SWIFT and messages tions are treated on a spot value date basis. unit is independent from the back office, offering Concerning securities, transactions are done on a thus an additional way to reduce settlement three-day settlement basis. Nevertheless, instruc- risks. The back office also copes with the follow- tions of all the transactions have to be processed up of accounting records, and the reconciliation the same day in order to provide the required time of all received reports from correspondents and to follow up on the settlement and to intervene in custodians. case of misstatement. 943. This computer system provides a hierar- 939. In other respects, the CBT has central- chical authorization system, based on passwords ized settlement processing through the main cor- and random codes access controls, which restrict respondent for each currency to have standard the scope of access of operators according to their settlement instructions. This has allowed cutting function needs. Besides, the system referential is the misstatement risk, especially from the centralized and managed exclusively at the back counterparty’s side. The CBT has also diversified office level. custodial risk by holding three security custody 944. Data backup is performed on a daily basis accounts with different institutions (Federal into the general specified server and periodically Reserve Bank of New York, Euroclear, on separate magnetic supports. Furthermore, the Clearstream, Bank of Tokyo Mitsubishi). The system is highly protected with sophisticated virus terms and provisions governing the relationship detection software, and with an auxiliary server. In of the CBT with these correspondents and cus- addition, the CBT dealing room is protected with a tody institutions point out clearly their responsi- card access system and equipped with fire detec- bilities vis-à-vis the CBT and the reporting tion instruments. arrangements. 945. Audit function is led by an internal entity. 940. To improve the reserves management This entity undertakes periodic missions in order to operational efficiency (either at the processing assess reserves management operations processing, level or at the monitoring one), the CBT has in accordance with objectives, principles, and oper- implemented an integrated computer system. ational procedures approved by the Governing This system integrates the management of front Board of the Bank. No external auditing has until and back office functions, and accounting of the now been undertaken. 18 • Tunisia 181

Establishing a Capacity to Assess and accordingly. Credit risk is controlled through con- Manage Risk straints on permissible investment instruments. Only sovereign AAA government and suprana- Risk management tional issues are allowed. Agencies and corporate Liquidity risk bonds are excluded from the bank’s assets. 946. Liquidity is guaranteed through an appropriate asset allocation and an adequate time hori- Market risk zon for investment operations. About 5 percent of 948. Foreign exchange risk is managed by foreign currency reserves is maintained liquid to matching the structure of reserves currencies to meet unanticipated treasury needs. Excess liquidity the currency structure of the balance of settle- is invested daily in short-term bank deposits ments. Adjustments are made when major discrep- (TomNext or OverNight). About 65 to 70 percent ancies from the objective structure arise, or to take of the reserves are invested in the money market, profit from substantial differentials in interest through bank deposits of 1-week to 6-month peri- rates, or following the Governor’s decision after ods, on the basis of anticipated fund flows. The proposals of the reserves management depart- remaining 25 to 30 percent of the reserves are ment. Equities are completely excluded from the invested in AAA sovereign government and supra- asset portfolio, making the portfolio immune from national bonds. stock market risks. 949. Interest rate risks are diminished through a choice of double duration limits: one on the Credit risk global portfolio of reserves (nine months), and the 947. Credit risk is managed through an ade- second on the bond portfolio (two to three years). quate choice of counterparties with sound finan- Long-maturity bonds (above 10 years), which are cial backgrounds. These counterparties are most sensitive to interest rate movements, are constantly followed, especially through several rat- excluded from the portfolio. Constraints on per- ing agencies reports. Quantitative limits on deposit missible instruments are also a factor diminishing amounts and investment periods are set for each interest rate risks. counterparty according to its rating. A continuous 950. The use of financial derivative instru- follow-up of the counterparties is ensured by an ments (swaps and options) is made only for hedg- independent department, and limits are updated ing purposes. 19 Turkey

Developing a Sound Governance and tral banking principles in the rest of the world. Institutional Framework Accordingly, the reserve management concept has fully evolved into a new stage at the Central Bank Reserve management objectives and with the implementation of modern management coordination principles. The Central Bank takes into account 951. Before 1980, Turkey had a fixed exchange the priorities of safety, liquidity, and return, in that rate regime with strict foreign exchange controls. order, while managing reserves. Risk awareness Reserves were used mainly for current needs. With and management have become primary concerns. the liberalization policies of the early 1980s, 954. Reserve assets managed by the Central exchange controls were eliminated and banks as Bank consist of readily available and marketable well as other institutions and individuals were foreign assets that are controlled completely by the allowed to hold foreign exchange. With these Central Bank. changes, reserves began to serve additional pur- 955. The reserve management strategies at the poses, such as intervention in domestic currency Central Bank are influenced by different factors. and providing a level of confidence to domestic One such factor is the Central Bank’s liability struc- and international markets. ture, which is somewhat different from most cen- 952. The accumulation of foreign reserves dur- tral banks. The Central Bank carries a relatively ing the second half of the 1980s made clear the large amount of liabilities in foreign exchange, need to improve portfolio management skills at the which consists of savings deposits opened by Central Bank of Turkey (the Central Bank). To this Turkish citizens living abroad. These accounts were end, the Central Bank employed a few external opened in the late 1970s to help Turkey overcome fund managers to manage fixed income portfolios foreign exchange bottlenecks. They proved to be a as part of the learning and training process for its stable source of foreign exchange over the years, own staff. The main function of those managers even in times of financial crises. The Central Bank was training and providing advisory services about also has other liabilities in foreign exchange to the developments in international markets. domestic (e.g., reserve requirements) and interna- External manager services were discontinued in tional institutions. These liability accounts have a 1995. major impact on the design of the reserve man- 953. With the liberalization of the Turkish agement strategies. economy, there was growing need to keep up with 956. Another factor that influences the reserve a rapidly changing financial environment and cen- management strategies is the monetary and

182 19 • Turkey 183 exchange rate regimes that are in place. The cur- Management Office is responsible for managing rent Central Bank Law dictates that reserves should the government debt and associated risks. be managed in line with the monetary policy objectives. In the last 20 years or so, Turkey adopted dif- Legal and institutional framework ferent forms of intermediate exchange rate regimes between fixed and floating, all of which 959. The current legal framework of reserve needed liquid reserves to be sustained. Therefore, management is defined by the Central Bank Law, providing liquidity for intervention had been the which gives the Central Bank the authority and the driving factor in designing reserve management responsibility to manage the country’s foreign strategies. At the end of 1999, Turkey announced a exchange and gold reserves. The Law, which was disinflation program, supported by the IMF. Under recently amended in order to strengthen the this program, the Central Bank started implement- Central Bank’s independence, cites the reserve ing a preannounced crawling peg and a rule-based management objectives as safety, liquidity, and monetary policy. During that period, reserve man- return in that order, and authorizes the Central agement was structured in such a way that the liq- Bank to do transactions in international financial uidity aspect of reserves was even more markets. pronounced because of the need to defend the 960. The Central Bank is the only institution crawling peg. Hence, the reserve management authorized to manage the official foreign reserves strategy was based mainly on liquidity. However, of the country, with principles and investment cri- the crawling peg regime had to be abandoned in teria determined by the Bank Board. The Central the aftermath of the two crises and the Turkish lira Bank acts as a financial agent for the Government. was floated on February 22, 2001. In this capacity, the Central Bank accepts foreign 957. Under the current floating exchange rate exchange deposits from and executes payments on regime, the Central Bank is committed to inter- behalf of the Government. vene only to smooth out extreme movements in exchange rates, which allows for a more efficient Organizational Structure liquidity management of the foreign exchange reserves portfolio. 961. The Central Bank Law defines the Central 958. Another important factor that influences Bank’s Board as the highest decision-making body the reserve management strategies is the external within the Bank. Based on this authority, the cash flows that arise mainly from foreign debt pay- Central Bank’s Board has made several decisions in ments executed on behalf of the Turkish Treasury, the past with regard to the reserve management which is responsible for debt management. Under operations, including the current investment the current institutional framework, asset and lia- guidelines. The Investment Guidelines include bility management functions rest with different allowable financial instruments and transactions, institutions. While the Treasury manages the gov- minimum external credit ratings, and transaction ernment’s foreign debt, the Central Bank is limits for different groups of counterparties. responsible for the management of foreign 962. Following recent trends in international reserves. This framework makes sovereign risk markets, the Central Bank restructured its reserve management a challenging task. However, the management process in 1998 in order to separate Central Bank solves this problem by taking risk and investment management functions. The expected foreign debt payments within the next Foreign Exchange Risk and Investment Committee year into account when designing the global was set up to shape the strategy and to make first- benchmark and by establishing close coordination layer strategic investment decisions in reserve and with the Treasury. The coordination between the risk management. The Committee is composed of two institutions is expected to develop even further a Vice Governor, the General Manager, and the two with the new Debt Management Office, which has Assistant General Managers of the Markets recently been set up within the Treasury. The Debt Department, who are responsible for reserve and 184 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT risk management. The Committee approves the 967. For most central banks, especially in global benchmark, sets and monitors risk limits, emerging market countries such as Turkey, it is and reviews performance reports. very difficult to estimate the timing of a possible 963. Also in 1998, the Foreign Exchange Risk run on foreign reserves, which makes liquidity Management Division was created within the management very difficult. Therefore, liquidity is a Markets Department to be responsible for manag- required criterion for any instrument to be ing financial and operational risks inherent in included in the reserve portfolio. The Central reserve management operations. Based on the Bank faces credit risk in the form of direct credit Board’s and the Committee’s decisions, Foreign risk, settlement risk, and replacement risk arising Exchange Transactions and Foreign Exchange Risk from its operations in international money, cur- Management divisions of the Market Department rency, and securities markets. As for the market carry out front, middle, and back office functions. risk, fluctuations in foreign exchange rates and interest rates constitute the two main sources of risk for the Central Bank. Transparency and accountability 964. Transparency and public disclosure of the Risk management Central Bank operations have gained importance in recent years. Turkey provides weekly data on 968. The Central Bank Law dictates that for- reserves through weekly balance sheets, monthly eign reserves should be managed with safety and information on foreign currency reserves, and liquidity objectives ahead of return. To this end, short-term possible drains through the IMF’s the Central Bank has adopted an asset-liability Special Data Dissemination Standards (SDDS), the matching strategy for minimizing currency and Reserve Data Template, and annual reports. interest rate risks in reserve management opera- Additionally, the Central Bank has had its financial tions. Although this may not be the best option statements audited by an external auditor accord- for every central bank, it provides a good approx- ing to internationally accepted accounting stan- imation toward a minimum risk exposure portfo- dards since 2000. lio for the Central Bank since its balance sheet is 965. Finally, the Central Bank is currently somewhat different from that of a typical central working on an entirely new approach to internal bank in that it carries a relatively large amount of auditing, which will include the reserve manage- savings deposits in foreign exchange that belong ment operations in the regular audit reports, as an to Turkish citizens living abroad. However, the effort to further improve the reserve management Central Bank has also considerable amounts of accountability. This project is planned to be put external cash flows such as foreign debt payments into practice in late 2002. executed on behalf of the Treasury, foreign exchange inflows from the Treasury’s borrowings, and foreign exchange interventions that make Establishing a Capacity to Assess and asset-liability matching somewhat difficult. This Manage Risk obstacle is overcome to a certain extent by treat- ing such outflows as if they were liability accounts. Sources of risks The currency distribution and duration target of 966. Considering the management policy the global benchmark are set to match the cur- objectives and the financial markets that the rency distribution and maturity structure of the Central Bank is involved in, liquidity, credit, and on-balance-sheet liabilities and expected external market risks have been identified as major finan- cash flows within the next year. Duration and cur- cial risks inherent in the reserve management pro- rency limits are used to control deviations from cess. It has also been accepted that the Central these targets. An overall bank limit is also Bank is exposed to certain operational risks during included in the global benchmark to control the this process. credit risk. 19 • Turkey 185

969. The global benchmark also includes the 973. Portfolio managers are allowed to deviate eligible instruments and transactions that can be from the target duration to reflect their market used in reserve management. These instruments strategies. However, such deviations are controlled and transactions currently include: through the use of portfolio duration limits, which • Sovereign bonds with minimum AA or equiv- are set in accordance with the global benchmark alent credit ratings and maturities up to 10 limits. years, 974. In order to further control the credit risk, the overall bank limit set within the global bench- • Supranationals and BIS instruments with mark is distributed into individual credit limits for maturities up to 10 years, each counterparty. These limits are determined • Time deposits placed with central banks and using an Internal Scoring Model. The Internal commercial banks with minimum A1/P1 or Scoring Model incorporates information about the equivalent credit ratings, counterparties, such as external credit ratings by different rating agencies, financial data, country • Spot and forward foreign exchange transac- ratings, and support status of the institution, in tions with commercial banks with minimum order to calculate a composite score. Based on this A1/P1 or equivalent credit ratings. score and the capital size, each counterparty is 970. The Central Bank is currently in the assigned a certain credit limit. process of expanding the range of products 975. The custodial risk is also addressed within used in reserve management to achieve more the credit risk management. The Central Bank diversification. prefers other central banks and international cus- 971. The liquidity risk is also addressed within todians for safekeeping its reserve assets. the global benchmark in two steps. First, consid- 976. In recent years, the Central Bank has paid ering the extremely high costs of possible liquid- special attention to eliminating any deficiencies that ity shortfalls, only the most liquid instruments may create operational risks. Within this context, such as certain government obligations and very the Central Bank restructured its existing back short-term bank deposits are included in the office in order to prevent possible operational losses global benchmark as permissible asset classes. due to human or system errors. As an additional Second, the reserve portfolios in major reserve measure against operational risks, the Central Bank currencies are divided into “tranches,” each pro- has recently set up a “Disaster Recovery Site” that viding liquidity in different time horizons. While could become operational in a very short time in the operational portfolios meet day-to-day liquid- case the current systems become unusable for any ity or working capital needs, the liquidity portfo- reason. Finally, the risk management unit is working lios provide liquidity in the short term. Although on issuing a “Code of Conduct” for reserve manage- they are relatively small in size, the investment ment staff. portfolios are managed with a return maximization objective while staying within the overall risk Reporting and monitoring limits. 972. Once the global benchmark is deter- 977. Once the overall level of risk that the mined as a long-term passive investment strategy, Central Bank is willing to bear has been decided on the sub-portfolio benchmarks are constructed in through the global benchmark, current risk expo- order to communicate the risk/return targets of sure is measured, monitored, and reported on a the global benchmark to the investment unit regular basis. As mentioned before, the portfolio (Foreign Exchange Transactions Division). The managers are allowed to take positions against sub-portfolio benchmark compositions are deter- their benchmarks based on their short-term invest- mined with optimization of return and risk (return ment strategies. However, these positions should volatility) based on historical return statistics of not go beyond the preset limits both on the sub- external indices. portfolio and the global levels. The currency risk is 186 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT monitored through the use of currency limits, Human resources which are set within the global benchmark in order to control deviations from the target currency com- 981. The Central Bank employs highly quali- position. The interest rate risk is controlled fied staff in the reserve and risk management area through duration limits that are set both at the and gives considerable importance to further train- global and the sub-portfolio levels. The usage of ing of the staff. In addition to the in-house training these limits is reported to the Foreign Exchange programs, the staff benefits from seminars held by Risk and Investment Committee on a regular basis. other central banks and major financial institu- 978. As a future step, the Central Bank is plan- tions. The Central Bank has also adopted a policy ning to use Value-at-Risk limits to improve the mar- of providing selected staff members with scholar- ket risk control. Value-at-Risk has been used at the ships for postgraduate programs at major universi- Central Bank for reporting purposes for the last ties abroad. couple of years. 979. The monitoring of credit risk is done by the Information technology “Real Time Limit Monitoring System,” which is developed in-house. This system is designed to warn 982. As for the information system needs, the traders if the trade exceeds the remaining limit and Central Bank has adopted a policy to develop its captures each deal in terms of amount and exposure own systems where possible. The Central Bank has period by counterparty. The system not only takes a relatively large IT Department with highly qual- into account the direct credit risk arising from ified staff. The IT Department has developed the deposit transactions but also considers “replacement current systems used in reserve and risk manage- risk” and “foreign exchange settlement risk.” The ment. However, for meeting sophisticated and system tracks limit usage and violations, and pro- specific software needs, such as certain risk mea- duces related reports by counterparty, rating cate- surement tools, developing products in-house gory, and country. may not be the most efficient option. In such 980. As for the performance measurement, the cases, the Central Bank prefers outsourcing this Central Bank has adopted a risk-adjusted perfor- service by trying to search for the most suitable mance measurement methodology that considers product in the market. additional risks taken to achieve the realized return. 20 United Kingdom

Reserve Management Objectives and currency from Departments with foreign currency Coordination receipts. 985. The U.K. Government has published a 983. United Kingdom official holdings of inter- Service Delivery Agreement (SDA) target to mini- national reserves are owned by Her Majesty’s mize the cost of holding reserves while reducing Treasury (HMT) and comprise gold, foreign cur- risk. The performance relative to this target is rency assets, International Monetary Fund (IMF) reported in detail in HMT’s annual report on the Special Drawing Rights (SDRs), and the U.K.’s expenditure plans of the Chancellor of the Reserve Tranche Position (RTP) at the IMF. With Exchequer’s Departments. the exception of the RTP, these reserves are held in the Exchange Equalization Account (EEA). The Bank of England manages the reserves as agent for Institutional framework—the annual Remit HMT, as well as providing advice on reserves man- 986. The Bank of England manages the agement issues, including liability management. reserves in accordance with criteria set out by HMT 984. The EEA was established in 1932 as a in an annual Remit, the main text of which is pub- fund for stabilizing the exchange value of sterling. lished in the Debt and Reserves Management Any U.K. government exchange rate intervention Report, which is published by HMT at the time of would therefore be conducted through the EEA.54 the Budget. The Remit summarizes the bench- The EEA also provides foreign currency services to marks that the reserves are actively managed Government Departments and Agencies, i.e., sales against; the investment constraints within which of foreign currency to Departments with foreign the Bank operates; the framework for risk control; currency obligations and purchases of foreign and the arrangements for the audit of the EEA. The Bank is also set a profit target, net of management costs, for active management against the benchmark; this target is not published. 54In addition to the United Kingdom’s Official Reserves, the Bank of England manages its own holdings of foreign currency assets and gold. As set out in the Chancellor of the Administration and control Exchequer’s letter of 6 May 1997 to the Governor of the Bank of England, the Bank can intervene in support of its monetary 987. The Bank reports to HMT on investment policy objective using the Bank’s own resources rather than those of the EEA. The Bank of England Act 1998 sets out rules performance at a monthly meeting chaired by the governing the disclosure of any such intervention. head of HMT’s Debt and Reserves Management

187 188 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT team. The Bank’s Foreign Exchange (FED) and ment performance are formally reported to senior Risk Analysis and Monitoring (RAMD) divisions management and to HMT on a monthly basis. account for the returns made, and for market and 992. This delegation of responsibilities and credit risks incurred. Any outstanding operational decision making is captured within the formal or policy issues are also discussed. Every six benchmark process, where higher levels of man- months, there is a meeting at which the EEA agement shape the benchmark for the next level Accounting Officer and the Bank of England’s down. This approach enables the attribution of Executive Director for Market Operations or dele- overall returns to the decisions taken at each level gated senior officials review investment perfor- and provides a direct and highly visible link between mance, discuss strategy, and agree upon analysis to decisions made and profits earned. This gives essen- be commissioned by HMT and undertaken by the tial feedback in analyzing performance and acts as Bank. Meetings to discuss individual issues, includ- an important motivator for reserves managers. ing changes to the Remit, may be proposed at any 993. As well as reporting directly to the time by HMT or by the Bank. Executive Director for Market Operations, RAMD 988. Every quarter, an independent opinion of has a reporting line to the Deputy Governor for the adequacy and effectiveness of the system of Financial Stability in the latter’s capacity of internal and financial control is provided to the Chairman of the Bank’s Asset and Liability Bank’s Executive Director for Market Operations Committee. This reinforces the independence of by the Head of the Bank’s Internal Audit. The the middle office. The operational independence Bank’s Executive Director sends these reports to of RAMD is considered to be an important pre- the EEA Accounting Officer. At the same time, the requisite for its effectiveness. Executive Director provides the Accounting 994. RAMD is responsible for legal, regula- Officer with a management report on the opera- tory, and ethical issues of compliance (external tion of the control framework. Separately, the U.K. control) as well as risk measurement and moni- National Audit Office undertakes an external audit toring (internal control). It ensures that detailed of the EEA on an annual basis. benchmarks, limits, and controls are in place that are consistent with the risk limits set by HMT in the Remit. It also establishes the compliance and Bank of England reserves management reporting procedures that managers should fol- structure low and sets up all the necessary legal agreements 989. The reserves management operation is and documentation. ultimately headed by the Executive Director for 995. Operational procedures are documented Market Operations, to whom the heads of FED and in a handbook that is frequently updated and RAMD report. It is an important principle that nei- made available to all staff involved in the manage- ther the middle office (RAMD) nor the back office ment of reserves. These include new products pro- report to the front office (FED). cedures, to ensure that investment managers and 990. FED and RAMD senior management are dealers trade only in instruments that can be han- responsible for implementing and reporting the dled by settlement, risk, accounting, and IT sys- results of the strategy agreed between HMT and tems. The rules governing insider dealing and the senior management at the Bank. Decisions on spe- declaration of personal financial transactions are cific investments and the degree of latitude for indi- also circulated. All staff employed in the manage- vidual portfolio managers, in addition to general ment and control of the reserves are required to staffing and budget issues, are taken at this level. sign these declarations on a frequent basis. 991. Dealers and portfolio managers within 996. RAMD is responsible for ensuring that FED provide active day-to-day management of the investments are correctly recorded and for moni- foreign exchange and asset portfolios, involving toring any breach of limits, controls, or other ele- tactical positioning and direct contact with market ments of compliance. All breaches are reported to counterparts. Market positions and overall invest- senior management. In addition, RAMD calculates 20 • United Kingdom 189 the profit and loss figures, which are reported to annual accounts was published, covering senior management and HMT. 1997–98; these financial statements are audited by the National Audit Office. HMT now has a statutory obligation, as set out in the Finance Act 2000, Training and retaining staff to publish a full set of financial accounts for the 997. The Bank of England devotes consider- EEA every year and, after examination and certifi- able resources to training its staff in the specialist cation by the Comptroller and Auditor General, skills required for reserves management. This to lay the accounts before each House of includes regular participation in internal and Parliament by the January 31 following the end of external courses in finance and portfolio manage- the financial year to which the accounts relate. ment techniques. Like other bank employees, staff The financial accounts for 2000–01 were the first involved in reserves management have their basic to be published within this framework. Although salary structure enhanced by a flexible package of this is the fourth year for which the accounts have financial and nonfinancial benefits, and individual been published, it is the first time they have been effort is rewarded through a system of discre- published under accruals accounting consistent tionary bonuses (though as a considerably smaller with U.K. Generally Accepted Accounting proportion of total remuneration than in the pri- Practice (U.K. GAAP). vate sector).

Establishing a Capacity to Assess and Transparency and accountability Manage Risk 998. The presentation and accounting basis of the U.K. reserves has changed radically in recent An asset/liability approach years. The United Kingdom has been at the fore- 1000. HMT’s foreign exchange assets and lia- front internationally in promoting openness and bilities are managed jointly on a day-to-day basis by transparency in reserves data. In September 1997 the Bank of England. However, whereas the assets the Chancellor of the Exchequer announced that are held in the EEA the liabilities are liabilities of he was “opening up the books” on the U.K. the National Loans Fund (NLF), which funds the reserves of foreign currency and gold. The ensu- EEA’s assets through a combination of sterling and ing quarterly report, which was initially published foreign currency borrowing. The Exchange with a two-month lag, provided a breakdown of Equalization Account Act does not permit the EEA assets and liabilities into broad currency blocs, to borrow. SDRs, and gold. Since April 2000, reserves data 1001. Any NLF exposures relating to the foreign have been published on a monthly basis in accor- currency reserves are managed alongside those of dance with the IMF/G10’s Special Data the EEA by the Bank of England, which also acts as Dissemination Standard (SDDS). Data from July HMT’s agent for foreign currency liability manage- 1999 onward can be found on the Bank of ment. For example, when the NLF borrows in a for- England website. These data record the value and eign currency to fund the reserves it assumes the composition of the U.K.’s gold and foreign cur- currency and interest rate risk as it sells the foreign rency assets, liabilities, and derivatives on a currency to the EEA for sterling. Through its invest- “marked-to-market” basis (that is, using current ments the EEA will take an offsetting currency and market valuations). The press release also reports interest rate position so that the government’s expo- the size(s) and date(s) of any intervention in the sures as a whole are hedged. foreign exchange markets, either by the EEA or 1002. EEA reserves fall into two differently by the Bank of England, and gives an explanation funded categories: “borrowed reserves” on which of any intervention carried out. the currency exposures have been hedged and 999. As a further enhancement of trans- “net reserves,” which are funded out of un- parency, in January 2000, the first set of EEA hedged sterling. 190 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT

Funding the borrowed reserves Net reserves 1003. The “borrowed” reserve assets are 1006. The net currency reserves are effectively financed both by foreign currency and sterling- financed by unhedged sterling, and by the EEA’s denominated liabilities, the latter swapped into net SDR liability. HMT sets a benchmark for net foreign currencies. Cost is the main determinant currency exposures that takes into account past of whether the foreign currency reserves are patterns of risk and return, as well as other macroe- funded by issuing foreign currency liabilities or by conomic factors such as trade flows and the likely sterling swapped into foreign currencies. The currencies used in any intervention. In 2001–02, least-cost method of funding can be determined this was 40 percent U.S. dollars, 40 percent euros, by comparing, on a swapped basis, the cost of issu- and 20 percent Japanese yen (excluding SDRs), ing bonds of a given maturity and nominal which has been unchanged since accounts were amount in dollars, euros, and yen with the cost of first published in 1997–98. issuing a similar bond in sterling. The EEA seeks 1007. Interest rate risk in the net reserves has to control the exposure in these borrowed largely been managed by investing in short-dated reserves by matching the risk characteristics, for instruments. Recently, however, the duration of example maturity, of its foreign currency assets to some of the net reserves benchmark has been those of the foreign currency liabilities. Any resid- extended to reflect a revised view about the best ual risk is managed by swapping the exposure of trade-off between risk and return. the asset into that of the liability through currency or interest rate swaps. Composition of reserve assets 1008. Under the Exchange Equalization Act, Recent trends in financing the funds in the EEA may be invested in any assets borrowed reserves denominated in the currency of any country; in the purchase of gold; or in the acquisition of SDRs. 1004. Since March 2000 a program was imple- 1009. In May 1999, the Government announced mented that replaced maturing foreign currency a restructuring of the reserves involving a program debt issues with sterling debt swapped into foreign of gold sales by auction to achieve a better balance currencies to finance the reserves. At prevailing in the portfolio by increasing the proportion held in interest rates and swap rates this offered a more currency. This program continued until the end of cost-effective means of financing than borrowing 2001–02. Following each auction, the proceeds of directly in foreign currency. As central government gold sales were invested in foreign currency interest net cash requirements for 2000–01 were revised bearing assets and retained in the reserves broadly down substantially, further swaps were undertaken in the proportion of 40 percent dollars, 40 percent to prefinance some of the foreign currency debt euros, and 20 percent Japanese yen. maturing in 2001 to 2003. This policy continued through 2001–02. 1005. Prefinancing led to a temporary rise in Securities and other eligible the gross reserves but did not increase the U.K.’s instruments net foreign currency exposures, because all transactions were hedged. As the prefinanced liabilities 1010. The statutory obligation of the EEA dic- are redeemed, the level of gross reserves will fall tates that investments must be highly liquid, so they back. Redemption of the longest-dated prefi- may be made available quickly for intervention nanced foreign currency obligation in January purposes if necessary. They must also carry accept- 2003 is expected to bring the level of gross reserves able credit risk. Essentially this means that the bulk down to $35 billion by the end of March 2003, of the assets are securities issued by the national from a recent high of $43 billion at the end of governments of the United States, euro area coun- September 2001. tries, and Japan. 20 • United Kingdom 191

1011. The EEA also makes use of other instru- 1014. The results of the liquidity model are ments, however, including: used to determine the neutral position of the borrowed reserves, and this forms the benchmark for (i) Bonds issued by highly rated suprana- active management. tional organizations and selected official sector agencies; (ii) Foreign currency spot, forward, and swap Active management benchmarks transactions; 1015. The Bank actively manages both the bor- (iii) Interest rate and currency swaps; rowed and net reserves in order to enhance (iv) Bond and interest rate futures; returns relative to benchmarks. Deviations from benchmarks are capped by the VaR limits set each (v) Forward rate agreements; year by HMT in its annual Remit. The benchmark (vi) Gold deposits, gold loco, and gold quality returns on borrowed reserves comprise the returns swaps; to the hedge portfolios held against the NLF for- (vii) SDRs; eign currency and returns generated by the ster- (viii) Certificates of deposit and bank and cor- ling swaps program. porate commercial paper; and 1016. The benchmarks for active management are adjusted for any positions taken by higher lev- (ix) Bank deposits. els of management such that the returns to active 1012. Options are not currently permissible risk taking are properly identified for each portfo- investments for the EEA. lio. Such management positions count against the overall VaR limits.

Liquidity policy Active management 1013. To determine the benchmark asset allocation for the EEA, the Bank employs an asset alloca- 1017. Portfolios are divided into major cur- tion model that explicitly trades off liquidity and rency blocs—dollars, euros, and yen—and portfo- return: the model determines an asset mix that max- lio managers establish tactical positions by buying imizes expected return for given levels of expected and selling securities against their individual cur- liquidation costs. Potential liquidation costs include rency benchmarks. They are also permitted to both bid-offer transaction costs, which are depen- establish positions using derivatives including dent on the size of liquidation, and price move- futures and swaps although not, currently, options. ments, which are primarily driven by market 1018. A range of positions including outright conditions at the time of liquidation. Liquidation longs and shorts, curve positions, spread switches, costs are incurred only if there is a call on the and relative value switches are taken at the active reserves. A “call” on the reserves is defined by three level. The decision to take profits on trades and to parameters: the size of the call, the probability of the unwind loss-making positions, in most instances, call occurring, and the length of time available to belongs to the portfolio manager although, excep- meet the call. In the absence of such a call, the tionally, senior management may ask for positions reserves are assumed to be held to maturity and to be closed in order to avoid a buildup of unac- yields between asset classes can be compared on a ceptable risks. Positions are monitored on a fre- spread-to-LIBOR basis (taking into account the basis quent basis by the direct line management of the swap if assets are denominated in different curren- active traders. cies). Various call scenarios are assumed, based on historic events and future potential needs. A core Market risk level of liquidity is also specified in the model, leading to minimum holding thresholds in particular 1019. Market risk is the exposure to move- asset classes such as U.S. Treasury bonds. ments in market variables. For the EEA, these vari- 192 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT ables are primarily interest rates and exchange and of the issuers of sovereign, supranational, or rates. Since 1999 the Bank has monitored and con- commercial paper. The creditworthiness of these trolled market risk using a VaR model, which pre- banks and issuers is subject to regular scrutiny by dicts, at a specified confidence level, the maximum the Bank. Although the Bank takes account of pub- likely loss for the portfolio over a certain time lished Agency ratings, it sets its own internal limits, period. The Bank applies a 99 percent confidence which limit the maximum exposure to each bank interval and a ten-day holding period, which pre- and issuer in terms of both amount and maturity. dicts that in 99 ten-day periods out of a hundred, Such exposures are monitored in real time against losses should not exceed those suggested by the the limits. A report of any limit excesses is sent to model. These VaR estimates are based on the past HMT each month. In addition, there are limits to volatility of returns on different asset classes and contain exposure to each country’s banking system on how the returns on each asset class are corre- and on instrument types. lated with other positions held in the portfolio. 1023. Where bonds are owned by the EEA, but 1020. The Bank measures the EEA’s VaR expo- held by custodians, these custodians may be autho- sure on a regular basis throughout the day. It also rized to use them in their bond lending programs. calculates the Delta exposure at the same fre- These programs involve lending the bonds against quency. Delta measures the change in value of the collateral consisting of either other bonds or cash. portfolios for each one-basis-point shift in the rele- The authorized custodians are permitted to invest vant yield curve. It supplements the VaR measure, cash collateral in money market instruments. The and helps to test the sensitivity of the portfolio to investment of this cash collateral is subject to credit changes in interest rates. Market risk reports are limits determined by the Bank. The amounts dele- produced daily. gated to the custodians are deducted from the limits 1021. Furthermore, the Bank conducts regular available to the Bank for its own EEA management stress tests, to explore the vulnerability of the EEA activities. Any maturity mismatch between the col- to hypothetical severe market movements and to lateral held and the corresponding investments is estimate the potential losses in these extreme con- strictly limited. Daily reports are received by the ditions. The results of these tests are reported to Bank, which allows compliance with the investment senior management. constraints to be checked. 1024. The EEA also exercises its right to call collateral each time exposures to swap or repo Credit risk counterparties rise above contractually defined 1022. The management of the reserves thresholds. Unsecured credit risk on such transac- involves exposure to the creditworthiness of banks tions is thereby kept to a minimum.