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 indepen- dently 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.