Guidelines for Foreign Exchange Reserve Management -- Part ...

IICOUNTRY CASE STUDIES

Governance and InstitutionalFramework

Objectives of reserves management

156. Australia’s foreign currency reserves aremanaged by the Reserve Bank of Australia (RBA).At the end of June 2002, the gross value of thereserves portfolio was US$20 billion, representingaround half of the central bank’s assets. The pri-mary role of the reserves portfolio is to fund for-eign exchange market operations that arise as partof the Bank’s broader monetary policy function.Reflecting this, the reserves are managed in a man-ner that gives priority to low levels of credit risk,limited exposure to market risk, and maintaining ahigh degree of liquidity. Subject to these objectives,the Bank also seeks to earn a positive return on theportfolio.

157. In 1990, the Bank undertook a formalreview of its approach to foreign exchange reservesmanagement. The outcome of the review was theestablishment of a rigorously defined operationalframework for managing risk and return. The cen-terpiece of the framework was the developmentand implementation of benchmark portfolios forcurrency and asset allocation, and for the durationof the asset portfolios. The benchmarks areintended to represent the optimal mix of risk andreturn for the RBA given its management objec-tives. The review also provided a greater role foractive management to take advantage of expected

movements in exchange rates, relative returns inbond markets, and changes in the level and slopeof yield curves. These changes were set in place in1991.

158. Experience with active management wasreviewed in 2000 after nine years of operation. Thereview highlighted the fact that short-term invest-ment decisions designed to take advantage of mar-ket anomalies had consistently made positivereturns, albeit small. In contrast, investment posi-tions taken in anticipation of medium-termmacroeconomic developments had made positivereturns of reasonable size in some years, but thesehad been largely offset by negative returns in otheryears, leaving only a small positive return from thisactivity overall. The RBA decided that the low aver-age, and high variability, of returns did not warranttaking investment positions of the same size andfrequency as in the past. As a result, managementdiscretion was curtailed, significantly reducing theimportance of discretionary management as asource of return for the reserves portfolio.

Institutional framework

159. The RBA’s responsibility to manageAustralia’s foreign exchange reserves is giventhrough broad legislative powers that allow theBank to buy, sell, and otherwise deal in foreignexchange (among other things) to achieve mone-tary policy objectives. Responsibility is not shared

35

1Australia

with other government agencies, reflecting therole of reserves as a source of intervention capital.The RBA acts independently in its managementdecisions.

Organizational and decision-making structure

160. The organizational structure of reservesmanagement at the RBA is summarized in Figure 1.Responsibility for management of reserves is dele-gated by the Governor of the Bank to the FinancialMarkets Group (FMG). This group comprises twodepartments, International and Domestic Markets.The International Department is responsible forthe Bank’s front office operations in markets forforeign exchange, gold, and offshore assets.

161. The International Department frontoffice manages the currency and asset allocationpositions of the portfolio, and directs policy issuesregarding investment of reserves, such as assessinginstruments and the structure of the benchmarks.It is supported by three dealing centers: one each

in New York, London, and the Bank’s Head Officein Sydney. These centers execute trades and havesmall discretion for position taking. The RBA hasfound considerable informational benefit in locat-ing dealing staff in major offshore centers. Thefront office is also supported by an analytical groupwith responsibility to provide in-depth analysis ofinternational financial and macroeconomic devel-opments that may impact on the value of thereserves portfolio.

162. Also part of the Financial Markets Group,but not within the International Department, is amiddle office function, known as Dealing Support.This unit is responsible for measuring risk andreturn and for maintaining front office systems.Valuation, performance, and risk information areprovided to the front office operation and tosenior management on a daily basis. The middleoffice reports directly to the Assistant Governoroverseeing the Financial Markets Group.

163. There are several other areas outside ofthe Financial Markets Group that provide services

36 GUIDELINES FOR FOREIGN EXCHANGE RESERVE MANAGEMENT: ACCOMPANYING DOCUMENT

Assistant Governor

Financial Markets Group

DealingSupport

(Middle Office)

AssistantGovernor

Assistant GovernorCorporate Services

PaymentsSettlementsDepartment(Back Office)

FinancialAdministrationDepartment

Governor

Audit

Head of International Department

Front Office

New YorkDealingCenter

LondonDealingCenter

SydneyDealingCenter

Analysis

Figure 1. Organizational Structure

to, or scrutinize the actions of, the front officereserve management operation. These include theback office (Payments Settlements) and account-ing (Financial Administration) functions. The backoffice provides standard settlement and communi-cation services to the reserves management frontoffice and is responsible for the final approval of alltransactions—dealers in the front office cannotconfirm trades. There are back office operations ineach of the dealing centers, with Sydney havingoverall responsibility. The Audit Department is alsooutside of the Financial Markets Group. Thisdepartment has a direct reporting line to theGovernor.

164. The structure and delineation of responsi-bilities in reserves management have evolved overtime as the nature of, and the RBA’s approach to,reserves management has changed. Until the late1980s, the International Department was responsi-ble for both middle and front office functions.Indeed, front office staff performed many of themiddle office responsibilities. Importantly, the backoffice was also located in the InternationalDepartment, albeit with separate reporting lines tothe Assistant Governor, Financial Markets Group,from those of the front office. This seemed to be areasonable structure, given the conservative limitson risk and the lack of flexibility in the RBA’s invest-ment operations at the time. However, as theapproach to reserves management changed in theearly 1990s and the scale of the operation increased,the Bank set in place a number of changes to reduceoperational risk and reflect best-practice in fundsmanagement.

165. Establishment of a middle office within theFinancial Markets Group, which reports indepen-dently to the corresponding Assistant Governor, wasa major change that occurred in the mid-1990s.Separation of the back office function was com-pleted in 1998 when the back office was physicallyrelocated to a different floor of the RBA’s HeadOffice building and put under control of theAssistant Governor, Business Services.

166. Decision-making processes have alsoevolved. In the early 1980s, almost every transac-tion in reserves management had to be approvedby higher management. While this maximized con-trol over the management process, it made deci-

sion making unwieldy and, therefore, poorly suitedto a more active risk management framework. Italso constrained initiative at manager levels. Withthe move to more active management in the early1990s, the Governor’s discretion for day-to-daymanagement of reserves was delegated to anInvestment Committee within the FinancialMarkets Group. The Committee, made up ofsenior managers from units involved in reservesmanagement, had discretion to take sizable posi-tions in currency and asset allocation subject tolimits approved by the Governor. The InvestmentCommittee met regularly and took positionslargely based on assessments of the medium-termmacroeconomic outlook of countries in which thereserves were invested. A small and qualifiedamount of trading discretion was delegated tomanagers in the trading centers.

167. The Investment Committee’s structureand its discretion to take positions changed fol-lowing the review in 2000. Senior managers over-seeing front office operations are now responsiblefor day-to-day management of currency and assetallocation, maintaining the portfolio close tobenchmark. They report directly to the AssistantGovernor of the Financial Markets Group. An out-line of the decision-making structure is shown inFigure 2.

168. Reflecting the more passive trading envi-ronment, there are no longer any formal meetingsto discuss investment strategy. In contrast, man-agers in the dealing centers have retained theirsmall amount of discretion to set short-term tacti-cal positions. These centers are also responsible forlending stock from the portfolio.

Transparency and accountability

169. With the introduction of a more rigorousapproach to reserves management, where decisionmaking was delegated to a large extent, the RBAneeded to be confident that an adequate level ofcontrol was being maintained and that its actionswere properly accounted for in line with marketbest practice. This required a system where indi-viduals and operational units were fully aware oftheir delegated authorities, the risks, and the valueadded from their decisions.

1 • Australia 37

170. A key element in the control of opera-tional risk has been the development of manualsdetailing investment and risk management proce-dures. The manuals specify the kinds of instru-ments in which investments can be made, the riskparameters for each portfolio, and the responsi-bilities of various positions associated withreserves management. They also specify how risks and returns are calculated and how officesystems should be used in specific circumstances.Procedures manuals also exist for middle andback office staff.

171. Staffing policy is another key element.The RBA has found considerable benefit in spe-cialization of professional staff in operationalareas. Frequently rotating staff in and out of theseareas in order to provide a breadth of experiencewas felt to be a significant constraint on maintain-ing adequate levels of experience and knowledge.

Over the past ten years, efforts have been made tomaintain a core of experience at senior levelswithin the operational areas while, at the sametime, allowing rotation at junior levels in order tobuild a foundation of experience. Compensation isreviewed regularly to ensure competitiveness withother organizations and staff are encouraged toparticipate in a range of courses, both internal andexternal, relevant to their work. These measureshave contributed to an average tenure over theoperational areas of four years.

172. The Governor requires that reserves areaccounted for in line with best practice and thatthe level of transparency is consistent with that inother parts of the RBA’s monetary policy opera-tions. To this end, the RBA publishes statisticalinformation on its reserves and foreign currencytransactions in its monthly Bulletin. Also, since1992, the Bank has provided an overview of


Governor

Assistant GovernorFinancial Markets Group

Senior Management

- Currency and Asset Allocation- Market Analysis- Reserves Management Policy

EconomicAnalysis

Dealing Support(Middle Office)

- Performance and Risk Measurement- Front Office System

Dealing Centers- Trading- Market Analysis

Front Office

Figure 2. Decision-Making Structure

reserves management operations and return rela-tive to benchmark in its Annual Report. This hasincluded in recent years an outline of the compo-sition of the benchmark portfolios and a discussionof the RBA’s approach to risk management.

173. The RBA’s annual financial statements areprepared in accordance with Australian AccountingStandards and other mandatory reporting require-ments contained in the Commonwealth Authoritiesand Companies Act. The statements are scrutinizedby an external auditor, the Australian NationalAudit Office, to ensure that they comply with rele-vant standards.

174. Reserves management functions areaudited internally each year in accordance withrecommended control frameworks published bythe Bank for International Settlements andrequirements set out by the Australian FinancialMarkets Association. The internal audit reportson compliance with controls and seeks tostrengthen management processes where it seespotential for loss through inadequate control. Itreports to an Audit Committee, which is chairedby the Deputy Governor of the RBA and consistsof a non-executive member of the RBA’s Boardand an external appointee.

Capacity to Assess and Manage Risk15

Benchmark portfolios

175. The composition of the currency andasset benchmarks, and the duration benchmark foreach asset portfolio, are shown in Table 2. Thebenchmarks represent the risk-return trade-offacceptable to the RBA over the long term, given itsmanagement objectives and its primary objectivefor holding reserves. Statistical, practical, and judg-mental factors relevant to the RBA are importantin deciding the appropriate composition.

176. With the aim of maximizing the Bank’scapacity to intervene, it was decided that a trade-weighted basket of currencies would be an appro-priate currency and asset composition for the

foreign currency portfolios. The decision wastaken to spread the composition across the threemajor reserve currencies—the U.S. dollar,deutschemark (later the euro), and Japanese yen.This also provided a diversified portfolio andmeant, too, that the RBA’s assets would beinvested in capital markets that are liquid andhighly rated. From very early on, mean-varianceanalysis, in addition to judgmental factors, hasplayed a major role in deciding on the weightsassigned to the three currencies in the bench-mark portfolio.

177. The choice of a duration benchmark of 30months for each of the asset portfolios was madeon the basis of factors specific to the RBA in itsresponsibility for managing reserves and analysis ofrisk and return for each asset. This duration repre-sents the maximum price risk that the RBA willallow itself while keeping the probability of capitalloss to an acceptable level over the Bank’s invest-ment horizon. An example of this analysis is givenin Figure 3.

178. The RBA’s investment horizon is twelvemonths. This is based on the Bank’s investmentobjectives and the period in which it reports on itsoperations to the Australian Parliament. Over a twelve-month period, the RBA expects thereturn on the portfolio to fall within a 95 percentconfidence band around the mean return, andwill accept a negative return on only 2.5 percentof occasions. On this basis, return is maximized at point A in Figure 3, where the lower boundaryof the confidence band crosses the horizontalaxis.

179. In addition to the currency and assetbenchmarks, the RBA has established benchmarksfor the composition of each of the three asset port-folios. These benchmarks are set out in Table 3.Like the other benchmarks, practical and judg-

1 • Australia 39

15An account of the RBA’s approach to risk management isdetailed in the Bank’s 2000/01 Annual Report.

Table 2. Currency, Asset, and Duration Benchmarks

UnitedStates Europe Japan

Currency allocation (%) 45 45 10

Asset allocation (%) 45 45 10

Duration (months) 30 30 30

mental factors, combined with the liquidity charac-teristics in each market, are important in decidingthe appropriate asset structure of the portfolios.

180. The desire to maintain a liquid and secureportfolio led the RBA to limit its benchmark invest-ments to government securities and cash instru-ments. Typically, some 75 to 80 percent of theRBA’s benchmark foreign investment portfoliosare held in government paper. This comprisesTreasury bills and notes in the U.S. portfolio, andJapanese government bills and bonds in the yenportfolio. For the European portfolio, the RBA hasdecided on a combination of French and Germangovernment securities as the best structure to sat-isfy requirements for credit risk and liquidity. Inorder to limit exposure to price risk, the maximummaturity of securities holdings is restricted to 10!/2years in each portfolio.

181. Cash invested under repurchase agree-ments (repo) and deposits with highly rated banksmake up the balance of the asset benchmarks.Historically, the RBA has found the short durationoffered by deposits to be attractive in marketswhere access to short-term government debt waslimited. They have also been a good, immediatesource of liquid funds during episodes of currencyintervention. That said, the proportion of foreignexchange reserves invested in deposits hasdeclined in recent years, reflecting tighter creditconstraints and changes in cash management prac-tices. The RBA now makes greater use of cash repo,

which has the security advantage of being collater-alized with government securities.

182. The benchmarks are reviewed periodicallyto ensure that they continue to reflect the RBA’slong-term management objectives. There havebeen relatively few changes. They have been madeto take account of structural changes to markets orchanges in the nature of the Bank’s operations.

Instruments

183. In addition to the assets held in thebenchmark portfolios, the RBA’s dealing centershave discretion to hold a small range of otherhighly rated instruments. These include the U.K.Gilts, Dutch and Swiss government paper, anddeposits and medium-term notes issued by theBank for International Settlements. With theexception of BIS deposits, these investments haveaccounted for a negligible share of total holdings.Discretion to hold U.K., Dutch, and Swiss paper isa remnant of a period in the 1980s when the com-position of Australia’s official foreign currency lia-bilities influenced the composition of the reservesportfolio. Discretion also exists to hold U.S.Federal Agency debt in the U.S. portfolio as asource of return enhancement. However, totalholdings are restricted to a maximum of US$500million.

184. In 1994, the Bank began trading interestrate futures contracts. This decision was driven by adesire to improve management of market risk and,in particular, to provide a liquid hedging instru-ment to minimize the risk of capital losses wheninterest rates were rising. An additional attractionof using futures was the greater liquidity and flexi-bility they provide in some markets when imple-menting investment strategies. Some futuresmarkets are more liquid than their underlyingphysical bond markets in that the bid-offer spreadis usually much narrower. Futures trading has beenconcentrated in the European and Japanese port-folios. The RBA does not use any over-the-counteror exchange-traded options in its reserves manage-ment activities.

185. Stock lending is also an activity under-taken by the dealing centers. Over the past fewyears, stock lending, particularly from the U.S.


–10

0

10

20

30

95 percent confidence band

543210

A

Return (percent)

Duration (years)

Figure 3. Horizon Analysis

portfolio, has risen to be a major component ofreturn enhancement. Though the back officeworkload associated with this activity can be large,the RBA sees this activity as relatively low risk.

Risk and performance measurement

186. Market risk and return enhancement aremeasured relative to the benchmark portfolios.For currency and asset allocation, senior manage-ment in the operational areas of the RBA’sInternational Department may allow the portfolioto vary by 1 percent either side of the benchmarkweights.16 Currency and asset positions are man-aged separately within the discretionary bandthrough the use of foreign currency swaps. Thecost/benefit of these swaps is taken into accountwhen measuring the performance of the asset andcurrency positions relative to benchmark. Foreignexchange dealers in each of the three dealing cen-ters have a small amount of discretion (set interms of a maximum open position) that fallswithin the ±1 percent discretionary limit on cur-rency allocation.

187. Risk measurement and trading discretionaround the duration benchmark for each assetportfolio are based on the concept of “dollars-at-risk.” This is the change in portfolio value arisingfrom a one basis point change in yield. Within eachof the portfolios, the dealing centers are requiredto maintain dollars-at-risk to within US$70,000 perbasis point at all times. This limit applies to theaggregate position of the portfolio and to the posi-tion undertaken in each maturity bucket of the

portfolio in order to control the amount of curverisk. Breaches of the limit are reported to AssistantGovernor on the day they occur. The dealing cen-ters are also required to report daily losses thatexceed US$1 million to senior management in theFinancial Markets Group.

188. The “dollars-at-risk” measure also formsthe basis of the Value-at-Risk (VaR) methodology,which the RBA has used since 1995 to estimate theconsolidated exposure of the Bank’s foreign cur-rency reserves to market risk. Though the overalllimits to control market risk—i.e., the discretionarytrading bands around the benchmark—are notdefined in terms of VaR, the RBA has found that itnonetheless provides a useful tool for conveyinginformation about the overall portfolio exposureto senior management and staff involved inreserves management.

189. The VaR number represents the portfolioloss the RBA could incur once every 20 businessdays in normal market conditions. Two VaR mea-sures are calculated each day—one based on thecorrelation method and the other based on histor-ical simulation methodology. The assumptionsunderlying these VaR methodologies are reviewedperiodically and their performance is tested regu-larly. In accordance with best practice, the RBAalso stress tests the portfolio. This involves simulat-ing and evaluating the impact of extreme marketmovements on the value of the portfolio.

Information system

190. All international transactions entered intoby the RBA are processed through a main-frameelectronic Global Trading and Settlement System(GTS). This system has been developed by anexternal software provider to our specifications,with functionality expanded as new products are

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

16Prior to the performance review in 2000, management haddiscretion to vary the portfolio as much as 20 percentagepoints either side of the benchmark.


Reserve management objectives andcoordination

191. The major responsibilities of the Bankinclude the management of foreign exchangereserves on behalf of the government. The Bankensures their safety and return by diversifyinginvestments within a framework of acceptable risks.A major feature of the reserves management prac-tice is to divide the reserves into sub-portfolios,namely, the Pula Fund (long-term) and theLiquidity Portfolio (short-term). The Bank’s poli-cies for the management of the foreign exchangereserves can be summarized in terms of three mainprinciples. In order of importance, these are safety,liquidity, and return. With respect to the long-termportfolio, the Pula Fund, return takes priority overliquidity, while safety continues to have the highestpriority for both the Liquidity Portfolio and thePula Fund. As of the end of 2001, the split betweenthe Pula Fund and Liquidity Portfolio was 80 per-cent and 20 percent, respectively.

192. The appropriate level for the LiquidityPortfolio is determined such that the portfolio actsas a buffer against short-term trade and capitalaccount fluctuations, and as a cushion to financeunforeseen developments in the external pay-ments situation. The Liquidity Portfolio is furthersubdivided into two tranches: the Transactions

Balances Tranche (TBT) and the LiquidityInvestment Tranche (LIT). The TBT functions as acurrent/checking account to take care of inflowsand outflows. The rest of the reserves are investedin the long-term Pula Fund. It is relevant to notethat the government has not experienced a need toissue government securities for funding purposes,as budgetary surpluses have been a feature of theBotswana economy for a long time (Figure 4).

193. Relative to many other central banks inthe region, the Bank of Botswana has for manyyears had a high level of external reserves, approx-imately 39 months of import cover as of December31, 2001. As such, the maintenance of a minimumlevel of reserves has not been a concern to theBank. Furthermore, the high level of reserves haspermitted the Bank to create the long-term fund(Pula Fund).

194. One of the objectives of establishing thePula Fund is to take advantage of the high level ofthe reserves and invest part of them in assets suchas long-term bonds and equities, with the expecta-tion of earning a higher return than could beachieved on conventionally managed foreignexchange reserves, thereby developing a long-termearner of foreign exchange for the country. Suchearnings would allow sustained long-term incomeeven if export revenues were to be adverselyaffected by factors over which Botswana has nocontrol. Based on historical data and financial the-ory, long-term bonds and equities are expected to

43

2Botswana

outperform short-term assets, such as cash andshort-term bonds, which comprise the bulk ofinvestments in the Liquidity Portfolio. Returns onlong-term assets are, however, more volatile thanreturns on short-term assets. Therefore, it becamenecessary to have a longer investment horizon forthe Pula Fund in order to benefit from theexpected higher returns.

Coordination with monetary policy and externaldebt management

195. To date, the external reserves have notbeen used as a mechanism for supporting theexchange rate in the context of the Bank’s mone-tary policy objectives. The Bank of Botswana doesnot intervene in the foreign exchange market.

196. With regard to coordination with exter-nal debt management policy, the Bank had aMatched Asset Liquidity Portfolio (MALP), whichwas established for the purpose of separating aportion of the reserves and investing them infixed income instruments that had the samematurity profile as external debt. It was consid-ered that combined asset/liability managementwould lead to better risk management than whenassets and liabilities are managed separately.While the reason behind establishing MALP was

considered to have merit, matched asset/liabilitymanagement was later considered to be more use-ful for countries with more debt or very lowreserves in terms of import cover and, accord-ingly, the assets held in MALP were transferred tothe potentially higher yielding Pula Fund in themid-1990s.

197. In Botswana, one of the key features ofreserve management is the contribution that theincome earned from the reserves makes to gov-ernment funding. In this regard, over the past fiveyears, income from external reserves has been thethird most important constituent of budgetaryrevenues.


198. The Bank of Botswana Act, 1996, outlinesthe primary functions of the Bank, which include,inter alia, the management of the foreign exchangereserves. In particular, the Act provides that theBank shall be responsible for establishing and main-taining a Primary International Reserve (LiquidityPortfolio), which shall, in general, consist of liquidshort-term assets. Furthermore, the Act provides forthe establishment of the long-term investment fund(Pula Fund), subject to meeting the requirementsof the primary reserve.


Aggregate Portfolio

Liquidity Portfolio

LiquidityInvestment

Tranche

TransactionsBalancesTranche

EquitiesGlobalFixed

Income

RegionalMandates(Active)

GlobalMandate(Passive)

Pula Fund

Figure 4. Portfolio Structure

199. Within this enabling legislation, otherparties in the reserve management process are theBoard, Investment Committee, Financial MarketsDepartment, and external fund managers.

Board

200. The Board is composed of members fromthe public and private sectors as well as academia.The Board is responsible for governance and ulti-mately the investment results; it enunciates the mis-sion, goals, and policies, as well as designs thestructure with appropriate accountability. Conse-quently, the Board sets the overall strategy for themanagement of reserves by approving investmentguidelines, size of portfolios, asset allocation, strate-gic benchmarks, and exposure limits.

Investment Committee

201. The Investment Committee is responsiblefor strategic decisions against the benchmarks aswell as the rebalancing of the portfolios. In doingthis, the Investment Committee receives and actson the recommendations of in-house analysts, whomaintain close contacts with the Bank’s counterpar-ties in major markets. The Investment Committeemeets periodically about 12 times a year to discussdevelopments in the international financial andcapital markets, based on background papers pre-pared by the implementing Department. At theInvestment Committee meetings, broad decisionsare made for the Bank-managed portfolios on cur-rency composition and modified duration withineach market. The decisions made by the InvestmentCommittee are subsequently implemented by theDepartment responsible for reserve management.The Investment Committee is composed of theGovernor as Chairman, Deputy Governor responsi-ble for the Financial Markets Department, Directorof that department, analysts for respective markets(including the Chief Dealer), and the Director ofthe Research Department.

Financial Markets Department

202. The Financial Markets Department isresponsible for the implementation of the deci-

sions of the Investment Committee. In addition,the Financial Markets Department is responsiblefor monitoring external fund managers and otherexternal relationships. The Department is struc-tured as follows:

Dealing and Strategy Unit

203. The Dealing and Strategy Unit is respon-sible for research and analysis of various financialand capital markets and for the compilation of thebackground paper for the Investment Committee.The Unit implements the decisions of theInvestment Committee by trading in bonds andforeign exchange.

Risk Management Unit

204. The Risk Management Unit focuses on therisk associated with all the investment portfolios.The Unit coordinates the risk management processand advises on all aspects of risk, performance, andcompliance with the investment guidelines for theexternally and internally managed portfolios.

Open Market Operations Unit

205. The Open Market Operations Unit is notdirectly involved in the management of the foreignexchange reserves; it is complementary to thatfunction. The Unit is responsible for the provisionof foreign exchange to the Bank’s customers, deal-ing in Bank of Botswana Certificates (BoBCs), andthe management of daily liquidity in the domesticmoney market.

Settlement Unit

206. The Settlement Unit’s primary responsi-bility is to ensure that the Bank meets its obliga-tions to pay and receive correct value fortransactions as contracted with counterparties, andto execute foreign currency payments for the gov-ernment and other customers.

Verification Unit

207. The Verification Unit provides the neces-sary “checks and balances” to ensure that theSettlement Unit pays out and receives the correctamount of funds on due dates and at the rightplaces. In the event that any of these factors areincorrect, the necessary steps are immediately taken

2 • Botswana 45

to restore the position, and this includes, in themain, communication with foreign counterpartiesand banks. The Verification Unit is also responsiblefor following up on issues raised by the Reconcilia-tion Unit of the Accounting Department.

Fund managers

208. A cardinal feature of the Bank’s opera-tional strategy for managing the reserves is the useof external fund managers. The Bank has had con-tractual arrangements with overseas fund man-agers since 1981. External management of reservesprovides an alternative or a fallback position in theabsence of specific relevant skills in the Bank (e.g.,equity management) and in case of a possible braindrain of the Bank’s scarce manpower resources.Furthermore, the incremental benefits that accrueto the Bank in terms of the training provided bythe fund managers to Bank staff over the years havemade a positive impact. The fund managers alsoprovide the Bank with a means of performancecomparison, given that both the fund managersand the Bank’s performance are measured againstcommon benchmarks.

209. The Bank manages approximately 50percent of the foreign exchange reserves inter-nally. The intention is for the Bank to eventuallymanage a higher proportion of the fixed incomeportfolios internally in line with development ofrelevant skills. A small proportion of reserveswould be managed externally for the purpose ofperformance comparison. In pursuing this objec-tive, the Bank would obviously have to be cog-nizant of local manpower constraints in reservemanagement.

Specialist advisory support

210. Since its establishment, the Departmentresponsible for managing the reserves has bene-fited from the services of a number of advisors. Atpresent, there is one advisor for the reserve man-agement function. Consistent with past practice,the advisor is also engaged in in-house training ofcitizen staff. Furthermore, the Bank has retainedthe services of an offshore investment consultingfirm that advises the Bank in three main areas,

namely, asset allocation, manager search, and per-formance measurement.


211. The Bank of Botswana has recognized thataccountability and transparency must be built intothe reserves management process. The Board hasgiven decision rights and delegated authority tothe Governor, with the actions of the latter beingmeasurable in terms of performance against theBoard-issued benchmarks. The following are othermechanisms that are built into the reserve man-agement process:

Investment guidelines

212. These are a strategic set of rules thatdefines the means of achieving the Board’s invest-ment policy. They address issues such as currencyrisk, equity risk, interest rate risk, credit risk, andinstruments and liquidity.

Procedures manuals

213. The front, middle, and back office opera-tions are guided by operations manuals, which arespecific to respective functions. The responsibili-ties and functions are defined such that there isclear separation of duties between the front andback office. The middle office acts as a policemanto ensure the proper implementation of the writ-ten procedures.

Auditing

214. The reserves management proceduresand processes are subject to regular audits by boththe internal and external auditors.

Regular reporting

215. Regular reports to the Board and AuditCommittee are produced outlining the reserves lev-els, trends, and performance as measured againstthe benchmarks. The reserves are also marked tomarket with currency and market gains and/orlosses disclosed to the Board and Audit Committeeas part of the financial statements.


Capacity to Assess and Manage Risk

Risk management

216. The objective of tranching the foreignexchange reserves is to reflect the different roles ofreserves in the Botswana economy. The LiquidityPortfolio is maintained at the equivalent of ninemonths of import cover and is invested in short-term money and bond market instruments. On theother hand, the Pula Fund is invested in long-terminstruments, such as long-term bonds and equities.The Liquidity Investment Tranche (LIT) serves toinsulate the Pula Fund from frequent drawdowns,which could undermine the latter’s investmentobjectives.

217. In determining the adequate level of theLiquidity Portfolio, the Bank undertook a compre-hensive analysis of factors that impact on the for-eign exchange reserves. Based on these factors, aframework for the determination of an appropri-ate level of liquid assets was derived. For each fac-tor, an estimate of monthly import cover is used toarrive at a total of an equivalent of nine months ofimport cover.

218. Risk is controlled at various levels of thereserve management process by different entitiesin accordance with the broad strategy of risk man-agement, investment guidelines, and proceduresmanuals.

Asset allocation

219. This is a key decision in the investment pro-cess as it seeks to balance return with risk as well asrecognize correlation of asset classes. With regard tothe Pula Fund, 40 percent of assets are allocated toequities and 60 percent to long-term fixed incomeassets. The appropriate asset classes for the LiquidityPortfolio are a combination of short-term incomeand money market instruments. The underlyingobjective in asset allocation is to diversify across themain asset classes and geographic regions in orderto achieve a low correlation coefficient.

220. Using the currently allowed asset classes, aportfolio optimization process is undertaken everythree to four years to determine the Pula Fundasset mix. This process is complemented by “whatif” scenario analysis to assure the Management and

Board about the risk/reward profile at the aggre-gate portfolio level.

Currency risk

221. The Bank follows conventional policies inestablishing an appropriate currency mix. Eligiblecurrencies must be convertible, relatively less sus-ceptible to frequent and sharp exchange rate fluc-tuations, generally free from restrictions on theiruse, and products of well-developed financial mar-kets. Accordingly, the Bank has established a mini-mum credit rating of a country’s sovereign debt tobe Aa2/AA for its currency to be eligible, exceptfor the G-7 member countries, whose minimumrating is Baa3/BBB-.

Currency benchmarks

222. The underlying philosophy for currencyexposure is that it is not appropriate to modifycurrency weights in response to short-termexchange rate fluctuations. The Bank mainlyinvests in the U.S. dollar, euro, pound sterling,and yen. The other eligible currencies are for pur-poses of diversification. In determining theappropriate currency weights, the followingapproaches were considered: the SDR-based cur-rency allocation, relative size of the economy, rel-ative use of the currency, market capitalization,equal weighting, and optimal currency allocation.The Bank has adopted a combination of the“SDR-based currency allocation,” the “optimalcurrency allocation,” and a market capitalizationapproach.

223. The TBT currency benchmark is constructed in such a way that it matches theinternational trade flows affecting the domesticcurrency.

224. The Pula Fund fixed income currencybenchmark replicates the SDR weights. The ratio-nale for this choice is the neutral and unbiasedcharacter of the SDR currency basket as a repre-sentation of world economic activity and SDR useas a reserve currency. The currency benchmark forLIT is SDR-based and the portfolio is invested infixed income instruments with a shorter duration(currently around 1.5 years).

2 • Botswana 47

Interest rate risk

225. Modified duration is used to control inter-est rate risk. Overall interest rate risk is a function ofthree factors—the size of the portfolio, modifiedduration, and the actual or expected change inbond yields. The Bank has adopted mainstreamand market-based benchmarks to facilitate riskmanagement and attribution of performance tovarious decision levels. Customized versions of theJPMorgan and Salomon Smith-Barney GovernmentBond Indices have been adopted for the Pula Fundand Liquidity Investment Tranche, respectively.

226. Liquidity and the safety of the funds areparamount in the TBT. For this reason, no specificduration benchmark is specified other than a max-imum maturity period of four months.

Credit risk

227. The Bank is exposed mainly to three kindsof credit risk, that is, bank risk, sovereign/suprana-tional risk, and corporate risk. Additional risks relat-ing to the use of counterparties, fund managers,and the global custodian are also addressed. TheBank subscribes to Fitch/IBCA in order to monitorbank risk and utilizes rating reports of Standardand Poor’s and Moody’s Investor Services to moni-tor sovereign/supranational and corporate risk.

228. Credit risk is low for the TBT because ofthe strict limit on counterparties’ credit ratings. Inthe Pula Fund, corporate risk is allowed but con-strained to top-quality issuers and to a small por-tion of the portfolio.

Fund management styles

229. A combination of active and passive fundmanagement styles is adopted for diversificationpurposes. In addition, the award of a managementcontract takes into consideration the firm’s techni-cal expertise with regard to global or regional man-date. Fund management styles are also diversified,for instance, U.S. equity value, growth, or broadmarket styles.

Global/regional equity mandates

230. Specialist fund managers are appointedto manage various equity components. The por-

tion allocated to each equity market is deter-mined by MSCI country weights. Generallyaccepted restrictions are detailed in the invest-ment guidelines.

Risk management at portfolio level

231. Once the portfolio is constructed, theactual portfolio management brings a differentlevel of risk, as the portfolios are allowed to deviatefrom the neutral position in order to outperformthe benchmark. The main risks incurred in portfo-lio management are of three types—operational,liquidity, and market risk.

232. The Bank manages operational risk byusing generally accepted practices, including segre-gation of duties. The internal and external auditwork add a level of oversight to the initial strongemphasis on control risk self-assessment. Straight-through-processing will be achieved shortly, thusreducing manual intervention and its inherent risk.

233. The liquidity risk is addressed mainly bythe layering17 of the portfolio into differenttranches that take into account the recognizednorm of three months of import cover as well as the “Greenspan rule”—the importance of taking into account capital flows in the wholeeconomy.

234. Market risk includes currency risk, inter-est rate risk, and credit risk. The currency risk iscontrolled in a more traditional way by definingranges around the neutral positions. For example,U.S. dollar exposure can be in the range of 35–55percent of the portfolio—plus/minus 10 percentdeviation from the benchmark.

235. The interest rate risk is monitored in asimilar way to the currency risk. A range ofplus/minus 1.5 years is allowed around the aggre-gate portfolio duration. This currently translatesinto allowing duration to fluctuate between zeroand three years for the LIT portfolio.

236. As mentioned earlier, the fixed incomebenchmark is 100 percent government bonds. It is,nonetheless, allowed to hold spread products in


17First, the TBT is virtually all cash. Then LIT invests only inshort-term bonds and money market instruments. Finally, thePula Fund is fully diversified.

the actively managed portfolios. The permitted risktaking is offset by the need to diversify by country,industry, and issuer as well as a very high minimumcredit rating.

237. The Bank of Botswana is gradually evolv-ing toward quantitative risk management method-ologies that will allow the portfolio risk to bemanaged at an aggregate level.

2 • Botswana 49



238. The objectives of reserves management aresubordinated to Banco Central do Brasil’s monetaryand foreign exchange policies. Brazil has a floatingcurrency regime and interventions are infrequentwith no sizable changes in reserve holdings.

239. The main objectives in holding externalreserves are to:

• Support monetary policy.

• Control excessive volatility of the foreignexchange market.

• Guarantee payment of foreign exchangedebt.

240. Based on these objectives, reserves are managed to ensure safety, liquidity, and profitability.

Institutional framework and decision-makingstructure

241. Banco Central do Brasil (BCB) is the soleauthority empowered by the Constitution to man-age Brazilian foreign exchange reserves. No othergovernment agency can hold foreign currencies.Regarding the allocation of roles, the BCB Boardof Governors is responsible for the reserves strate-

gic allocation and defining the investment policies.Therefore, they have established a detailed bench-mark and guidelines and opted for an active man-agement of the reserves. The Vice Governorresponsible for the monetary policy—Dipom—is responsible for the active management, asdecided by the Board. The International ReservesOperations Department—Depin—executes thenecessary transactions to follow up the benchmarkand Dipom’s active strategies. Depin is also respon-sible for suggesting modifications in the bench-mark according to changes in long-term marketconditions and/or other factors, and for providingDipom with market updates and strategy proposals.An Investment Policy Committee for active man-agement meets monthly to analyze the market sce-narios and to propose active strategies.

242. The Investment Policy Committee wascreated by a board decision, while the investmentprocess was defined by a formal document signedby the Vice Governor of Monetary Policy. The fol-lowing officers participate at the meetings as votingmembers:

— Vice Governor responsible for MonetaryPolicy (retains veto power);

— Head of International Reserves Department;

— Deputy Head of International ReservesDepartment;

— Head of International Reserves InvestmentDivision;

— Head of Foreign Exchange Division;

50

3Brazil

— Interest Rate Portfolio Managers (1 jointvote);

— Foreign Exchange Portfolio Manager;

— Interest Rate Strategists (1 joint vote); and

— Foreign Exchange Strategist.

243. Active management positions may betaken at strategic and tactical levels. Strategic posi-tions have an investment horizon of 1 to 3 monthsand are subject to discussion and decision at theInvestment Policy Committee.

244. Depin is organized in three distinct areas:front office (trade desks), middle office (compli-ance, risk management, performance evaluation,pricing, and IT), and back office (accounting andsettlement).

245. In the middle office, a compliance areachecks all guidelines defined by the Board on adaily basis and is responsible for standardizing pro-cedure manuals. This area is also responsible forchecking transaction prices against market pricesin order to identify any kind of mismatching. Anew area was recently created to ensure correctasset pricing and to verify data integrity and cor-rectness by performing checks of other numericalvariables such as VaR, returns, etc.

246. An Ethics Code, which outlines standardsfor the conduct of civil servants, was implementedin 2001. In addition to this, all civil servants mustpresent their annual income tax returns.

247. The BCB Board of Governors defined thatthe investment strategy should match reserves withsovereign external liabilities in terms of currencyexposure. In this way, we have an integratedAsset/Liability Management (ALM) in terms offoreign exchange exposure. The main benefit ofthis strategy is to prevent a short-term loss ofreserves caused by a mismatch in currenciesbetween reserves and short-term obligations.

248. Improper tracking of external liabilitiesand lack of a formal ALM long-term strategy maycause inefficiencies. Efforts are being made in thedirection of unifying strategies and coordinating allsovereign external debt with reserves management.


249. In recent years, Banco Central do Brasilhas promoted increased transparency and account-

ability in managing reserves and reporting results.The main procedures taken to follow these objec-tives were:

• Definition of a detailed and replicablebenchmark with clear guidelines and unam-biguous sharing of responsibilities withinBanco Central do Brasil’s hierarchy;

• Public disclosure of reserve managementparameters and procedures;

• Quarterly performance reports to the Boardof Governors;

• Hiring of an independent auditing firm;

• Adherence to the IMF’s SDDS—Special DataDissemination Standard.

250. In terms of auditing, there are four sepa-rate inspections, which are conducted by theInternal Auditing Department of BCB (Deaud), anexternal independent auditing firm, the Ministryof Finance, and the Brazilian Court of Accounts(TCU). All these auditing inspections are periodicand have the objective of verifying compliance pro-cedures, accounting systems, IT systems, limits,controls, etc.

251. Banco Central do Brasil’s training pro-gram for the reserves management area is made up basically of courses offered by the externalmanagers18 and periodic visits to other centralbanks and premier commercial banks. In order toobtain qualified staff, the International ReserveOperations Department of BCB—Depin—selectspersonnel from within the Bank, based on theirmarket experience/skills and quantitative back-ground. In some cases, a deep knowledge of com-puter systems is required. To retain the staff, BancoCentral do Brasil has a defined professional careertrack and incentives for employees to pursue grad-uate degrees in Brazil or abroad. However, there isno specific wage/bonus incentive related to marketoperations or to performance.

3 • Brazil 51

18The External Asset Management Program was implementedin October of 2000 with two main objectives: to keep Depin’steam updated with the best investment practices available inthe market and to be used as a reference for the performanceevaluation of the internal active portfolio.

252. Banco Central do Brasil has made hugeinvestments in system information resources updat-ing. In fact, technical areas have access to the mostsophisticated mathematical and statistical enginesavailable in the market. This policy has been veryimportant to allow financial model improvementsand also to retain research-oriented employees.


Risk management

253. Banco Central do Brasil investment policyfor foreign exchange reserves is based on three pil-lars—the reference portfolio, investment guide-lines, and performance measurement. The firstone, also known as the benchmark, is replicableand details unmistakably the included assets. Thisportfolio reflects the Board of Governors’ risk/ return preferences for the international reserves.The second pillar is the list of guidelines thatdefine operational limits, allowed investmentinstruments, risk methodologies, and deviationlimits for the active management.

254. The third pillar is a quarterly perfor-mance measurement report for the Board, whichstates the results of passive (reference portfolio)and active management. The Association forInvestment Management and Research (AIMR)standards, when applicable, are followed for pre-senting results of benchmark and active strategiespolicies.

255. The complexity of the benchmark frame-work imposed the use of information technologytools. Considering the existence of appropriatehuman and IT resources for the development of asoftware system, Depin opted for an in-house soft-ware solution. The system includes several man-agement tools such as market risk (VaR), credit risk(expected and unexpected default), performanceevaluation, performance attribution, referenceand active portfolio management, operational risk,and compliance. Besides that, the system gives thepossibility of executing stress tests for active strate-gies. These tests can be based on historical data orstress scenarios defined by the user. Depin is nowbeginning to perform stress tests for the reserves asa whole on a regular basis.

256. Banco Central do Brasil takes into accountmarket, credit, liquidity, operational, and legalrisks. In terms of market risk, the Board has defineda VaR limit for the active management relative tothe benchmark, i.e., a differential VaR. This limit iscalculated on a daily basis, using RiskMetrics’methodology with 95 percent confidence level andone-day time horizon. The VaR is back-tested andthe results of the methodology adequacy are pre-sented in the quarterly performance reports. TheBoard defined a VaR limit for the active manage-ment, and it is up to the Investment PolicyCommittee to approve a risk budget among its sub-portfolios, as suggested by portfolio strategists. TheVaR limit can be considered small in the sense thatreturns come basically from the reference portfolio,with active management giving a marginal result.

257. Credit risk is managed using two distinctapproaches for the money market portfolio. Thefirst one is for the portfolio as a whole. In this case,a proprietary model was developed based onCreditmetrics and the Merton model. This modeluses expected and unexpected default probabili-ties, and the Board stated limits for these two vari-ables. The main objective of this approach is toimpose geographical and counterpart diversifica-tion, not to calculate VaR exposure. The secondapproach is transaction oriented, for which theBoard has approved minimum counterpart ratings(short-term and long-term), maximum volume,and maturity exposure based on the counterparttotal assets and ratings. For the fixed income port-folio, BCB accepts only federal government, agen-cies, and supranationals issues restricted tominimum rating. In terms of liquidity risk, theBoard approved additional constraints related tothe permitted range of investment instrumentsand maximum exposure in each asset.

258. Operational risk losses in reserves man-agement are tracked with the objective of gettingstatistics about internal procedures and the rela-tionship with counterparts.

259. The BCB’s legal department analyzes andapproves contracts, and together with audit entitiesensures that each transaction has the necessarylegal support.

260. Regarding external managers’ portfolios,the operational guidelines are basically the same as


the ones defined for the self-managed portfolio,except for the VaR limit. Since external managersare restricted to fixed income investments and donot have a money market tranche, they have alarger VaR limit. Banco Central do Brasil receivesdaily transaction reports and monthly perfor-mance reports from the external managers andfrom the global custody agent and has periodicportfolio reviews with the managers.

Reference portfolio

261. The reference portfolio, as approved bythe Board, is divided into three tranches: gold,emerging markets, and core reserves. The corereserves tranche represents the large majority ofthe reserves, as the position in gold and emergingmarkets debt is less than 3 percent of totalreserves. This tranche is denominated in threebase currencies: the U.S. dollar, euro, andJapanese yen and is divided between money mar-ket and fixed income portfolios. Allocation is 60percent in the fixed income market and 40 per-cent in the money market.

262. The gold portfolio is divided into twoportfolios: one located in Brazil and the otherinvested in short-term gold deposits in the interna-tional market.

263. The emerging markets portfolio is man-aged using the “EMBI Brazil +” index as a reference.Banco Central do Brasil is restricted to investing inBrazilian sovereign external debt bonds.

264. The money market portfolio has fourtranches. A small working capital tranche is fullyinvested in U.S. dollar overnight deposits. It hasthe purpose of controlling excessive volatility andproviding liquidity for a sustainable domestic for-eign exchange regime eventually. The other threeportfolios are for each one of our benchmark cur-rencies (U.S. dollar, euro, and Japanese yen). Theterm of the deposits can go as long as 6 months,but the total duration of the money market portfo-lio is about 1 month. Eurodeposit is the referenceinstrument and LIBID is used as the referenceindex.

265. The fixed income portfolio is divided intotwo subportfolios, one based in U.S. dollars andthe other in euros. J.P. Morgan’s “1–3 years

Government Bond Index” is the reference for eachrespective currency. Minimizing the probability ofcapital loss over a certain time horizon was oneimportant aspect considered when choosing the1–3 year index. The fixed income portfolio denom-inated in Japanese yen is, in fact, allocated in theeuro and U.S. dollar portfolios, with currencyhedge to Japanese yen.

266. Six external asset managers manage asmall part of the reserves, about 3 percent. Theyhave the same benchmark as our fixed incomeportfolio and similar guidelines. The main purposeof the program is know-how transfer.

267. Market indexes were chosen as refer-ences because they represent the industry stan-dard, are replicable, and contain sufficiently liquidassets. In terms of performance, they make thecomparison with other managers possible.Regarding maturity, the decision of using the 1–3year index was made taking into account the risk/ return trade-off, since it has a small probability ofquarterly negative return.

268. All portfolios, except money market, areclosed portfolios, that is, they have no inflows oroutflows, except for coupon and amortization pay-ments. In a normal situation, the money marketportfolio absorbs all changes in the size of theexternal reserves. Portfolios are rebalanced on anannual basis to maintain the proportion betweenthe fixed income and the money market portfoliosand also the size of the emerging market portfolio.

269. Regarding the currency hedge, the corereserve replicates the currency distribution of theshort-term sovereign external debt up to theamount of the core reserves. In order to imple-ment this strategy, Banco Central do Brasil followsup the external debt currency composition on adaily basis. However, to avoid excessive turnover,the benchmark is rebalanced every time the exter-nal debt currency proportion differs by more than2 percent from the reference portfolio.

Investment guidelines

270. Investment guidelines have been estab-lished for each aspect of risk management. To con-trol market risk, a daily VaR limit is in place fordeviations from the benchmark. It is enforced for

3 • Brazil 53

the active strategies of the whole reserves. IntradayVaR calculation has not been implemented yet.Banco Central do Brasil does not use automaticstop-loss techniques in monitoring market risk lim-its. In case of any breach of VaR limit, theInvestment Policy Committee will meet to decidewhether the positions should be kept or not. If thedecision is that it is in order to maintain the posi-tions, it must be submitted to the Board ofGovernors for approval.

271. In terms of liquidity and credit risk, thereare different approaches to money market andfixed income portfolios. For the money marketportfolio, the Board of Governors has establishedthe following investment guidelines:

• Maximum expected and unexpected defaultprobabilities for the actual portfolio devia-tion from the benchmark;

• Minimum rating limits of “A” and “P-1” foreach counterpart, according to Moody’s;

• Maximum allocation per counterpart calcu-lated as a percentage of the counterpart’stotal assets, limited to a certain maximumamount per counterpart; and

• Three to six months’ maximum maturitydepending on the institution’s rating.

272. For the fixed income portfolio, therestrictions are:

• List of permissible countries for investmentin terms of sovereign debt. All of them musthave a minimum rating of “A” according toMoody’s.

• Bonds issued by any country in a currencyother than its own are submitted to addi-tional restrictions in terms of rating; and

• Investments in “AAA” government-sponsoredagencies and in supranational debt arerestricted to a maximum percentage of thefixed income portfolio.

273. There are also the following asset concen-tration limits:

• Maximum percentage of the total outstand-ing amount of any issue; and

• Maximum percentage of a single asset con-tribution to the total fixed income portfolio.

274. There are other limits, such as:

• Permissible financial instruments;

• Breakdown of gold reserves in Brazil andabroad;

• Size of the gold portfolio; and

• Size of the emerging market portfolio.

275. Options investments are not allowed, butcurrency forwards and futures, interest rates andgold futures and swaps, commercial papers issuedby financial institutions, CDs, CPs, repos, andreverse repos can be used.

276. Risk and compliance areas are indepen-dent from the front office but not independentfrom active management decisions in the hierar-chical structure; we overcome this problem byusing a software function that automaticallyinforms the Board of Governors of any breach oflimit, at the same time that the compliance areareceives the alarm. Afterward a confirmation isdelivered to guarantee that it was not a system or ahuman failure. On the same day, the portfoliomanagers have to explain the reasons for theoccurrence to the Board.

Information system

277. Banco Central do Brasil uses a mainframeand a PC-based network system based on WindowsNT/2000. The software was entirely developed in-house, except for database management software.The mathematical and financial models weredeveloped based on publicly available technicaldocumentation, so there is no use of financial“turnkey systems.” The only inputs of the systemare price data from data providers and transactionsput into the system by traders. The software pro-vides tools for:

• Risk management;

• Technical documentation;

• Performance measurement (including per-formance attribution models);

• Simulations;

• Compliance (comprising automatic limitcontrols);


• Back-office operations;

• SWIFT communication;

• Accounting; and

• Trade desk support.

278. The software was developed consideringoperational and research purposes using both theactual transactions database and the historicaldatabase to test new models. A large quantity ofdocumentation, such as BIS and IMF papers,research papers in general, system technical docu-ments, etc., is available online. The software wasalso designed with audit in mind, having a full revi-sions control, auditable numbering sequences, anda back-up procedure.

Implementing a new approach in reserves management

279. Reserves management in Banco Centraldo Brasil has changed dramatically over the pastfive years. Before 2000, the head of Depin and thetrade desks could decide the overall profile of thereserves, since guidelines established by the Boardwere generic, with no specific rules for perfor-mance measurement and an unclear role of eachplayer in the decision-making process.

280. With the incidence of international finan-cial scandals in the nineties, central banks in gen-eral became more aware of some risks that theywere incurring and so, in 1997, Banco Central doBrasil introduced market risk calculations of thereserves based on the VaR concept (US$).However, there was no type of operational limit. Inthe following years, the importance of risk man-agement and a detailed benchmark to manage thereserves became increasingly clearer to BancoCentral do Brasil. Studies were made consideringcommon market management procedures and, asa consequence, a proposal was developed for a newframework in the time span of about one year.

281. In 2000, Banco Central do Brasil’s Board ofGovernors approved a benchmark with clear guide-lines and performance measurement procedures.

282. The main problems faced during thedesign and the implementation of the new reservesmanagement concept and their solutions were:

• Natural resistance to changes in policy;

— Time to absorb new concepts and tounderstand the advantages that wouldcome from the new environment, like aclear performance evaluation procedure.From initial ideas to final development,the process took about five years. Themain factors that contributed to this delaywere international crises and changes ofthe Banco Central do Brasil executivedirection.

• Understanding the new roles in each part ofthe hierarchical structure;

— It took several months of meetings, dis-cussions, and presentations to explain therole of each part of the hierarchy to over-come this problem.

• Steep learning curve for the staff to under-stand risk management, performance, andperformance attribution models;

— Well-structured and intensive trainingprogram. The program is continuous andstarted back in 1996.

• Lack of an integrated computer platform;

— Acquisition of a new networked hardwareand basic software system (operational sys-tems and other support software).

• Modifications of the compliance system withthe new guidelines;

— Adapt procedures to the new environ-ment.

• Changes in accounting system related to thenew kind of instruments allowed;

— Adapt accounting system to the newinstruments.

• Authorization and support to develop a soft-ware solution in-house;

— Develop a sound design environment andfull documentation of the proposal.

• Difficulties in getting consistent asset pricingdata, which is fundamental for the robust-ness of VaR calculations and performancemeasurement.

3 • Brazil 55

— Creation of a new workgroup (area) tocheck and guarantee asset pricing consis-tency and new data providers.

283. However, there were some aspects thatwere essential for the successful design and imple-mentation of the new framework for reserves management:

• Human resources with deep knowledge offinance, mathematics, and computer scienceand previous experience in developing andmanaging software with large databases;

• Existence of an IT area in the InternationalOperations Department—Depin;

• Necessary infrastructure resources to imple-ment the system, such as computers, commu-nication lines, data sources, etc.; and

• Emphasis on training, including periodic vis-its to premier financial institutions and othercentral banks. In this case, our external assetmanagement program was an invaluabletool.

284. The software architecture was structuredin independent modules and it is fully upgrad-

able. This approach allowed a modular-baseddevelopment, i.e., each application module (e.g.,market risk, credit risk, reference portfolio, per-formance attribution, etc.) was developed inde-pendently and connected to the system in a laterphase. The kernel that was developed initiallysupported basic portfolio management and hadthe main software functions encapsulated in aprocedural environment.

285. The kernel and the modules of marketrisk, credit risk, reference portfolios, and compli-ance were designed and developed in ninemonths, and another three-month period wasnecessary for tests. The operations began in July2001. Afterward, other modules such as opera-tional risk, documentation, and stress testing wereincluded.

286. Improving the software system and thereserves management framework is an endless andcontinuous task as market practice keeps evolvingin time.

287. Nowadays, Depin is focusing on improv-ing stress test procedures, performance attributionmodels, operational risks statistics, and referenceportfolio.


Introduction

288. In Canada, foreign reserves are owned bythe government and managed by both the Bank ofCanada and the Department of Finance. As ofDecember 31, 2001, Canada held about US$34 bil-lion in total international reserves. Of that amount,about US$30 billion (89 percent of total reserves)was held in liquid assets.19

289. These liquid reserves are held in a specialaccount called the Exchange Fund Account (EFA)under the Minister of Finance’s name at the Bankof Canada. The EFA is financed with foreign-currency-denominated liabilities issued by theGovernment of Canada. Liquid reserves and goldare actively managed by the Bank unlike othercomponents of the reserves such as SpecialDrawing Rights (SDRs) and the reserve position atthe IMF. This report will focus on the liquid assetsof the reserves.


Reserve management objectives and scope

290. The objectives of reserve managementare:

• to provide general foreign-currency liquidityfor the government; and

• to provide funds to help promote orderlyconditions in the Canadian dollar in the for-eign exchange market.

291. The management of reserves has changedover the past 25 years, reflecting developments infinancial markets. The government has increasedthe level of foreign reserves in recent years toreflect increased flows in foreign exchange marketsand to bring its level of reserves more in line withother comparable sovereigns. This increase in turnhas required the reserve managers to focus onasset-liability and risk management, and on reduc-ing the cost-of-carry of these reserves while main-taining a high degree of liquidity and capital safety.

292. In order to meet these objectives, the liq-uid reserves are subdivided:

• A proportion of reserves is held in highly liq-uid U.S. dollar-denominated assets to fundimmediate foreign currency liquidity require-ments and intervention activity.

• The remainder is held in a diversified port-folio of high-quality assets, denominated inU.S. dollars, euros, and yen.

293. Reserve management activities consist ofthe management of foreign currency assets and lia-bilities, which includes the use of derivative financialinstruments. Reserve management follows a well-

57

4Canada

19Liquid reserves consist of marketable securities and depositsdenominated in U.S. dollars, euros, and yen.

coordinated Asset-Liability Management frameworkdescribed later in the paper, while at the same timefocusing on cost-of-carry minimization.


Legal foundation

294. Canada’s reserve assets are governed bythe Currency Act, which serves as the legal frame-work for EFA asset management and investmentoperations. The Minister of Finance approves poli-cies for managing the EFA, mainly through a set ofinvestment guidelines. The liabilities that fund theEFA are governed by the Financial AdministrationAct.

Internal governance

295. The responsibility for the management ofthe EFA is jointly shared by the Department ofFinance and the Bank of Canada while the man-agement policies are set by the Minister of Finance.The Bank of Canada, acting as a fiscal agent,administers and effects transactions for theAccount on behalf of the Minister of Finance.

296. The Director of the Financial MarketsDivision at the Department of Finance and theChief of the Financial Markets Department at theBank of Canada are responsible for the ongoingmanagement of the EFA. A Policy Committee,which is composed of senior officials from theDepartment of Finance and the Bank of Canada,meets semiannually to review developments andmajor policy initiatives, and provide guidance andaccountability on the management of the Account.The Risk Management Committee (RMC), whichconsists of managers from the Department ofFinance and the Bank of Canada, including twomembers with no connection to the operations ofthe EFA, meets quarterly to advise on the manage-ment of risk related to the government’s debt pro-gram, including the foreign exchange reserves.

297. The responsibilities for the day-to-dayportfolio management and strategy implementa-tion of the EFA rests with the staff of the ForeignReserves Management Team at the Bank. The RiskManagement Unit (RMU) at the Bank overseesand manages the risks associated with the EFA.

Transparency and accountability of reservemanagement and benchmarking

298. Reporting in a regular and timely manneris a key element of Canada’s reserve managementpolicy. The Minister of Finance provides an AnnualReport20 to Parliament on the operations of theEFA for each calendar year within five months afterthe expiration of that calendar year, and this reportis available publicly. The EFA Annual Report alsoincludes the result of annual audit of the EFA con-ducted by the Auditor General of Canada. In addi-tion, periodic review by external third-party expertsis undertaken, and the results of such reviews areshared with the government.

299. The EFA’s current asset managementbenchmark, in the context of asset-liability managementdetailed later in the paper, is the government’s for-eign currency liabilities. The cost-of-carry is cur-rently used as a performance measure for the EFA,and is disclosed in the EFA Annual Report.Additional benchmarking approaches are also cur-rently under study.

300. Internally, the RMU provides daily reportson the EFA risk position to trading staff, andmonthly and quarterly reports to the RMC and theBank’s senior management.

301. Since July 1999, Canada has reported itsdisaggregated reserves position on a weekly basis.21

This disclosure of reserve positions is achieved bymeans of the Bank’s website on the first business dayfollowing the 8th, 15th, and 23rd of each month. Onthe third business day following month-end, a morecomprehensive breakdown of Canada’s reserve posi-tion is published by the Department of Finance.

302. In addition, documentation of the chain ofauthority, decision making, and delegation inreserve management has been made publicthrough Bank of Canada Review articles.22


20In addition, the Department of Finance publishes an annualDebt Management Report and Debt Management StrategyReport, which provide an overview of foreign reserve manage-ment operations.21Canada was one of the first countries to fully meet therequirements of the IMF’s and G–10’s new format for presen-tation of international reserves data.22See De Leon, J., 2000–2001, “The Bank of Canada’sManagement of Foreign Currency Reserves,” Bank of CanadaReview; and Rochette, M., 2001–2002, “Risk Management inthe Exchange Fund Account,” Bank of Canada Review.

Establishing a Capacity to Assess andManage Risk

Risk management

303. The goal of risk management is to balancerisk and return. In 1997, the Bank and theDepartment of Finance jointly established an RMUto oversee the risk position of the government ofCanada.

Strategy for managing risks

304. The EFA is exposed to various types ofrisk, such as credit risk, market risk, liquidity risk,operational risk, and legal risk. The government’srisk management strategy is to recognize, measure,and manage each type of risk individually as well ascollectively.

305. The RMU manages EFA risk in threesteps:

• Identifies, analyzes, evaluates, and modelsthe risks;

• Advises on guidelines to limit the risks; and

• Ensures day-to-day adherence to the guide-lines, while periodically proposing new riskcontrol mechanisms.

Credit risk

306. To control credit risk, the RMU currentlyuses an approach based on the BIS 1988 BaselAccord and subsequent amendments, whereby allexposures are risk-weighted according to entitytype. In addition, the RMU has adopted the BISAccord “add on” approach to calculating potentialexposure on derivative transactions. Credit risk ismanaged through diversification of the EFA assetportfolio, with appropriate use of credit ratings,counterparty limits, netting agreements, and col-lateral support.

Market risk

307. To limit market risk, the government fol-lows an asset-liability management frameworkwhereby foreign reserves are managed so thatassets match liabilities in currency and duration.

Over the long run, EFA assets and liabilities areexpected to be held in approximately equal marketvalues, thus keeping the account balanced. Assetsmatch liabilities for the euro- and Japanese yen-denominated reserves. At present, U.S. dollar lia-bilities exceed U.S. dollar assets, largely due toforeign exchange intervention and commitmentsmade to the IMF in 1998. This imbalance has beenreduced through a program of U.S. dollar acquisi-tion in foreign exchange markets, and the plan isto eliminate the mismatch over the next year. Inorder to minimize the impact of any mismatches,the “excess” U.S. dollar liabilities are concentratedat the short end of the yield curve.

308. In addition, two types of forward-lookingtechniques, namely “stress test scenario analysis” and“sensitivity stress testing,” are conducted. Stress testscenario analysis is based on a potential marketevent, such as a stock market crash. Sensitivitystress testing is based on standardized moves inclosely linked market risk factors, such as a parallelyield curve shift.23 These scenarios are explicitlydefined and reported on a monthly basis.

Liquidity risk

309. Various policies are implemented to limitliquidity risks. These policies require that no morethan 10 percent of any single issue be held in theEFA, and that the issue size be a minimum ofUS$500 million. Furthermore, the securities of anyone issuer cannot exceed 10 percent of EFA liquidassets, except for “home currency” bonds issued byAAA sovereigns and their directly guaranteed agen-cies. As well, no more than 15 percent of the EFA’sliquid assets can be in investments that cannot besold or redeemed prior to maturity (i.e., non-marketable securities and fixed-term deposits).

310. In addition, to limit rollover risk, EFA lia-bilities that mature within any 12-month periodcannot exceed one-third of EFA assets. Finally,other means of raising liquidity include a short-term U.S. dollar commercial paper program(Canada Bills) and holdings of highly liquid U.S.dollar, euro, and yen securities.

4 • Canada 59

23Bank for International Settlements, 2001, A survey of stresstests and current practice at major financial institutions (April).

Operational risk

311. To control operational risk, the RMUuses a “bottom-up” method that is consistent withthe concept of total quality management. It startsfrom examining the different aspects of opera-tions performed by the organization and thenmaps the process.

312. Sound operational risk management alsorequires qualified staff and adequate managementinformation systems. In the case of the EFA, theRMU analyzes operational processes and estab-lishes controls that are regularly reviewed.Although the RMU is not directly involved in per-sonnel management, the bank has a humanresources strategy to maintain a competitive com-pensation structure with abundant training andlearning opportunities. It also offers various flexi-ble working hour agreements. The Bank is alsocurrently improving its operational processes andimplementing relevant technological applicationssuch as a new integrated straight-through process-ing system.

Legal risk

313. The government’s Department of Justicehas the responsibility of advising on legal risk, andthe preparation of an annual legal risk report forthe Risk Management Committee and senior man-agement. The report identifies any potential legalrisk issues with respect to existing documentation.

Currency composition and eligible investment instruments

314. There are restrictions on the EFA’s cur-rency composition and the types of eligible investmentinstruments to control overall risk. The EFA’s eligi-ble currencies are the U.S. dollar, euro, and yen.The EFA portfolio must be composed of a mini-mum of 50 percent U.S. dollars with the rest allo-cated in euros, and Japanese yen, according to thefunding and investment opportunities in each cur-rency. This currency composition reflects theimportant role of the U.S. dollar as a reserve cur-rency, and the fact that intervention in support ofthe Canadian dollar has been historically under-taken through the U.S. dollar.

315. The Currency Act allows the EFA to trans-act in foreign exchange on a spot and forwardbasis, and to invest in deposits of supranationalorganizations and financial institutions, and insecurities issued by sovereigns and their agencies.It also allows the EFA to lend any of the eligibleinstruments, and enter into derivative transactionsbased on any of the eligible instruments. In addi-tion, the government is moving toward moreextensive use of collateral in its reserve manage-ment operations to protect against current andpotential credit exposure.

Use of derivatives

316. Among the eligible derivatives mentionedearlier, the government of Canada has made exten-sive use of long-term interest rate and currencyswaps since 1984–85. The government uses theseswap agreements to obtain cost-effective financing,to fund the foreign exchange reserves, and to per-mit flexibility in managing liabilities. For example,cross-currency swaps are currently used to convertCanadian-dollar-denominated fixed-rate debt intoeuro and U.S. dollar fixed-rate liabilities. In addi-tion, short-term currency forwards and goldoptions have been used by the EFA.

External managers

317. The government uses external securitieslending managers to manage a securities lendingprogram for a portion of its U.S. dollar-denomi-nated securities. Formal agreements are signedbetween Canada and the external managers. Theexternal managers must follow the policies andguidelines provided by the government. To man-age the risks, there are restrictions as to the securi-ties allowed to be lent, the types of borrowers,eligible collateral, and investment of cash collat-eral. The external managers are required to submitreports, on a monthly basis and upon request,describing details of the loans and investments.Currently, there are two external managers.

Recent trend with respect to reserve management

318. Consistent with best practices in risk man-agement in recent years, the government has been


moving toward making more extensive use of col-lateral to reduce credit risk exposure in its foreignreserve operations.

319. This year, the government has put in placea collateral management framework for the gov-ernment’s derivative counterparties. Canada’s col-lateral management system requires counterpartiesto put up collateral to the government when creditexposure on swaps and forwards exceeds given lev-els. An external firm is being used to manage secu-rities posted as collateral to the government. In2002, the government will also be moving a largeproportion of its uncollateralized short-term U.S.dollar deposit investments to collateralized repur-chase agreements.

Reserve Management Operations inDeep and Liquid Markets

320. Canada’s reserve management operationsare undertaken in the most efficient and liquidmarkets in the world, i.e., the U.S., Japanese, andEuropean markets. Foreign currency borrowingthat finances the EFA’s reserves is also conductedso as to maintain Canada’s reputation as a “suc-cessful borrower” in international capital markets.

321. Continued access to these capital marketsis facilitated by ensuring that Canada has the nec-essary legal documentation in place to allowreserve managers to raise funds in a variety of mar-kets and jurisdictions.

4 • Canada 61

Developing a Sound Governance andInstitutional Framework


322. The mission of the Central Bank of Chile(CBCh) is to safeguard the stability of the local cur-rency and the normal functioning of internal andexternal payments. International reserves providethe CBCh with one of the policy instruments that ithas in order to attain its mission. Within the mon-etary policy framework, based on inflation target-ing and a floating exchange rate that it hasembraced, the CBCh intervenes in the foreignexchange market in exceptional and qualified cir-cumstances. In addition, the Treasury and privatebanks are allowed to maintain foreign currencydeposits at the central bank.

323. In this context, the basic goals of reservemanagement are to maintain an appropriate levelof liquidity in foreign currency and to protect thevalue and safety of investments. Subject to con-straints derived from the above goals, reserves aremanaged to obtain maximum return.

324. For liquidity purposes, the CBCh holds aCash Portfolio in order to meet any interventionneeds and also to handle deposits and withdrawalsfrom foreign currency accounts held by theGovernment Treasury, other public institutions(like Codelco and Banco Estado de Chile), andprivate banks at the central bank. Regarding

foreign exchange interventions, on September 2,1999, the CBCh announced a free float of its currency.

325. For the remaining balance of reserves notdirectly devoted to meeting liquidity needs, the fol-lowing factors are taken into account in determin-ing the way they are managed:

• The CBCh’s foreign debt composition. TheCBCh aims to replicate the currency compo-sition and duration of its debt. In this cate-gory, any debt denominated in localcurrency but linked to a foreign currency isalso considered.

• The currency composition of liabilities (pri-vate and public), in order to back the pay-ment of capital and interest of debt duewithin twelve months.

• The currency composition of trade imbal-ances, in order to finance any trade deficitsin the event that access to the internationalcredit markets is limited.

• Risks and financial considerations.

326. In considering all of the above aspects, thereserves of the CBCh, from an asset managementperspective, can be defined as a multicurrencyportfolio invested in products ranging fromovernight deposits to bullet bonds with maturitiesup to thirty years, issued by prime rated countries,agencies, and financial institutions.

62

5Chile

327. A small percentage of the reserves are heldunder the management of external asset managers.This program was started in 1996 as a way to have anadditional and real benchmark for comparison andto gain further knowledge of markets and instru-ments. The asset management program will proba-bly be extended during 2003 to create an externallymanaged portfolio of mortgage-backed securities.

328. The CBCh manages its internationalreserves and foreign exchange rate policy, anddoes not take responsibility for the management ofother public funds. Other public institutions areable, nevertheless, to establish time deposits withthe CBCh and to maintain current accounts withthe Bank as previously mentioned. No special coor-dination efforts between the CBCh and such pub-lic institutions are needed to service said accounts.In fact they are treated as normal liabilities of theCBCh, just as the ones held by commercial banks.


329. The Constitutional Organic Act of TheCentral Bank of Chile, Law No. 18,840 of October10, 1989, establishes that the Central Bank of Chileis an autonomous entity, in terms of the decisionsit makes and in terms of the ownership of its capi-tal. The Law establishes explicitly its ability to man-age, hold, and dispose of its international reserves.

330. At the central bank, there is a clear setupand separation of responsibilities, which isreflected in the organizational chart attached inAnnex I.

331. The decision-making process at differentlevels of the organization is also clearly defined.

Board level

332. The CBCh’s Board defines the mainreserve management objectives and approves theinvestment parameters articulated in the invest-ment policy guidelines of the central bank.

Division level

333. Acting on behalf of the CBCh’s Board, andunder a scheme of delegated responsibilities, theDirector of the International Division reviews and

approves the quarterly investment strategies with amedium- to long-term perspective, and monitorstactical and strategic decisions made at lower levelsof the organization.

Management level

334. The Investment Manager reviews thestrategies designed by the front desk and proposes,to the Director of the International Division, theoptimal way to implement them. Additionally, theInvestment Manager and the front desk maydevelop and implement tactics that could deviatefrom the original plan and/or the benchmark, inorder to extract value with short-term views on mar-ket developments.

Operational level

335. The International Money Desk Depart-ment (the front desk): Here the Head of theMoney Desk and Portfolio Managers design thequarterly investment strategies and implement thedecisions approved at the upper levels of the orga-nization. Using financial tools and techniques, theydecide the timing and the security selection inorder to achieve the strategic and, at times, tacticalallocations.

336. International Treasury Department (theback office): The Treasury Department completesand processes the transactions made by the portfo-lio managers. This department interacts with theinternal accounting systems and sends confirma-tion messages to all the parties involved. It shouldbe noted that no single transaction can be com-pleted without the authorized signatures of both aportfolio manager and a senior member of theTreasury Department. This department, amongother things, also ensures that the Front Desk’soperations comply with internal investment guide-lines. This task is carried out by the Operation andControl Unit of the department.

337. Performance and Risk MeasurementDepartment (middle office): This departmentreports directly to the Director of the InternationalDivision. The middle office calculates risk parame-ters and measures the performance of the portfolioin absolute terms and relative to the benchmark.

5 • Chile 63


338. The Law clearly states the CBCh’s man-date, powers, and accountability. At least threetimes a year, the CBCh’s Board meets with theFinance Committee of the Senate, and once a yearwith the plenary of the Senate, to present the stateand prospects of the economy and the actionstaken by the CBCh to achieve its main objectives. Italso prepares audited annual reports, which areavailable to the public.

339. The CBCh releases periodic disclosures ofthe reserves’ accounting value on a biweekly basis.It also adheres to the Special Data DisseminationStandard of the IMF. Therefore on a monthly basis(with a time lag), the central bank reports the levelof international reserves and foreign currency liq-uidity, and discloses the end-of-year value of thereserves in its annual report. In the annual report,an accounting measure of the absolute return ofthe investments is presented and measured in localcurrency terms. There is also analysis of the com-position of returns, i.e., those derived from interestand capital gains and those attributed to variationsin the value of the local currency vis-à-vis foreigncurrencies.

340. The information disclosed about reservemanagement, such as internal governance proce-dures and specific investment policies, is regularlyunder review. In the 2001 Annual Report, new para-graphs were added that describe the way the CBChachieves the liquidity goal of reserve management.These paragraphs list the types of financial instru-ments in which reserves are invested and the com-position of reserves at year-end (showing thepercentage of reserves allocated to two broad cate-gories: bank (time deposits) and fixed incomeinstruments). In the same section of the Report,there is also a discussion of how the CBCh controlscredit, market, and operational risks and protectsthe value and safety of the investments. In order tocontrol credit risk, minimum credit ratings for coun-tries and counterparties are specified. Market risk ismanaged by diversifying the portfolio of investmentsamong different currencies, instruments, and termsto maturity. Market risk is also measured and con-trolled by calculating the duration and Value-at-Risk(VaR) of the reserves (the year-end duration andVaR are presented), and operational risks are con-

trolled by a clear separation of functions, responsi-bilities, and internal controls.

341. The central bank also fully disclosesreserve management goals and counterparty trans-action rules to market participants. The selectioncriteria, for both the countries and the counter-parties, are objective:

• Country Criteria: Long-term credit risk rat-ing, debt level of the country, and the relativesize of the country measured by its GrossDomestic Product.

• Commercial Banks: Long-term credit risk rat-ing and size of the institution measured by itsequity.

• Counterparties: Primary dealers and broker-age houses that have their own credit ratingwithin the ranges required by the centralbank, or those that are at least 90 percentowned by approved commercial banks.

Internal reporting

342. There are different levels of reporting atthe CBCh:

• On a monthly basis, the International Divisionreports to the Board the absolute and relativeperformance of the internally and externallymanaged portfolios compared to their bench-mark. These reports also contain different riskmeasurements, such as duration and Value-at-Risk.

• On a semiannual basis, the InternationalDivision reports to the Board the list ofissuers and counterparties used in the man-agement of reserves during the reportingperiod.

• Annually, the International Division reviewsthe soundness of the current benchmark, andproposes changes if deemed appropriate.

• The Front Desk and the Investment Managerreport their operations to the DivisionManager in a weekly meeting. This meetingis also used to report credit risk news thatmay affect margins and eligibility of eithercountries and/or counterparties (reported


by the middle office) and to decide on spe-cific issues related to the implementation ofthe investment strategies. For example, theremay be a decision to change the timing for acertain investment allocation, or if there arenew market developments, there may be adecision to make a tactical deviation from theoriginal plan and/or benchmark.

Auditing

343. Different agents constantly audit the man-agement of the reserves:

• On an annual basis, there is an audit by anestablished independent auditing company,whose observations are included in the cen-tral bank’s annual report.

• Internal independent auditors, who do notreport to the Director of the InternationalDivision, conduct internal audits at leastthree times a year. The audit process coversall aspects of reserve management, fromcompliance with the guidelines to broad rec-ommendations about different aspects of theinvestment process and operations, such asthe auditing of the securities lending pro-grams, the physical security inside the deal-ing room and the treasury department, etc.

• Independent internal auditors, who reportdirectly to the central bank’s Board, also con-tinuously monitor compliance with invest-ment guidelines and the nature of accountingprofits and losses. This monitoring process isdone on a remote basis through the use of thecentral bank’s accounting system, which ismanaged by a separate group, the Manage-ment and Development Division.

344. The Operation and Control Unit is part ofthe Treasury Department and reports to the Headof the Department and to the Investment Manager.This unit is responsible for checking the portfoliomanagers’ daily compliance with investment guide-lines. These checks look for compliance on stan-dard procedures related to financial transactions(such as ensuring that the obtained prices were inline with market levels), issuers, counterparts, and

margins. This unit is also responsible for monitor-ing external asset managers, the securities lendingprograms, and custodian services.


Policy guidelines

345. Risk management forms an integral partof the CBCh’s broad policy guidelines for invest-ments. For instance, one of the main objectives ofthe policy guidelines is to first define the playingfield for the investment decisions. The centralbank’s Board defines these guidelines and thendelegates the responsibility for implementing themto the International Division. These guidelinesimplicitly incorporate the main objectives of thereserve management and therefore represent theinvestment philosophy of the fund. This overridingphilosophy takes form in the ranges and limitsimposed on different types of investments.

346. The policy guidelines can be categorizedinto the following groups:

Foreign currency exposure/composition

347. There are guidelines governing which for-eign currencies can be held, their amounts(expressed as a percent of the total portfolio), andmargins of deviation from these amounts. The cri-teria for choosing the currency composition, whichwas previously presented, takes into account thehedging needs for covering the liabilities of theCBCh, the country’s trade deficit, any short-termexternal debt servicing needs, and financial con-siderations derived from the use of financial opti-mization models. The reserve portfolio has fourmain currency blocs (U.S. dollar, euro, pound ster-ling, and Japanese yen) and minor currencies, sub-ject to additional holding restrictions, i.e.,exposure limits, which are associated with the maincurrencies. The process of association of the minorcurrencies to the main ones rests on the correla-tion of the historical returns.

Credit exposure

348. We define three main sources of creditexposure:

5 • Chile 65

Bank risk

349. Bank exposure, which takes the form oftime deposits, current accounts, certificates ofdeposit, and foreign exchange operations, is man-aged in two ways:

• The maximum authorized amount of globalbank risk is limited to a specific percentage oftotal reserve assets.

• There are also limits on the time to maturityand amount of investment exposure theBank can have with any single banking insti-tution. To meet the criteria for counterpartyeligibility, banks also must comply with mini-mum size requirements (measured by theirequity) and have a certain long-term debtcredit rating.

Sovereign and supranational

350. As previously mentioned, the country riskeligibility depends on the relative size of the coun-try, the level of public debt, and its long-term debtcredit rating. Individual maximum exposures areassigned to each country. The supranational expo-sure is subject to a global maximum limit, while theindividual amounts depend on the credit rating ofeach agency and its size measured by its equity.

Counterparty risk

351. The eligibility of counterparties is alsosubject to objective parameters. Primary dealers, aswell as brokerage houses with approved credit rat-ings and 90 percent owned subsidiaries of eligiblebanking institutions, are eligible to be the centralbank’s counterparties.

Definition of sub-portfolios

352. According to the degree of immediacythat the funds may be needed, i.e., depending onhow transitory or permanent the funds are,24 wehave defined three sub-portfolios:

• The Cash Management or Liquidity Portfolio:It consists of overnight and weekend deposits,and is the preferred source of liquidity to facedaily demand stemming from withdrawalsfrom accounts held by public and/or com-mercial banks. The liquidity portfolio canreceive/transfer funds from and to a secondportfolio (short-term investment portfolio)when its balance is too low or too high.

• The Short-Term Investment Portfolio (BufferPortfolio): Acting as a buffer for liquidity pur-poses, this portfolio may receive/transferfunds from and to the liquidity portfolio. It isinvested in bank deposits and money marketinstruments, ranging from a week to twelve-month maturity.

• The Long-Term Investment Portfolio:Invested in medium- to long-term instru-ments, including nominal bullet bonds andinflation-protected securities (U.S. TIPs)with maturities ranging from one year tothirty years. Transfers of funds from thelong-term portfolio to the short-term one(and vice versa) are mainly due to financialconsiderations, although at times it has toabsorb excess liquidity or meet liquidityshortages.

353. In general, the strategic investments inand between short- and long-term portfolios aresubject to an investment review, which is done atleast on a quarterly basis. The resulting investmentstrategy is based on external forecasts and ourexpectations of future domestic and foreign finan-cial market developments. The general macroeco-nomic scenario is provided by the InternationalAnalysis Department while the InternationalMoney Desk (front desk) forecasts future yieldcurves and rates of return (the financial scenario).These scenarios and expected values are presentedand discussed at meetings chaired by the Directorof the International Division and attended bysenior staff of the area, in order to achieve a con-sensus view at the Division level.

354. The expected rates of returns for three-and twelve-month horizons are fed into an opti-mization model; the results are analyzed and thenadjusted according to the market experience of


24Johnson-Calari, Jennifer, “Risk Management Practices at theWorld Bank: Global Liquidity Portfolios,” Risk Management forCentral Bankers (London: Central Banking Publications),defines the liquidity requirements as stable, discretional, andoperational.

our officials. That is particularly the case whenusing standard, although imperfect, mathematicalmodels that do not take into account the costs ofadjustments, and may recommend allocations thatare too aggressive or too concentrated in a limitednumber of assets.

355. The composition of the benchmark forcomparison purposes comes from the output of ahistorical standard mean-variance optimizationmodel, which is subject to a number of ad hoc con-straints reflecting the risk-return profile of the cen-tral bank. For example, there is a constraintlimiting the percentage of assets allocated to matu-rities greater than three years. This constraint isdesigned to limit the duration or the market sensi-tivity of the overall portfolio, thereby preservingthe capital of the fund.

356. The reserve benchmark is a tailor-madecombination of internationally known indices. Forexample, we use BIS’s six-month Fix Bis index forthe short-term portfolio associated with the short-term sovereign and supranational investments, aLibid index for the banking investments, and sec-tor indices of the JPMorgan Chase global index forthe bond portfolios. There is a similar index foreach main currency of the portfolio.

357. As mentioned, investment and allocationstrategies for the portfolio are reviewed at least on aquarterly basis, but sudden market moves can makethe portfolio managers take a position that goes in adifferent direction than the one recommended bythe current strategy. These actions are previouslyapproved by the Investment Manager and commu-nicated to the Director of the Division. By how muchcan portfolio managers deviate, and what is the neteffect of those particular actions are issues that theDivision is currently addressing. The Division is alsomaking efforts to better identify the attribution andcomposition of returns of the overall portfolio.

Risk management framework

358. Risk management is approached in fourdifferent ways or instances:

Financial risks (Ex ante measurement)

359. The primary indicator of financial risk isthe portfolio’s duration. For the short- and long-

term portfolios, as well as for the overall portfolio(excluding the liquidity portfolio), there are dura-tion benchmarks and predefined margins of devia-tion from these benchmarks. On an ex ante basisand as unofficial calculations, the portfolio man-agers calculate the duration, VaR, and trackingerrors associated with the strategy for the invest-ment of the reserves. All day-to-day operations andreports of the front and back office are preparedusing internally developed systems that are able tointeract with the general accounting system of thecentral bank and with the SWIFT system for inter-national messages. From the moment a portfoliomanager closes a trade, approximately 90 percentof the steps needed to complete the transaction areautomated. There are still some activities that canbe automated. For example, the manual enteringof each transaction by back office personnel couldbe replaced by an automated system, where theportfolio managers directly enter trades into thesystem. This system upgrade would save time andlower the risk of clerical mistakes. The financial cal-culations are done using mainly Bloomberg andRiskMetrics.

Financial risks (Ex post measurement)

360. The official calculation of different port-folios’ durations is the responsibility of the middleoffice. This calculation is presented to the invest-ment officials twice a month, at the time of theweekly meetings chaired by the Division Manager.As a recent development, the middle office is alsocalculating the VaR (absolute and relative) of theportfolio, which is analyzed every week at theweekly meetings. An internally developed system isused for the calculation of the duration of the port-folio, and RiskMetrics is used to compute the VaRparameter.

Credit risk

361. The middle office is responsible for mon-itoring this type of risk. This unit monitors changesin credit ratings and names due to the ever-evolv-ing processes of mergers and acquisitions of banks.According to the changes, the list of approvedbanking institutions varies, incorporating new

5 • Chile 67

names, taking out others, and changing the maxi-mum individual amounts and maturity of invest-ments with each bank.

Operational risks

362. The Operation and Control Unit, which ispart of the International Treasury Department,monitors operational risk by checking compliancewith the guidelines, in terms of exposure to institu-tions, approved names and locations of sub-sidiaries, margins, and internal operationalprocedures established for financial transactions.The control conducted by this unit is mainly man-ual and done on a spot check basis over a randomsample of operations. Because no software systemhas been developed yet and because these activitiesalso apply to the external asset managers, there is aconsiderable workload in regard to the manage-ment of operational risk, and a related need forautomated processes.

Performance evaluation

363. The official performance calculationdone for internal purposes is the responsibility ofthe middle office. It issues a monthly report with atime lag that contains the accounting and marked-to-market returns of the investment portfoliosmanaged internally and externally. An extensiveeffort has been made to reduce the time lagbetween the reporting date and the month that isbeing reported. The performance report includesthe monthly return and rolling twelve-monthreturns for all the portfolios and managers (inter-nal and external asset managers), and ranks man-agers by their performance. There is also adiscussion of other topics, such as the duration ofthe portfolio, VaR, and financial developmentsduring the reporting period.

Recent developments

364. In this section we highlight the most rele-vant developments and actions taken by the area:

Range of products

365. In an effort to increase the returns onreserves, the CBCh is about to expand the range ofproducts eligible for investment. This projectspecifically is considering the incorporation of U.S.Agencies (GSEs), German Pfandbriefs, and mort-gage-backed securities.

Securities lending

366. Yield-enhancing activities such as a U.S.dollar securities lending program have been inplace since July 20, 1998. The program was subse-quently extended to euro-denominated notes andbonds on May 10, 2000, to the portfolios held bythe external asset managers on April 9, 2001, andto the portfolio of assets held in pounds sterling onOctober 26, 2001.

External consulting

367. Another interesting initiative that werecently began was to rely on external consultantsfor advice and recommendations to the entireinvestment area. This is a requirement of theCBCh’s Board, and so far, two external consultan-cies have been used in the last four years. Theyhave been helpful in ensuring soundness of actualprocedures within the area and identifying areaswhere improvements could be made. The creationof the Operation and Control Unit in 1999 is oneof the results of these external consultancies, aswell as some of the current observations to ourarea that are actually included in this document.The external consultants were senior staff mem-bers of prestigious institutions in the reserve man-agement arena. Through these exchanges theinvestment area has the opportunity to learn fromthe experience of more developed operations, andfrom central bank partners (or supranational insti-tutions) that do not view consulting as a business,but rather as a collaborative effort aimed at devel-oping institutions with similar goals and levels ofcapacity.


5 • Chile 69

Board of Governors

General Management

InternationalDivision

Research DivisionGeneral Counsel Financial PolicyDivision

Management andDevelopment Division

International InvestmentManagement

General AuditingManagement

International FinancialOperations and

Analysis Management

Foreign Trade andCommercial Policy

Management

International MoneyDesk Department

International TreasuryDepartment

Head of Department +6 Portfolio Managers

Back Office8 Analysts

Performance and RiskMeasurement Department

Head of Department +5 Analysts

Operation and Control4 Analysts

Head of Department +

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

Introduction

368. In 1997 the Banco de la República (BR),Colombia’s central bank, developed a long-termstrategic project designed to manage the interna-tional foreign exchange reserves of the country inthe most efficient manner, given the stated objec-tives for holding reserves in line with the highestinternational standards and practices. This ambi-tious project, which is reviewed periodically, has ledto significant changes in the organizational struc-ture, the decision-making process, the humanresource policy, the technological platform, therisk control procedures, as well as the reserve man-agement policies.


Reserve management objectives, scope, andcoordination

Objectives

369. Reserve management seeks to maintainan adequate level of assets denominated in con-vertible foreign currencies readily available to meeta defined range of objectives for holding reservesin the most efficient manner. In order to under-stand reserve management policy in the case of theBR, it is important to first identify its objectives forholding reserves.

370. There are three reasons for holdingreserves: (i) for transactional purposes, to supporttrade in an open economy; (ii) for precautionarymotives, associated with potential balance of pay-ments crises; and (iii) as collateral, to improve acountry’s access to the international capital mar-kets via maintaining sound foreign exchange liq-uidity policies. The first two motives havetraditionally had strong theoretical support,whereas the last motive has been referred to in theliterature only recently.

371. Before the 1990s, the main objective ofreserves was the transactional motive, for whichreserve adequacy was set in terms of the months ofimports required to support its trade-related oper-ations. The reserve adequacy objective also tookinto account the fact that the country was under acrawling peg foreign exchange system and had alow exposure to capital outflows due to restrictiveregulation. During recent years, the BR hasreviewed its reserve adequacy objective in light ofthe following: (i) the deregulation that has takenplace during the last decade; (ii) empirical evi-dence of the growing impact of contagion in devel-oping nations; and (iii) a review of the relativeimportance of sound liquidity policies in the coun-try’s overall creditworthiness.

372. On the domestic front, three main devel-opments had an important impact on the reserveadequacy objective. In 1991, Congress approvedLaw 09, by which the foreign exchange market was

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6Colombia

deregulated in order to encourage foreign directinvestment and facilitate trade-related operations.In the same year, the crawling peg was graduallyreplaced by a currency band system, and in 1999, afree float exchange regime was introduced.25

Finally, the traditional sources of funding for pub-lic debt in the international markets via syndicatedloans were replaced by the issuance of bonds in theinternational capital markets, and the private sec-tor’s exposure to external indebtedness increased.

373. During the same time period, theMexican, Asian, and Russian/LTCM crises high-lighted the vulnerability of developing countries tocontagion. Based on empirical evidence of theimpact of such crises in developing nations withsufficient but limited access to the internationalcapital markets, Bussiere and Mulder (1999) con-cluded that countries that maintained during thisperiod a ratio of at least 1 in the reserves/short-term debt indicator were less vulnerable to conta-gion, even in conditions of slight misalignments intheir current account and real exchange rates.26

For larger misalignments in these variables, theauthors recommended a higher reserve adequacyobjective.

374. Furthermore, the motive for holdingreserves as collateral is emphasized by the fact thatthe international capital markets use the Bussiereand Mulder indicator as a yardstick to measureappropriate liquidity levels, an important variablein the country risk models that determine a coun-try’s creditworthiness and the cost of its access tointernational capital markets.

375. As a result of this evaluation, the centralbank adopted as the minimum reserve adequacyobjective the expected value of one year’s publicand private residual debt payments and amortiza-tions due, plus a provision for current accountdeficits that can range from zero to the standarddeviation of the long-term component of the cur-rent account, given that the country has a tendency

to run current account deficits.27 The inclusion inthe reserve adequacy objective of real exchangerate misalignments is under study.

Implications on reserve management

376. The changes that took place in the deter-mination of the reserve adequacy objective of theBR had three important implications on reservemanagement policy.

377. The amount of reserves invested to coverimmediate liquidity requirements in a WorkingCapital liquidity bucket was significantly loweredfrom almost 90 percent of total reserves before1994 to 5 percent, given that under a free floatexchange rate regime the probability of recurrentintervention decreased.

378. In order to lower the opportunity cost ofmaintaining reserves for precautionary and collat-eral purposes, two additional liquidity buckets weredefined with investment guidelines that are consis-tent with their expected investment horizon. Thesewere the Intermediate Liquidity bucket to coverpotential intervention requirements over a one-year period and the Stable Liquidity bucket forsuch funds with the lowest probability of beingused over a one-year period.

379. As the higher return objectives for thenew liquidity buckets implied additional risks, thecentral bank committed resources for the enhance-ment of its risk control capabilities and delegatedthe management of the Stable Liquidity bucket tospecialized asset managers.

380. A more detailed description of the criteriaused by the BR to determine the size of each liq-uidity bucket, its liquidity policies, its investmentguidelines, and its risk management capabilities isprovided later in this chapter.

Scope

381. The scope of reserve management is lim-ited to those assets denominated in convertible cur-rencies that are readily available and are under the

6 • Colombia 71

25In 1991, the central bank defined target zones within whichthe market determined the exchange rate, at first through theissuance of exchange certificates until 1994.26Bussiere, Matthieu, and Christian Mulder, 1999, “ExternalVulnerability in Emerging Market Economies: How HighLiquidity Can Offset Weak Fundamentals and the Effects ofContagion,” IMF Working Paper 99/88.

27The Economic Research Department, using the Hodrick-Prescott methodology, estimated long-term component of thecurrent account and volatility.

control of the central bank to meet its objectives,including claims in the derivatives market used tohedge currency and interest rate exposures. TheBR also manages the liabilities it acquires for thesole purpose of supporting the liquidity of reserves.However, it does not manage the liabilities of thecentral government, which are under the control ofthe Ministry of Finance (MOF).

Coordination and strategy

382. The key elements that influence currentreserve management policy are the country’s tran-sition to a free float exchange system, character-ized by a rapid process of deregulation in itsexchange/capital controls, and its increasingdependency on the international capital marketsfor financing. The maintenance of a high level offoreign exchange reserves in order to reduce theimpact on the country of contagion is also deemedto be a very important element in setting reservemanagement policy.

383. The BR does not use the purchase or saleof reserve assets against domestic currency as aninstrument of monetary policy. It determines thevalue of reserves in accordance with the desiredreserve adequacy level, for which monetary effectsthat are derived from changes in the level ofreserves are sterilized, if necessary through openmarket operations, in order to keep the monetarybase within the ranges defined by the BR’s Boardof Governors.

384. On exchange rate policy, the central bankis committed not to influence the exchange rate,unless it is to maintain an orderly market in extremevolatility conditions for which it auctions volatilityoptions to the market whenever the exchange rate isabove or below 4 percent of its 20-day moving aver-age. The BR at its discretion may also tender optionsto accumulate or sell reserves to adjust its reserveadequacy objectives. Any changes in the policy ofintervention trigger a review of the central bank’sliquidity and investment policies.

385. On the fiscal front, there is no clear linkbetween reserve management and debt manage-ment as each pursues different investment objec-tives. Nevertheless, at a macro level there is a closecoordination between the MOF and the central

bank Board of Governors in order to ensure thesustainability of fiscal policy and the maintenanceof adequate liquidity levels.


386. The BR’s mandate that supports its man-agement of the country’s foreign exchangereserves is defined in the political constitution ofColombia and in Law 31 of 1992.

387. Chapter 6, Article 371, of the politicalconstitution of Colombia determines that the cen-tral bank “...will be organized as a public legal bodywith administrative, patrimonial and technicalautonomy, subject to its own legal regime.” Amongthe functions that the Constitution assigns to thecentral bank is the administration of the foreignexchange reserves and the requirement that itshould inform Congress periodically on the per-formance of its different responsibilities, includingreserve management.

388. Law 31 of 1992 Chapter IV further elabo-rates on the mandate the central bank has in themanagement of the foreign exchange reserves inthe following way: “The Board of Directors ofBanco de la República will administer the foreignexchange reserves in conformity with public inter-est, to benefit the national economy and with theobjective of facilitating the external payments ofthe country. Its administration involves the man-agement, investment, custody and disposition ofreserve assets. Reserve assets will be invested sub-ject to criteria of security, liquidity and return inassets denominated in freely convertible currenciesor gold.” Furthermore, the Law permits the BR toset up capital subscriptions with international mul-tilateral institutions, so long as such subscriptionscan also be considered reserve assets; it cannotgrant loans on account of the internationalreserves; it is allowed to open margin accounts toenable it to execute operations in the derivativesmarkets for hedging purposes; and it allows it tocontract credits to support the balance of paymentsas long as the product does not affect the monetarybase. The law establishes the immunity of the for-eign exchange reserves against seizure.

389. Insofar as the IMF Code of Good Practiceson Transparency in Monetary and Financial


Policies section 2.1 refers to operations of the cen-tral bank in the domestic markets, the BR hasdefined rules and procedures for the implementa-tion of its monetary and exchange rate policy.These rules and procedures clearly define the con-ditions, obligations, and rights a counterpartyshould meet in order to participate in open marketand foreign exchange operations with the centralbank. The rules and procedures are publicly dis-closed in regulation that is easily accessible to thepublic, for example, at the BR’s website.

390. For the management of the foreignexchange reserves, in which the BR does not act asa market maker, it selects its trading counterpartiesthrough internal formal processes of selectionwhere the relevant criteria are established at thehighest levels of decision-making hierarchy depend-ing on the type of service required, restricted tocounterparties that are members of well-establishedtrading associations such as the Bond MarketAssociation (BMA), the International SecuritiesMarket Association (ISMA), or the CommoditiesFutures Trading Commission (CFTC). In certaincases, standard legal contracts are entered into withcounterparties to strengthen the procedures oftrading in addition to market practices establishedby the relevant trading association.

391. The BR is fully compliant with the SpecialData Dissemination Standard (SDDS), and its asso-ciated data template on international reserves andforeign currency liquidity position, which is pub-lished according to specified schedules. Additionalinformation on foreign exchange reserves is dis-closed to the public on a preannounced schedulethrough the central bank’s website as follows:

• Position and foreign exchange liquidity on aweekly basis.

• Monthly and quarterly audited accountingbalances are delivered to the Superintendencyof Banks and the General Public AccountingOffice of Colombia. At the beginning of everyyear, the annual balance sheet as of December31 of the previous year is published in a widelydistributed national financial newspaper.

392. The semiannual report to the Congressprovides an overview of the Central Bank’s activi-

ties and includes a summary of the level, composi-tion, investment criteria, and performance onreserve management during the previous period.

Auditing

393. The political constitution of Colombiaestablishes that the President of the Republic exer-cises the control of the central bank. Law 31 of1992 establishes that the President delegates thefunction of control of the central bank to an exter-nal auditor, appointed by him, for the purpose of“certifying the Bank’s financial statements, complywith the functions that the code of Commerce ofColombia assigns to the agent responsible for fiscalsupervision, and exercise the control over the activ-ities and performance of the entity,” including itsmanagement of the foreign exchange reserves. Assuch, the auditing process has an autonomous bud-get from any other department within the BR andis conducted by an auditor who is independent ofthe central bank.

394. The auditor’s notes on the central bank’sfinancial statements, which constitute the endresult of its functions, include commentaries on themanagement and performance of the internationalreserves that are publicly available at the Bank’swebsite and widely disseminated through nationalnewspapers. The auditor certifies that the account-ing of reserve assets is conducted in conformitywith accounting principles determined by theSuperintendency of Banks of Colombia and pre-sents quarterly evaluations on the different aspectsof the management of the foreign exchangereserves to the President, the Superintendency ofBanks, and the Board of Governors.

395. This year, apart from the external audi-tor appointed by the President of Colombia, theBR engaged the services of an international audit-ing firm, Deloitte & Touche, to audit its financialstatements.

Accounting

396. The accounting procedures for reservemanagement follow the guidelines set by theFinancial Accounting Standards Board (FASB),insofar that they are not in conflict with the

6 • Colombia 73

accounting regulations of the Superintendency ofBanks of Colombia.28 The reserve’s portfolio ismarked to market on a daily basis, with the P/Laffected by both realized and unrealized profitsand losses. However, it must be highlighted thatthere are distinctive characteristics to the distribu-tion of P/L results over a financial year. In the caseof profits due to interest rate exposure, includinghedging, these are distributed to the governmentwithin the first three months after the end of eachfinancial year. Profits on the foreign exchangeexposure to non-U.S. currencies in terms of theU.S. dollar may be registered in a special reserve tocover future losses. Finally, the results of the valua-tion of the reserves in local currency terms do not

affect the P/L but are reflected in changes inequity in the balance sheet of the institution.


Legal foundation

397. As mentioned earlier, the BR’s mandate tomanage the international foreign exchangereserve of the country is established in the politicalconstitution of Colombia and Law 31 of 1992.

Internal governance

398. The organizational structure of reservemanagement is described in Figure 5.

399. The Reserves Committee and the InternalReserves Committee were created by an internalresolution approved by the Board of Directors thatestablishes the objectives, functions, and responsi-bilities of each Committee, updated last year inaccordance with the recommendations contained


28The main difference between FASB rules and theColombian Superintendency of Banks has to do with the pro-cedure involved with the valuation of derivative products,resulting in marginal differences.

Board of DirectorsReserves Committee

(Board of Directors, General Manager)

Internal Reserves Committee(Technical Manager, VP of

International and Monetary Affairs)

General Manager

Executive Manager

Technical Manager

Vice President of Internationaland Monetary Affairs

Director of the InternationalReserves Department

Vice President ofInternal Control

Vice President ofBanking operations

Director of theOperational Department

Director of theInternational Department

Accounting ConciliationsConfirmation PaymentsMiddleOffice

FrontOffice

ResearchUnit

AuditDepartment

Figure 5. Organizational Structure

in the “Guidelines for Foreign Exchange ReserveManagement” approved by the Executive Board ofthe IMF in September 2001.

400. The Reserves Committee meets every twomonths, and is presided over by the Governor ofthe central bank and integrated by the Board ofDirectors. It is responsible for the determination ofthe objectives, principles, and general policies forreserve management.

401. The Internal Reserves Committee was cre-ated last year in order to define the operationalprocedures for reserve management, in accor-dance with the objectives, principles, and generalpolicies determined by the Reserves Committee. Itmeets monthly, and it is presided over by theTechnical Manager of the central bank (not amember of the Board of Directors) and integratedby the Executive Vice President of the MonetaryAffairs and Foreign Reserves Department and theDirector of the Reserves Department.

402. The Director of the Reserves Departmentis responsible for ensuring that the investmentpolicies set by both the Reserves Committee andthe Internal Reserves Committee are observed.Within the Reserves Department, the front office isresponsible for the trades of the portfolio managedinternally. The middle office is in charge of com-pliance, risk management, and performance attri-bution for both the internally and externallymanaged portfolios, reporting directly to theInternal Reserves Committee to guarantee trans-parency and independence. A Research Unit wascreated to support the Department’s training,development, and research requirements.

403. The Operational Department is in chargeof accounting, confirmation, and settlement ofoperations carried out by the Reserves Departmentin a highly automated environment. Additionally, itkeeps track of operational issues with the custodi-ans, counterparties, correspondent banks, andasset managers. Reserve assets are reconciled on adaily basis by a separate Department.

404. The Internal Control Department was cre-ated in accordance with Law 87 of 1993, by whichthe procedures that regulate the exercise of inter-nal controls of public entities were stipulated, inorder to evaluate independently from the areas incharge of implementing reserve management pol-

icy, their procedures, and practices on a recurrentbasis.

Human resource policy

405. The Bank’s human resource managementstrategy includes specialized selection, training,remuneration, evaluation, and promotion policies.Selection of the staff involves recruiting the top 10percent of graduates in different disciplines fromthe top-tier universities in the country, out of whichpersonnel are selected on the basis of an evaluationprocess that includes their level of technical exper-tise, their proficiency in English/computer skills,and an evaluation of their personal characteristics.

406. The training program is structured inthree levels, as described in Table 4.

407. In order to reduce the risk of staff’s rota-tion, a special remuneration scheme is used basedon the HAY GROUP methodology. Under this sys-tem a salary/benefit curve is established for thebank based on a comparison with that of its peergroup within the country for each area.29 Eachposition is evaluated and graded according to therequired know-how, responsibility, and problem-solving skills, for which the attainment of each levelof CFA by the employee is crucial in order to estab-lish the salary and benefits within the Bank’s over-all salary curve.

408. In 1999, a five-year human resource man-agement plan was deployed with the support ofexternal specialized consultants. This planincluded the definition of technical and personalcompetencies required for the bank’s employees,annual performance indicators, and developmentplans to promote these competencies. TheReserves Department uses this framework to deter-mine the different types of training and salary basefor employees with basic, intermediate, andadvanced proficiency levels.

409. All employees are subject to bothColombia’s Disciplinary Code for public servantsestablished by Law 200 of 1995 (later modified by

6 • Colombia 75

29After five years the employee receives a salary increase thatgradually reaches a level equivalent to 20 percent of the aver-age salary paid by the industry.

Law 734 of 2000) and the Bank’s general code ofemployment conditions that establishes their rightsand obligations, including the appropriate code ofconduct that every employee must observe.Employees of the Reserves Department are alsosubject to a special internal code of conduct thatconcerns the nature of the operations on reservemanagement. The institution that regulates PublicService in Colombia requires that every year, allemployees declare their assets and liabilities for theperiod.


Risk management

410. The overall framework for risk manage-ment at the BR seeks to enable it to comply with itsreserve management objective at all times; that is, toensure that an adequate level of foreign exchangereserves is maintained readily available to meet inter-vention requirements in the most efficient manner.It must be highlighted, however, that some of thepolicies described below are in a transition phasedue to be fully implemented at the end of this year.

Liquidity risk

411. The financial risk management frame-work of the central bank is based initially on the

assessment of its liquidity requirements that aredetermined largely by the fact that under a floatingexchange rate regime the probability of recurrentintervention has fallen and, at the same time, thelevel of reserve adequacy has increased. As such, inorder to cover intervention requirements in themost efficient manner, total reserves have beensegregated into three liquidity buckets as follows:

• Working Capital to cover immediate liquidityrequirements, composed mostly of overnightinvestments at the Federal Reserve Bank.This bucket may fluctuate within a rangedefined by the Reserves Committee, accord-ing to current intervention policy, and ismanaged internally by the Bank.

• Intermediate Liquidity Bucket to cover up toone year’s liquidity requirements, which areestimated to be equivalent to the annualvolatility of historical percentage changes inforeign exchange reserves with a 99 percentconfidence level.30 These funds are managedinternally by the BR under an indexation


Table 4. Training Programs

Level Objectives and Activities

Basic Learning specific procedures/manuals of the area and an overallknowledge of the Bank, reserve management theory, and basicfinancial and economic concepts.

Intermediate Sponsorship of three levels of Chartered Financial Analyst (CFA)certificates to all front and middle office personnel (as of thisyear, replacing the ISMA General Certification Program).Internships with external managers. Management skills programsare given to senior members of the group to ensure thecontinuity of the department’s development.

Advanced This level includes the sponsorship of postgraduate studies at topinternational universities in fields such as financial engineering,international economics, and business administration, with astrong emphasis in finance; this step implies a long-termcommitment between the employee and the Bank.

30The central bank is at present working on a dynamic stresstest model for the balance of payments in order to determinemore precisely its liquidity requirements over a one-yearperiod. Under the current procedure liquidity requirementsover a one-year period may be overestimated given that thehistorical volatility of the reserves reflects the prolongedperiod in which the country was under a crawling peg and amanaged float exchange regime.

mandate to a benchmark that reflects thecurrency composition of the balance of pay-ments consisting of a combination of moneymarket instruments referenced to LIBID andhighly liquid government bonds with a mod-ified duration of 1.45 years. As such, its mainsource of added value over the WorkingCapital is its higher exposure to short-termcredit risk, duration exposure, and currencydiversification.

• Stable Liquidity Bucket, composed of theexcess of reserves over the value of the firsttwo buckets, which by definition have thelowest probability of being used for interven-tion purposes over a one-year period. At abenchmark level these funds reflect the cur-rency composition of the balance of pay-ments, invested in a combination of moneymarket instruments referenced to LIBID andhighly liquid government bonds with a mod-ified duration of 2. Furthermore, this bucketis delegated almost in its entirety to special-ized external managers under non-indexa-tion mandates that permit the possibility toinvest in a range of nongovernment assetclasses, credit risk, non-benchmark curren-cies, and active duration strategies.

412. The rationale behind the construction ofsuch liquidity buckets is to allow the central banksufficient time to liquidate the Stable LiquidityBucket to cover unexpected intervention require-ments under extreme market conditions, in orderto minimize the risk of either assuming higherthan normal transactions costs in liquidating less-liquid nongovernment asset classes or beingunable to meet such needs in a timely manner. Assuch, a formal liquidity policy was devised in orderto reduce further this risk.

413. The value of the Working Capital and theIntermediate Liquidity Bucket together can fluctu-ate within a sufficiently ample range (the equiva-lent of the historical volatility of reserves changeswith a 90 percent, minimum, and 99 percent, max-imum, confidence level) before liquidating theStable Liquidity Bucket.

• A policy on the use of repos to attend tounexpected liquidity requirements on a

temporary basis when the cost of sucharrangements, collateralized by securitiestraded as “specials,” which are part of theIntermediate Liquidity Bucket, is lower thanthe cost of liquidating a particular securityin the Stable Liquidity Bucket in abnormalmarket conditions.

• A policy on the use of contingency lines avail-able through multilateral institutions.

414. Furthermore, periodically the InternalReserves Committee reviews the liquidity require-ments in light of the changes in the interventionpolicy and/or changes in the underlying assump-tions that support the value of each bucket.

415. To determine the investment guidelinesand risk management policies of the Intermediateand Stable Liquidity Buckets, the ReservesCommittee drew on the international standardsand practices documented by the IMF, the Bank for International Settlements (BIS), theGroup of Thirty, and the Colombian Super-intendency of Banks. As a result, the bank defineda risk management policy framed in a five-stepdynamic process: identification, measurement,monitoring, limits/control, and validation, to befully implemented by December 31, 2002. Theoverall risk management framework is depicted inFigure 6.

Benchmark risk

416. The benchmark approved by the ReservesCommittee represents the most efficient long-termstrategy to accomplish the reserve managementobjectives of the BR for its investment portfolio(both the Intermediate and Stable LiquidityBuckets), constrained to assets with the highest liq-uidity characteristics. The benchmark embodiesthe following two objectives:

• The currency composition of the benchmarkof the total investment tranche, both theIntermediate and Stable Liquidity Buckets,must reflect the moving average of threeyears of the currency composition of the out-flows of the balance of payments, in order tomaintain the capacity of reserves to respond

6 • Colombia 77

to external pressures.31 As such, in order tomeasure this risk, an in-house model wasdeveloped in order to determine the cur-rency composition of the outflows of the bal-ance of payments.

• The interest rate exposure of the benchmarkof the total investment tranche, both theIntermediate and Stable Liquidity Buckets, islimited to a 95 percent confidence level thatit will not register negative returns in anygiven year. This limit is set so as not to hinderthe desired reserve adequacy level withadverse price movements and/or to exposethe central bank to criticism for its handlingof reserve management. The exposure of thebenchmark to interest rate risk is determined

by its sensitivity to parallel, twist, and curva-ture changes in the term structure of interestrates for a given modified duration/convex-ity, using an exponentially time-weighted VaRassociated with these factors and a variance-covariance matrix to estimate the correlationbetween different index components. Inaddition, historical stress tests are conductedto evaluate the consistency of the model anddetermine worst-case scenarios.

417. The composition of the benchmark thatcomplies with these two objectives is describedlater in this chapter. At the end of each financialyear the Reserve Committee reviews both the cur-rency composition and interest rate exposure ofthe benchmark in light of the changes in theunderlying assumptions in the models that supportthese decisions to determine adjustments, if any, inits currency composition and modified duration tocomply with these investment objectives over thenext financial year. Normally, such adjustments onthe total investment tranche are applied to the


Absolute Benchmark Risk+

Aggregated Tracking Error(We + Wi ) < 0.48% at actual market value

No losses at the 95% confidence interval in 1 yearTotal InvestmentPortfolio

External Adm. (We)

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

Internal Indexed (We)

Tracking Error < 1%

Tracking Error = 0.2% over Benchmark per Adm.

Minimal Tracking Error(Indexed)

Figure 6. Overall Framework for Risk Management

31Since this is a reserve adequacy objective, a reserve accountwas created in the balance sheet of the institution composedof the foreign exchange profits resulting from the non-U.S.dollar exposure of the portfolio in terms of the U.S. dollar. Inthe case of losses this reserve account is used.

Intermediate Liquidity Bucket only, in order not toincur unnecessary transaction costs implicit in thetypes of assets in which external managers investthe Stable Liquidity Bucket.

Portfolio risk

418. The overall annual tracking error the port-folio managers may take against the benchmark islimited to 0.50 percent of the total value of theinvestment portfolio (both Intermediate and StableBuckets). The Intermediate Bucket is managedinternally under an indexation mandate to thebenchmark, as a result of which its contribution tooverall tracking error is minimum. Most of theauthorized tracking error is allotted to the StableBucket that is managed exclusively by external assetmanagers. The allowed tracking error, currentlyaround 1 percent available for external managers, isas a result higher than for the overall portfolio,depending on the weight of the IntermediateBucket with respect to the Stable Bucket at any givenmoment in time. The Reserves Committee also lim-its the amount of tracking error allotted to any indi-vidual mandate to a tracking error of around 1percent, so long as it does not exceed 0.125 percentof the value of the total investment portfolio, toensure manager type diversification.

419. The measurement of the concurrenttracking error of the portfolios is based on a multi-factor model based on two regressions. In the firstregression, it determines the exposure of the port-folios with respect to the benchmark to parallel,twist, and curvature changes in the term structureof interest rates. In the second regression, it esti-mates three additional sources of risk: economicsector risk, issuer credit risk, and prepayment risk.Foreign exchange risk is calculated as a separatecomponent. Overall tracking error is estimatedusing a variance-covariance matrix.

420. At the beginning of each financial yearthe Reserves Committee reviews the limits on track-ing error in order to maintain a 95 percent confi-dence level so that in addition to benchmark risk,portfolio risk is not inconsistent with either the cur-rency or the interest rate objectives.

421. In addition to the constraints on trackingerror, the Reserves Committee also limits exposure

to the different specific types of risks that can betaken by the portfolio managers as presented inTable 5. The investment guidelines of the portfolioare presented later in this chapter.

Operational risk

422. Operational risk arises from inadequacies,failures, or nonobservance of internal controls andprocedures, which threaten the reliability andoperation of business systems. The Director of theReserves Department is responsible for identifyingand establishing the controls or procedures to mit-igate these risks. In addition, the Internal ControlDepartment and the Audit Department evaluatethe procedures to control this risk, and make rec-ommendations in this respect, based on their ownindependent risk analyses that are supported byinternational standard methodologies of audit andcontrol like the Committee of SponsoringOrganizations of the Treadway Commission(COSO) and the AS/NZS 4360:1999 (Australianand New Zealand Risk Management Standards).

423. The key operational risks identified inreserves management are the following: fraud risk,dealing risk, settlement risk, custodial risk, finan-cial error or misstatement risk, loss of potentialincome, information technology risk, contingencyevents, and legal risk. The Reserves Departmentand Operations Department rely upon a series oftools to mitigate these risks, of which the mostimportant is a well-established culture of auto-con-trol, where the personnel are aware of the impor-tance of the management of operational risk andare encouraged to verify every task and process.The specific approach to control each of the oper-ational risks is as follows:

424. Fraud risk: Frauds or thefts are preventedthrough strict control of the reserves operationsthrough manuals of procedures, the assignment ofkey responsibilities according to levels of hierarchy,and an appropriate segregation of duties withinthe organization.

425. Information technology risk: The assess-ment of this risk responds to the failure of theinformation systems and guarantees the securityand maintenance of critical information. The net-work infrastructure, distributed in two nodes, uses

6 • Colombia 79


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6 • Colombia 81

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a cluster architecture that allows load balancingand redundancy for disaster recovery of the mostcritical services on just one node. Disaster recoveryis possible using online mirroring of data on top ofa fiber-optic interconnection. From a security per-spective, passwords and access controls arerequired to access computers and applications, andall data transmissions of sensitive information overthe extranet and Internet use regular security fea-tures. The portal Servicios Electronicos del Bancode la Republica (SEBRA) handles authentication,encryption, and firewall functions. The manage-ment of the international reserves is based on eightprincipal applications systems that are described inTable 6.

426. Dealing risk: OPICS is a straight-throughprocessing system with a single point of entry oftrade operations restricted to authorized traders,limited by the system to the type of operations eachtrader is allowed to enter; limits on transaction size;authorized counterparties; the observance ofcredit risk limits; and a price tolerance check of theoperations to ascertain that trades were transactedat current market levels. Once entered, the systemgenerates a confirmation message of each tradethat matches automatically to the trade details ofthe confirmation received from the counterpart,including a verification of the standard settlementinstructions that a counterpart must provide as a

requisite to be allowed to trade with the Bank, afterwhich it generates the appropriate paymentinstruction via SWIFT.

427. Settlement risk: Trading counterpartiesare reviewed and approved by the InternalReserves Committee. Standard settlement instruc-tions are required for each counterpart and, in thecase of disputes such as late settlement claims,these are conducted based on the laws, rules, andrecommendations of ISMA or any other interna-tionally recognized trading association.

428. Custodial risk: The prevention of a possi-ble failure by the custodian is done at the selectionprocess, which focuses on selecting professionaland globally recognized entities for its custodialoperations. Specific requirements include: experi-ence, size (measured by the volume of assets undercustody), the maintenance of sound technologicalresources to carry out its operations, the robustnessof its contingency plans, its sub-custodian network,its reporting capabilities, and its management of failtrades. Once the custodian has been selected, itsresponsibilities are defined in a contract, and itsperformance is monitored through the daily recon-ciliation of portfolios with the central bank andexternal managers.

429. Financial error or misstatement risk: Thedefinition of reserve assets or liabilities follows theBalance of Payments methodology from the


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 Tradingtime deposit trades.

OPICS Client/server: Back office application, trade entry FrustumNT/NT Oracle 8i system, settlement (SWIFT), credit risk,

pricing, cash flows, and accounting.

ABACUS Client/server: Performance measurement system. Wilshire AssociatesNT/W2000 DB2

AXIOM Client/server: Multifactor risk and performance Wilshire AssociatesNT/W2000 C-tree attribution system, investment guide-

line compliance, and portfolio analysis.

SWIFT Client/server: Payment system. SWIFTNT/UNIX

International Monetary Fund. All components ofreserves must be registered in the balance sheet,and the International Exchange Department cal-culates the total value of reserves on a daily basis,with the support of the Accounting and EconomicInformation Departments, to evaluate the consis-tency of this information.

430. Loss of potential income: The control ofthe ledger accounts of the BR is executed throughthe Cash Management Systems provided by its cor-respondents, which control in real time both debitsand credits on the account, represent an alternativeto SWIFT to execute payments in a contingency, andpermit investment of excess funds throughout theday in different overnight alternatives. In addition tothe above, the BR is in the process of contractingwith its correspondents’ overnight repo facilities togenerate liquidity collateralized by governmentbonds as part of its general liquidity policy. The cashflow module in the OPICS processing system is usedin addition to the Cash Management System todetermine the required balances of the ledgeraccounts, a process that the Bank intends to auto-mate via an interface between the two systems, anda separate Department from the Reserves Depart-ment, which is in charge of the control of treasuryoperations, conducts daily reconciliation of theledger accounts using the nostro conciliation systemprovided by SWIFT.

431. Contingency events: Based on the method-ology documented by the Disaster RecoveryInstitute International, the Reserves and the ITDepartment have established contingency plans toguarantee the continuity of reserves operations atdifferent levels of contingency. Important aspects ofthe contingency plan include a daily backup systemwith an updated copy of all vital information and anoff-site contingency location that fulfills all tradingand system requirements.

432. Legal risk: The management of legal riskis under the responsibility of the Reserves Depart-ment and the Legal Department of the BR, withthe support of an external advisory firm. The pro-cess focuses on the administration of contracts andlegal documents associated with the reserves oper-ations; that is, external management, securitieslending, futures trading, custody, etc. These con-tracts specify each party’s right and obligations,

fees, investment guidelines, warranties, thesovereign immunity of the reserves, and the appli-cable legislation and jurisdiction. They also involvethe establishment of new contracts, as well as themaintenance of the current contracts in accor-dance with the central bank’s internal regulationsand international market regulations.

External management program

433. The objective of the external manage-ment program is to add value to the benchmarkthrough the specialized management of risks thatthe Bank cannot manage internally. The frame-work for the external asset management programincludes:

• Program size: The Stable Investment Bucketis allocated to external managers, with theexception of a small portfolio managed inter-nally under a non-indexation mandate.

• Tracking error: 0.50 percent of the value ofthe total investment portfolio (which equatescurrently to 1 percent of the value of theStable Liquidity Bucket), of which 0.125 per-cent can be allocated to one single externalmanager to ensure manager type diversifica-tion (currently around 1 percent per man-date).

• Benchmark and investment guidelines: Thetotal program shares the benchmark andinvestment guidelines described in Section D.

• Types of managers: Manager diversification ispromoted through the selection of globalmanagers and U.S. sector rotation managers,with appropriate benchmarks and special-ized investment guidelines for each thattogether reflect the overall desired exposureto the different specific types of risk.

• Selection process: The selection of the man-agers is based on a Request for Proposal(RFP) that evaluates the company, organiza-tion, investment philosophy, historical per-formance, risk management capabilities,back-office processes/reporting, and addi-tional services provided, such as researchfacilities. Finalists in the RFP process are vis-

6 • Colombia 83

ited on-site and asked to provide an eco-nomic offer.

• Fee structure: A performance fee structurebased on percentages of the normal fixed feecharged by each manager for a given marketvalue of the mandate, tailored in such a man-ner that at the expected long-term excessreturn of each type of mandate (Global orU.S. Asset Rotation) the normal fixed fee andthe performance fee are equal.

• Performance evaluation: A three-year hori-zon is used to measure the performance ofeach mandate.

434. Managers for each mandate are classifiedas outstanding when excess return is above thelong-term expected average, acceptable when it isin a range between the normal fixed fee of the man-ager and the long-term expected average, and lowwhen performance is below the normal fixed fee.

435. Each category is reclassified according tothe information ratio obtained by each manager.

436. Guideline compliance and operativeerrors are also evaluated in terms of both the num-bers of errors and potential cost.

437. On the basis of this evaluation the ReservesCommittee adjusts the mandates of external man-agers. The Internal Reserves Committee reviews theperformance of the asset managers on a monthlybasis, as well as any breaches of the guidelines oroperative errors. The middle office in the ReservesDepartment is responsible for the day-to-day controlof the asset managers who have to report their oper-ations daily to both the OPICS processing system foraccounting purposes and Axiom for risk, perfor-mance, and compliance control.

Performance measurement and attribution

438. Performance measurement is based on adaily mark-to-market valuation of the portfolios cal-culated by the Abacus system from WilshireAssociates Inc., which complies with the AIMR(Association for Investment Management andResearch) and GIPS (Global Investment Perform-ance Standards). A daily time-weighted rate ofreturn that is geometrically linked is used to calcu-late a monthly figure. Performance is measured for

time horizons such as monthly, year to date, yearly,rolling three years, and since inception, using U.S.dollars as the base currency. This is applied to boththe benchmark and the portfolios and thereforereturns can be measured on an absolute and a rela-tive basis. Both gross and net returns are calculatedfor the portfolios, deducting operating costs such asfees, custody, and administrative expenses. In addi-tion, risk-adjusted returns are also calculatedthrough the use of the following measures:32

• The information ratio that measures averageexcess return over the benchmark per unit ofobserved risk. This indicator evaluates theefficiency with which the managers have uti-lized risk.

• The risk ratio that measures average excessreturn over the benchmark per unit of track-ing error ex ante. This indicator evaluatesthe success of managers’ use of allowed track-ing error.

• The efficiency ratio measures the consistencyof the risk models used by the managers bycomparing observed tracking error with exante tracking error.

439. Attribution analysis is performed byAxiom using its multifactor model for each of therisk factors at the following levels: security, assetclasses, countries, currencies, portfolio, and com-posites. This model offers an attribution measure-ment that goes beyond the traditional approach33

since it allows an integrated analysis of return andrisk factors, which determines the efficiency of theoverall investment strategy.

The role of efficient markets

440. As explained later in this chapter, the BRis extremely sensitive to liquidity risk. On the onehand, it constrains its reserve management activi-ties to markets that have sufficient liquidity as mea-sured through qualitative and quantitative factors


32These risk-adjusted measures are implemented following theRiskMetrics methodology.33The Brinson-Fachler model measures attribution in terms ofasset allocation, security selection, and an interaction effect.

that determine the quality of the liquidity of a par-ticular market, factors that are reviewed periodi-cally. Furthermore, the central bank sets limits onits exposure to a specific market, asset class, andindividual issuer/issue in accordance with thequality of the liquidity of each investment alterna-tive in order not to affect the relevant marketthrough its own operations. Finally, the BR is alsosensitive to trading in abnormal market conditionsfor which it has set rules to buy time to liquidateless-liquid assets at such times. It also must behighlighted that the central bank delegates toexternal managers the management of non-government asset classes since they have the nec-essary capabilities to liquidate them moreefficiently in any market environment.

General Investment Guidelines

Working Capital

Reference rate: Fed funds.Size: Range from US$390 to US$750 million.Currency denomination: U.S. dollar-denominated

assets.Investment guidelines: Up to $390 million may be

invested in overnight facilities provided by theFederal Reserve Bank of New York, of which upto $180 million may be invested in the overnightfacilities provided by other treasury correspon-dents. No limit is imposed on U.S. Treasury Billsand Fixbis. A limit of $80 million each isimposed on money market instruments issuedby the World Bank, Fannie Mae, Freddie Mac,and Federal Home Loan Banks.

Maximum maturity of investments: Three months.

Investment portfolio

441. The investment portfolio is segregatedinto two liquidity buckets: the IntermediateLiquidity Bucket and the Stable Liquidity Bucket.

442. The size of the Intermediate LiquidityBucket, including investments in Working Capital,can range between $2,120 million (the volatility ofthe percentage changes in the foreign exchangereserves with a 90 percent confidence level) and$4,378 million (the volatility of the percentage

changes in the foreign exchange reserves with a 99percent confidence level).

443. Excess funds over $4,378 million may beinvested in the Stable Liquidity Bucket.

444. In the case of a reduction in the foreignexchange reserves, the Working Capital Bucketand then the Intermediate Liquidity Bucket will beused until the sum of the two buckets reaches theminimum authorized level. After such level isreached, reserve reductions will be covered pro-portionally by the Intermediate and StableLiquidity Buckets. In order to delay further the liq-uidation of the Stable Liquidity Bucket, repos andcontingency lines may be used.

1. Aggregate Benchmark

445. The Money Market portion (MM) is ref-erenced to the iMoneyNet First Tier Institutionalindex and the bond portion is referenced to theSalomon Smith Barney Government bond indexweighted by country and sector as described inTable 7. Benchmark weights in each currencymust be adjusted over time to reflect the three-year rolling average composition of the outflowsof the Balance of Payments of Colombia. Theoverall average effective duration of the aggregatebenchmark (Intermediate and Stable LiquidityBucket) must be consistent with a 95 percentprobability that its exposure to interest rate riskwill not register negative returns over any givenyear.

2. Investment Guidelines for the Money MarketPortion of the Benchmark (applicable to bothIntermediate and Stable Liquidity Buckets)

3. Investment Guidelines: Intermediate LiquidityBucket

446. The objective of the mandate is to repli-cate the risk/return characteristics of the bench-mark of the Intermediate Liquidity Bucket depictedin paragraph 445, with the lowest possible trackingerror, following the Investment Guidelines for theMoney Market Portion described in Table 8, andmatching the composition of the bond portion ofthe benchmark.

6 • Colombia 85


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 thebenchmark is 90 days.

Exchange risk 100% U.S. dollars. Investments are also allowed in the following currencies with theirrespective currency hedge against U.S. dollars: Canadian dollar, Japanese yen, euro, Britishpound, Swiss franc, Swedish krona, Danish krone, Norwegian krone, Australian dollar, andNew 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 creditrating of P–1 by Moody’s Investor Services, A1+/A1 by Standard and Poor’s, and F1 by FitchRatings.

• At the time of purchase the issuer of an eligible asset or the eligible asset itself must be ratedby 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 canbe used if and only if the third agency does not issue an opinion about the rating status ofthe issuer and/or issue. The lowest of the available ratings applied by any of the agencies toan issuer or issue at the time of purchase will prevail over the others. Exception is made forU.S. Government securities.

• Downgrades after purchase to P–3/A–3/F–3 by any of the rating agencies mentioned abovemust be sold within the 10 Trading Days following this event. These rules also apply todowngrades to P–2/A–2/F–2 in excess of 5% of the money market portion of thebenchmark.

• The maximum non–U.S. Federal Government sector exposure as a percentage of the moneymarket 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% inasset-backed commercial paper (ABCP).

• The maximum non–U.S. Federal Government exposure (current face*price/100 asdetermined on the date of purchase) allowed per issuer as a percentage of the moneymarket portion of the benchmark is 5%. In the case of ABCP, when an entity guaranteesmore than 10% of an issue, such amount guaranteed must be added to the credit exposureof 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 amaximum maturity of 397 days.

• Investments are also allowed in term deposits with a maximum maturity of 1 month and upto 10% of the value of the money market portion of the benchmark.

4. Investment Guidelines for the Stable Bucket:U.S. Asset Rotation Mandates

447. Of the total value of the Stable LiquidityBucket, 50 percent is allotted to U.S. asset rotationmandates with the following investment guidelines:

Objective

448. The objective of the mandate is to generatereturns over the performance of the benchmark (asdescribed below) in excess of 30 basis points perannum over three-year rolling periods, within amaximum ex ante expected tracking error objectiveof 100 basis points per annum and in compliancewith the investment guidelines set forth below.

Benchmark

449. The benchmark composition is as pre-sented in Table 9.

Risk limits

(i) Currency risk

The Mandate may invest up to 50 percent ineligible assets (as described below) denominatedin eligible currencies provided that they are fullyhedged to the U.S. dollar within a tolerance limitof ±0.25 percent of the value of the Mandate inunhedged exposure to non–U.S. dollar currencies.The following are the eligible currencies: U.S. dol-lar, euro, Japanese yen, Swiss franc, British pound,Canadian dollar, Australian dollar, Swedish krona,Danish krone, Norwegian krone, and New Zealanddollar.

(ii) Interest rate risk

450. The effective duration of the Mandatemay vary in a range between ±1 with respect to thatof the benchmark; its convexity may not be below

–1 in absolute terms and spread duration may notexceed ±2.85.

(iii) Money market investment guidelines

• In addition to the investment guidelinesdescribed in Section 2 for the Money Marketportion of the benchmark, the mandate mayinvest up to 100 percent of its value in U.S.Federal Government securities and up to 15percent in First Tier Short-Term InvestmentFunds (STIF) available with the Custodian.

• The restriction in Section 2 on the maximumWAM of 90 days for the Money Market por-tion of the benchmark is replaced by theoverall restrictions on interest rate risk inSection 2.3.ii applied to the value of the over-all mandate.

(iv) Bond investment guidelines

• Eligible assets: bonds and debentures withoutattached options in eligible currencies, bonds,and debentures with embedded optionsdenominated in U.S. dollars only, Fixed-Coupon Mortgage-Backed Pass-ThroughSecurities (MBS) denominated in U.S. dollarsonly, Asset-Backed Securities (ABS) denomi-nated in U.S. dollars only, collateralized bycredit card receivables and auto loans,Collateralized Mortgage Obligations (CMOs)denominated in U.S. dollars only, restricted tofirst or currently paying tranches of sequentialbonds, planned amortization classes (PAC),targeted amortization class bonds (TAC), andfloating rate bonds that are not supporttranches. Private placements, including 144asecurities, are not considered an eligible assetclass.

6 • Colombia 87

Table 9. The Benchmark

Sector Currency Weight1 Reference

Money Market U.S. dollar 15% iMoneyNet First Tier Institutional (gross offees and taxes).

Bonds U.S. dollar 85% 1–5 yr. Salomon Smith Barney U.S.Government Bond Index Component ofthe World Government Bond Index.

1These weights are not final and will be adjusted to achieve the relevant effective duration near thedate of funding of the account.

• Eligible investments must have a debt senior-ity of guaranteed, Senior secured, or Senior.

• At the time of purchase the issuer of an eligi-ble asset or the eligible asset itself must berated by at least two of the following ratingagencies as: A3 by Moody’s Investor Service,A- by Standard and Poor’s, and A3 by FitchRatings. The ratings by two agencies can beused if and only if the third agency does notissue an opinion about the rating status ofthe issuer and/or issue. The lowest of theavailable ratings applied by any of the agen-cies to an issuer or issue at the time of pur-chase will prevail over the others. Exceptionis made for U.S. Government securities.

• In the case of a downgrade after purchasebelow the minimum acceptable level by anyof the rating agencies mentioned above, theinvestment must be sold within ten tradingdays following this event.

• Sector limits as a percentage of the totalvalue of the mandate: 100 percent in U.S.

Federal Government securities, 100 percentin Sovereign securities issued in local eligiblecurrencies, including fully guaranteed agen-cies, 8.2 percent in Sovereign/Supranationalsecurities issued in non-local eligible curren-cies, including fully guaranteed agencies ofwhich 4.1 percent may be invested inSupranationals, 11 percent in U.S. Agencieswithout explicit guarantee from the U.S.Federal Government, 45 percent in GinnieMae, 8.2 percent in U.S. corporates, and 8.2percent in U.S. Asset-Backed Securities guar-anteed by credit card receivables and autoloans. Sector limits described in this sectionare exclusive of the sector limits described inSection 2 for the Money Market.

• Issuer limits as a percentage of the total valueof the mandate (Current Face*price/100 asdetermined on the date of purchase) are pre-sented in Table 10.

• Investments must have a minimum issue sizeof $500 million in accordance with the index


Table 10. Issuer Limits

Limit inIssuer Credit Quality Percent

United States government U.S. government No limit

Sovereign in local currency (includes agencies AAA 35.4fully guaranteed) AA 21.2

A 10.6

Sovereign in nonlocal currency (includes AAA 4.1agencies fully guaranteed) AA 1.4

A 0.3

Supranationals AAA 2.0AA 0.7

A 0.1

U.S. agencies without explicit guarantee—GSEs Federal Home Loan Banks 10.6Fannie Mae 5.3

Freddie Mac 3.5

U.S. agencies explicitly guaranteed Ginnie Mae 44.7

U.S. corporates AAA 0.8AA 0.8

A 0.2

U.S. dollar-denominated ABS (restriction per AAA 0.8individual program)

inclusion criterion established by theSalomon Smith Barney indices, with theexception of MBS, CMOs, and ABS, wherethis limit does not apply.

• The maximum holding of any specific issue isrestricted to 10 percent of the issue size ofany security, with the exception of MBS,CMOs, and ABS, where this limit does notapply.

(v) Investment guidelines for instruments withembedded options

• The mandate may invest in assets withembedded options other than MBS or itsderivatives and ABS up to 8 percent of thetotal value of the mandate. This provisiondoes not apply to Treasury InflationProtected Securities (TIPS).

• For MBS a limit is set at 45 percent of themarket value of the mandate, of which 7.5percent can be allocated to eligible CMOs.For CMOs the notional amount of any secu-rity purchased will be added to the exposureof the issuer of the security, not to the expo-sure of the issuer of the underlying asset, andthey are to be issued and collateralized by aneligible GSE.

• For Asset-Backed Securities, the limit is set at8.2 percent of the market value of the man-date.

Other restrictions

(i) Restriction on eligible financial markets

451. Eligible issuers may not be located in theoffshore financial markets described in Table 11.

(ii) Restrictions on managers

452. Managers may not invest in securitiesissued by themselves, their parent company, or anyof their affiliates (or any special-purpose subsidiaryfor which they serve as incorporator, manager, ortrustee, or in which they are an investor).

Derivatives

(i) Over-the-counter (OTC) currency forwards

• Foreign exchange forward transactions canbe executed for hedging purposes only.

• The maximum maturity of foreign exchangeforward transactions cannot exceed four (4)months as from the date of transaction.

• Eligible counterparties for forward and spotforeign exchange transactions must have aminimum credit rating of A-1 by Standard &

6 • Colombia 89

Table 11. Noneligible Offshore Financial Centers

Africa Middle East Western Hemisphere Asia and the Pacific Europe

Seychelles Bahrain Anguilla Cook Islands AndorraAntigua and Barbuda Macao SAR CyprusAruba Malaysia (Labuan) GibraltarBelize Marshall Islands GuernseyBermuda Nauru Isle of ManBritish Virgin Islands Niue JerseyCayman Islands Palau LiechtensteinDominica Samoa MonacoGrenada VanuatuMontserratNetherlands AntillesPanamaSt. Kitts and NevisSt. LuciaSt. Vincent and the GrenadinesThe BahamasTurks and Caicos Islands

Poor’s, P-1 by Moody’s Investor Service, andF-1 by Fitch IBCA by at least two of theseagencies.

• If any eligible counterparty with which thereis an open position is downgraded below theminimum permitted credit rating by any ofthe credit agencies, the position must beclosed with such counterparty during the ten(10) trading days following such event solong as the Adviser maintains an enforceablenetting agreement with such counterparty.

• The net exposure in open foreign exchangeforward and spot operations with any eligiblecounterparty cannot exceed 10 percent ofthe value of the mandate at any givenmoment of time.

• The maximum amount of foreign exchangeoperations to be settled on the same datewith any eligible counterparty cannot exceed5 percent of the value of the mandate. Forcounterparties with which the manager doesnot have an enforceable netting agreementin place, the limit shall be 2.5 percent.

• The notional amount of all open foreignexchange forward operations may not exceed50 percent of the value of the mandate.

(ii) MBS to-be-announced (TBA) trades

• TBA trades are authorized restricted to a set-tlement date not exceeding three monthsfrom trade date.

• The underlying pools for TBA trades mustcome from an eligible MBS.

(iii) Exchange-traded futures contracts

• The futures contracts and correspondingexchanges that are shown in Table 12 areauthorized:

• The maximum expiration or delivery date ofany contract cannot exceed six (6) monthsfrom trade date.

• Eligible counterparties for futures contracts:broker-dealers designated as futures commis-sion merchants by an appropriately desig-nated self-regulatory organization or govern-ment body as required by applicable laws andregulations. Eligible broker-dealers must bemembers of the clearinghouses associatedwith the following exchanges: Chicago Boardof Trade, Chicago Mercantile Exchange,Eurex, and London Financial Futures andOptions Exchange.


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 futurescontracts

Chicago Mercantile Exchange Eurodollar

Eurex Schatz; Bobl and Bund contracts

London Financial Futures and EuriborOptions Exchange Long Gilt

Tokyo Stock Exchange JGBs

Bourse de Montréal Canadian government bond

Stockholmsbörsen Swedish government bond

Sydney Futures Exchange Australian government bond; New Zealandgovernment bond

Københavns Fondsbørs Danish government bond

(iv) Restrictions on leverage

453. The notional amount of all long futuresand MBS TBA positions shall not exceed the mar-ket value of all assets with a final maturity of lessthan 397 days.

5. Investment Guidelines for the Stable Liquidity Bucket: Global Mandates

454. Of the total value of the Stable LiquidityBucket, 50 percent is allotted to global mandateswith the following investment guidelines:

Objective

455. The objective of the mandate is to gener-ate returns over the performance of the bench-mark in excess of 30 basis points per annum overthree-year rolling periods, within a maximum exante expected tracking error objective of 100 basispoints per annum and in compliance with theinvestment guidelines set forth below.

The benchmark

456. The benchmark composition is as pre-sented in Table 13.

Risk limits

(i) Currency risk

• The mandate may invest up to 50 percent ofthe value of the account in eligible assets (asdescribed below) denominated in eligiblecurrencies, in addition to the eligible assetsof the benchmark, provided that they arefully hedged in such a way that the account

maintains the currency composition of thebenchmark. The following are the eligiblecurrencies: U.S. dollar, euro, Japanese yen,Swiss franc, British pound, Canadian dollar,Australian dollar, Swedish krona, Danishkrone, Norwegian krone, and New Zealanddollar.

• The mandate may deviate up to ±10 percentin unhedged currency exposure in any of theeligible currencies with respect to its partici-pation in the benchmark, subject to the con-straint that the maximum aggregate currencyexposure is 10 percent of the value of theportfolio. The aggregate currency exposureshall be calculated as the sum of all net longpositions in each individual eligible currencyagainst the benchmark.

(ii) Interest rate risk

457. The effective duration of the mandatemay be in a range between ±1 with respect to thatof the benchmark.

(iii) Money market investment guidelines

• In addition to the investment guidelinesdescribed in Section 2 for the Money Marketportion of the benchmark, the mandate mayinvest up to 100 percent of its value in U.S.Federal Government securities and up to 15percent in First Tier Short-Term InvestmentFunds (STIF) available with the Custodian.

• The restriction in Section 2 on the maximumWAM of 90 days for the Money Market por-

6 • Colombia 91

Table 13. The Benchmark

Sector Currency Weight Reference

Money Market USD 15% iMoneyNet First Tier Institutional (gross of fees andtaxes)

Bonds USD 57% 1–5 yr. Salomon Smith Barney U.S. Government BondIndex

EUR 22% 1–5 yr. Salomon Smith Barney German GovernmentBond Index

JPY 6% 1–5 yr. Salomon Smith Barney Japanese GovernmentBond Index

tion of the benchmark is replaced by theoverall restrictions on interest rate risk inSection 4.3.ii applied to the value of theoverall mandate.

(iv) Bond investment guidelines

• Bonds and debentures without attachedoptions in eligible currencies. Floating ratenotes with a maximum final maturity of fiveyears and a maximum reset period of up toone year. 144a securities, including privateplacements, are not considered an eligibleasset class.

• Eligible investments must have a debt senior-ity of guaranteed, Senior secured, or Senior.

• At the time of purchase the issuer of an eligi-ble asset or the eligible asset itself must berated by at least two of the following ratingagencies as: A3 by Moody’s Investor Service,A- by Standard & Poor’s, and A3 by FitchRatings. The ratings by two agencies can beused if and only if the third agency does notissue an opinion about the rating status of theissuer and/or issue. The lowest of the avail-able ratings applied by any of the agencies toan issuer or issue at the time of purchase willprevail over the others. Exception to this stip-ulation is made in the case of U.S. FederalGovernment securities.

• In the case of a downgrade after purchasebelow the minimum acceptable level by any

of the rating agencies mentioned above, theAdviser must sell the investment within the10 trading days following this event.

• Sector limits as a percentage of the totalvalue of the mandate: U.S. Federal Govern-ment Securities, 100 percent; Sovereign in eligible local currencies, including fully guaranteed agencies, 100 percent;Sovereign/Supra-national in eligible non-local currencies, 36 percent, of which 18 per-cent can be invested in Supranation-als; U.S. Agencies (GSEs) without explicitguarantee from the U.S. Federal Govern-ment, 11 percent.

• Issuer limits as a percentage of the total valueof the mandate (current face*price/100 asdetermined on the date of purchase) aredepicted in Table 14.

• Investments must have a minimum issue sizeof $500 million in accordance with theindex inclusion criterion established by theSalomon Smith Barney indices.

• Investments in any security may not exceed10 percent of its issue size.

Other considerations

(i) Restrictions on eligible financial markets

458. Eligible issuers may not be located in thefollowing financial offshore centers described inTable 15.


Table 14. Issuer Limits

Issuer Credit Quality Limit in Percent

United States government U.S. government No limitSovereign in local currency (includes fully guaranteed agencies) AAA 35.4

AA 21.2A 10.6

Sovereign in nonlocal currency (includes agencies fully guaranteed) AAA 17.9AA 6.0

A 1.2Supranationals AAA 8.9

AA 3.0A 0.6

U.S. agencies without explicit guarantee—GSEs (Noncallable Federal Home Loan Banks 10.6debentures only) Fannie Mae 5.3

Freddie Mac 3.5

(ii) Restrictions on managers

459. Managers may not invest in securitiesissued by themselves, their parent company, or anyof their affiliates (or any special purpose subsidiaryfor which they serve as incorporator, manager, ortrustee, or in which they are an investor).

Derivatives

(i) Over-the-counter (OTC) currency forwards

• The maximum maturity of foreign exchangeforward transactions cannot exceed four (4)months as from the date of transaction.

• Eligible counterparties for forward and spotforeign exchange transactions must have aminimum credit rating of A–1 by Standard &Poor’s, P–1 by Moody’s Investor Service, andF–1 by Fitch IBCA by at least two of theseagencies.

• If any eligible counterparty with which thereis an open position is downgraded below theminimum permitted credit rating by any of the credit agencies, the position must beclosed with such counterparty during the ten (10) trading days following suchevent so long as the manager holds anenforceable netting agreement with suchcounterparty.

• The net exposure in open foreign exchangeforward and spot operations with any eligiblecounterparty cannot exceed 10 percent ofthe value of the mandate at any givenmoment of time.

• The maximum amount of foreign exchangeoperations to be settled on the same date witheach eligible counterparty cannot exceed 5percent of the value of the mandate. For coun-terparties with which the manager does nothave an enforceable Netting Agreement inplace, the limit shall be 2.5 percent.

• The notional amount of all open foreignexchange forward operations may not exceed50 percent of the value of the account.

(ii) Exchange-traded futures contracts

460. The authorized futures contracts and cor-responding exchanges are depicted in Table 16.

• The maximum expiration or delivery datecannot exceed six (6) months from tradedate.

• Eligible counterparties for futures contracts:broker-dealers designated as futures commis-sion merchants by an appropriately desig-nated self-regulatory organization or govern-ment body as required by applicable laws and

6 • Colombia 93

Table 15. Noneligible Offshore Financial Centers

Africa Middle East Western Hemisphere Asia and the Pacific Europe

Seychelles Bahrain Anguilla Cook Islands AndorraAntigua and Barbuda Macao SAR CyprusAruba Malaysia (Labuan) GibraltarBelize Marshall Islands GuernseyBermuda Nauru Isle of ManBritish Virgin Islands Niue JerseyCayman Islands Palau LiechtensteinDominica Samoa MonacoGrenada VanuatuMontserratNetherlands AntillesPanamaSt. Kitts and NevisSt. LuciaSt. Vincent and the GrenadinesThe BahamasTurks and Caicos Islands

regulations. Eligible broker-dealers must bemembers of the clearinghouses associatedwith the following exchanges: Chicago Boardof Trade, Chicago Mercantile Exchange,Eurex, and London Financial Futures andOptions Exchange.

(iii) Restrictions on leverage

461. The notional amount of all long futurespositions shall not exceed the market value of allassets with a final maturity of less than 397 days.


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 Zealandgovernment bond

Københavns Fondsbørs Danish government bond



462. The functions and objectives of holdingreserves determine the reserve management strat-egy of the Czech National Bank (CNB). There aretwo main functions of reserves. The first is to serveas a source of liquid funds for meeting known andpotential foreign liabilities and obligations of thecentral bank. In a wider sense, the obligations of theCNB are (i) to meet foreign exchange interventionrequirements; (ii) to meet foreign exchange pay-ments of CNB’s clients (of which the government isthe most dominant one); and (iii) as a “backup” formeeting balance of payments crises. The secondfunction is to serve as a form of national wealth,although it is only the central bank that has access toreserves. Foreign exchange reserves are a by-prod-uct of the monetary and exchange rate policy of thecentral bank. Due to the exchange rate regime andother developments since 1993, foreign exchangeinflows are being absorbed into reserves. The for-eign exchange inflows in the form of foreign directinvestment (FDI) or speculative capital put pressureon the domestic currency, and by reverse interven-tions, the foreign exchange is accumulated in for-eign exchange reserves of the CNB.

463. The general objective of reserve man-agement is to ensure that reserves are positive,

stable, and readily available for use. Positivenessand stability represent the risk limits, and avail-ability for use ensures liquidity. This is a widelydefined objective, and more detailed and con-crete objectives are defined by the managementof CNB depending on the conditions in the mar-kets. However, even clear objectives are not easyto transform into measures of risk managementsuch as investment horizon, duration, or the bestcurrency composition.

464. From the inception of the Czech korunain 1993 until 1997, it was pegged to a basket oftwo currencies, namely, the deutschemark andthe U.S. dollar. It was easy to define the currencyallocation in terms of the basket while at the sametime avoid accounting losses. On a daily basis, thecentral bank bought (rarely sold) hard curren-cies. Each reserve currency was divided into twoportfolios. One was the investment portfolio,which was fixed in size, and the other was the liq-uidity portfolio, which absorbed all inflows. Therisks in each portfolio were managed separatelywith separate benchmarks primarily for durationand instruments. During the first three years of itsexistence, the central bank had accumulated sub-stantial reserves with the level increasing byalmost nine times. These inflows reduced theoverall duration of the reserve to zero, therebyaffecting returns when the yield curve wasupward sloping. This situation arose because thefocus was too much on the individual portfolios

95

7Czech Republic

instead of on the entire reserves. There were no automatic procedures that would properlyadjust the risk profile of reserves (the overallduration to development of balance of payment).This policy was changed in 1999 and today all thelimits are set up first at the overall level, and thelimits of individual portfolios are derived fromthe overall limits. Furthermore, the limits areexpressed in relative terms (i.e., their absolutelevel is a function of the size of reserve) and thefuture development of reserve size is taken intoconsideration.

465. It is important to note that except for thecentral bank’s obligations and liabilities, the for-eign reserves do not reflect the liabilities of anyother entity. Even the central government’s posi-tion in foreign exchange is treated separatelyfrom the position of the central bank. If the gov-ernment would like to either eliminate or hedgeits foreign exchange position it must deal with theCNB. The central bank does not consider the gov-ernment’s foreign exchange position while struc-turing its reserves. The reason is that it would behard to differentiate between the position of thecentral government and positions of other institu-tions and companies financed from the central bud-get. For example in the Czech Republic, thegovernment owned a company dealing with gas.The company was buying gas from abroad and dis-tributing it here, meaning that this company’s assetswere in Czech koruny while its liabilities were in U.S.dollars. This was exactly the opposite of the centralbank balance sheet. If the dollar strengthenedagainst the koruna, the central bank booked a profitand the company booked a loss. This loss had to becovered from the central budget. The profit of thecentral bank is by law transferred to the central bud-get. Both the central bank and the company haveseparate budgets and it could happen that bothhave the same position (if the company decides tohedge its foreign exchange position). The questionis whether such a setup is enough to (i) have foreignreserves in the same structure as the company’s lia-bilities, and (ii) allow the company to avoid hedgingits liabilities against foreign exchange risk justbecause the loss is compensated by the centralbank’s profit. We believed that this is not a manage-able situation.


466. The CNB, since its inception after the fallof the old central planned economy, has per-formed all the functions, including reserve man-agement. In the Law of the CNB, internationalreserves management is defined as one of the mainactivities of the central bank. When carrying outthis activity, the CNB acts independently of the gov-ernment. The reserves are part of the balancesheet of the CNB. However, by the same law, all theproperty of the CNB, including the reserves, is thestate property, which the CNB is mandated to man-age. Therefore it is sometimes difficult to point outthe legal owner of reserves. The CNB can freelydeal with the reserves and the return on reserves ispart of the CNB’s total performance. The bank’snet profit, after appropriation to certain funds, istransferred to the central government budget. Theperformance report that provides the details of theCNB’s profits and losses is submitted every year tothe Lower House of the Czech parliament. Theabove description confirms the central bank’s inde-pendence from the government and parliament,but also points out that its operations are undercertain supervision of the government andParliament. This kind of supervision creates pres-sure on providing positive and stable return, indi-rectly influencing the risk profile of reserves.

467. The CNB Board, which is the highest deci-sion-making level in the CNB, approves the basicstrategy of reserve management and the permissibleinstruments. The strategy is defined by setting thecurrency allocation and maximum duration, andstipulating rules for credit and operational risk man-agement and rules for portfolio management. Theexecutive director for risk management sets thecredit limits and the benchmarks (currency bench-mark within 5 percent from the strategic currencyallocation). The portfolio managers cannot deviatefrom the currency benchmark but can deviate fromthe duration benchmark up to ±20 percent only.The portfolio management rules permit deviationfrom the benchmark on credit quality, that is, invest-ment in securities issued by issuers other than thoseincluded in the benchmark. Two separate depart-ments—the Risk Management and TransactionsSupport Department and the Financial Markets


Department—provide for execution and control ofreserves management independently of each other.


468. The CNB is not required under any regu-lation, including an internal one, to publish detailson reserve management. However, it regularly pub-lishes the level of reserves in the “Statistics” sectionof its website and, in addition, in response to pub-lished standards of the IMF, it decided to changethe structure of the published information onreserve management in its Annual Report for2001. The new structure provides more informa-tion on the results achieved in reserve manage-ment rather than on the market conditions as wasthe case until now. The chapter on reserve man-agement now consists of absolute and relative per-formance and risk profile of reserves, includingcredit, interest, and currency risks. The CNB sub-scribes to the SDDS of the IMF and has been pub-lishing its balance sheet since the last decade.Information on the basic structure of reserves andforeign liabilities of the CNB can therefore beaccessed.

469. The foreign reserves management as awhole, including results, trading and settlementprocedures, control and check systems, informa-tion systems, and distribution of responsibility areaudited every year as part of the overall externalaudit of the CNB. The central bank does not carryout special audit of only the reserve managementfunction. The auditor is selected by public tender,its term is five years, and both the CNB Board andthe Minister of Finance must approve the selectedauditor. The performance of the CNB is notaudited by the highest auditing office but, as men-tioned above, the performance is submitted to theParliament. The Parliament can either agree or dis-agree with the report. If Parliament disagrees withthe report, the central bank is requested to provideadditional information and data.

Information systems

470. There are two major information systemsin use in the area of reserve management—one forthe front office and the other for the back office.

Both the systems have been developed internally.The decision to use internal capacity was made in1996. Until that time, the portfolio managers, therisk managers, and the settlement staff used PC-based applications such as Excel or Lotus. It was adilemma to choose between externally and inter-nally built systems. The rationale for choosing thelatter was that the CNB did not want to lose theoption to incorporate in the future its proceduresand methods for dealing, settlement, risk manage-ment, and accounting, which it would probablyhave to do if it chose the external system. Somefinancial limits also existed and influenced thefinal decision. Working with an external adviser,the basic content and structure of the system wasdesigned in such a way that it is flexible to futureinternal changes in terms of organization struc-ture, new products and instruments, new riskmethods, changes of the accounting standards,and similar demands. Until now we have been suc-cessful in implementing functions like real-timedistribution, deal entry, a database of historicalprices, and a database of approved instruments.Within the next two years, we plan to implementthe position keeping functionality and some of therisk measurement calculations, and connect thefront office with the back office system. The advan-tages of an internal system are that it is flexible andfriendly to changes, it is built under a controllablebudget, and other aspects like backup or emer-gency installation are less difficult to do from theoperational point of view. It is, however, unclear ifthese advantages are not offset by the fact that thesystem is still to be completed and the delay of fouryears limits the implementation of new risk mea-surement methods and introduction of new instru-ments. Because the project is in a very advancedstage, it was agreed that it should be finalized. Butthe planning and budgeting process and mainlythe control of the time schedule and budget arebased on the limited capacity of the CNB, whichsuffers a major handicap in IT projects comparedto external and specialized firms.

Human resources

471. In the field of the human resources, theposition of the CNB does not differ a great deal

7 • Czech Republic 97

from other central banks. On the position of port-folio manager, of which we have six positions, 24men have changed during the last 11 years. A verysimilar situation exists in the area of risk manage-ment, IT support, and open market operation. Thelimited financial capacity of the CNB to pay com-petitive salaries has resulted in most of our staffbeing fresh graduates from universities. We wouldlike to share an interesting and useful experimentthat was organized by the CNB together with theWorld Bank in 1991. Through the public tender, 25men were selected according to their knowledge ofmathematics, statistics, and English. These individ-uals were offered work in some commercial banksand in the central bank, mostly in treasury areas.They had to undergo a three-year course on finan-cial markets, instruments, and banking; severalshort seminars; and affiliations in commercialbanks abroad. The course was financed by the cen-tral bank and the commercial banks. The partici-pants of the course agreed to return the loan, inthe event they left the course before completion orif they left the banks they had joined. Currently,many of the successful participants have reachedthe highest levels of management in the centralbank, the commercial banks, and financial institu-tions in Czech Republic (e.g., vice governor of theCNB, executive director of risk management of theCNB, board member in Komercni banka and GECapital Bank, etc.).


Risk management

472. The CNB started active reserve manage-ment in 1991. At that time bank deposits were theonly instrument used for investment. Foreignexchange trading was used as an additional sourceof return. Risk management was “operated” byboth the front office and back office. The backoffice provided the liquidity structure and the deal-ers managed liquidity. There also was a book of lim-its for deposits with approved banks but limits were“impressionistic” rather than based on any strictformula or rule. The interest rate risk, the foreignexchange risk, and the operational risk were not

monitored. The reporting consisted of the gainsand losses from foreign exchange trading and didnot include mark-to-market valuation of termtrades such as forwards. Six dealers and four backoffice operators performed the entire reserve man-agement function. In 1992, the central bankbought its first security, the U.S. Treasury bill, andthereafter the risk management department wasestablished. The main task of the department wasliability management, credit risk management, andbenchmarking. With the help of the World Bankand neighboring central banks (the Austrian cen-tral bank mainly) the new book of limits was cre-ated based on the financial strength of the banks.The formula calculating the limits was a functionof the bank’s rating, capital, and assets. Theapproach is currently more sophisticated and theterm of the investment is considered, as a distinc-tion is made between the trading counterpart andthe debtor.

Benchmarking process

Interest rate risk

473. The benchmarking process started in1993 with simple benchmarks applied on each ofthe portfolios. They were combinations of generalmaturities such as one-week and three- monthLIBOR indices for the liquidity portfolios, and two-, three-, and five-year benchmark governmentnotes and bonds for the investment portfolios. Theoverall duration, calculated ex post, was around 1.5years in the very beginning, though the rationalefor choosing this duration is difficult to find out.This approach was changed in 1999 when the newbenchmark representing the entire reserve andtwo sub-benchmarks for each reserve currencywere set up. The benchmark is a composite of ageneral maturities index for the money marketpart and the external Merrill Lynch governmentindex for the medium- and longer-term part of theyield curve. The most important fact is that theoverall duration is derived from the objectives andtargets of reserve management. Duration is estab-lished based on the requirement that the portfolioshould not record a loss in any three-monthperiod. For setting the target duration, historicaltime series of yields on the relevant financial mar-


kets are used. In addition to historical data, themethodology for setting duration takes intoaccount the current situation in the financial mar-kets. If short-term interest rates are higher, thehigher is the interest rate risk that can be accepted.By historical statistical data, it is proved that byusing this approach the benchmark performs bet-ter by 5–10 basis points. This type of reset of thebenchmark is done quarterly and therefore hasmarginal impact on transaction costs. It is ourexperience that neither the internal nor the exter-nal (public) benchmark would help to decide whatduration and currency composition is ideal.

Currency risk

474. The currency risk was until May 1997 rel-atively easy to manage. The koruna was fixed to abasket of U.S. dollars and deutschemark, and thecurrency allocation of reserves was identical to thebasket. The U.S. dollar and deutschemark offeredthe two most liquid markets and absence of yielddiversification was compensated by the fact thatthere was no risk of accounting losses when thereserves were valued in domestic currency. In May1997, the CNB decided to float the koruna, and thebasket as an anchor for reserve currency allocationceased to exist. The deutschemark was declared asthe intervention currency and thus emerged largeforeign exchange risk because reserves were inboth U.S. dollars and deutschemark whereas thekoruna was floating. Taking into consideration, thecurrency of intervention, benefits of diversifica-tion, and the need to operate in liquid and effi-cient markets, it was decided to hold reserves onlyin U.S. dollars, deutschemark, and yen and the cur-rency allocation decision was based on the struc-ture of the balance of payments, that is, 65 percentin deutschemark, 30 percent in U.S. dollars and 5percent in Japanese yen. After three years, due toproblems with rating of Japan and its banking sys-tem, it was decided to hold reserves in U.S. dollarsand euros. The allocation of reserves into thesecurrencies takes into account various factors, animportant one being investment diversification.The aim is to attain the most stable income possi-ble given the exchange rate between the reservecurrencies. When setting the ratio between the two

currencies in the international reserves, the CNBanalyzes the historical time series of the yields onU.S. and European markets and the EUR/US$exchange rate. Other factors taken into considera-tion include the nature of the domestic foreignexchange market, where EUR/CZK is the mostimportant and most traded currency pair. Based onthese considerations, the currency compositionwas set at 73.4 percent for euros and 26.6 percentfor U.S. dollars.

Credit risk

475. Credit risk issues can be divided into twogroups: issues relating to the selection of theissuers of the financial instruments used forreserves management, and issues relating to theselection of business partners for the execution ofreserves management transactions. The soleacceptable issuers are the governments and centralbanks of OECD countries as well as certain govern-ments and international organizations (e.g., theWorld Bank) and selected banks from those coun-tries. Moreover, maximum maturity is limited to 10years for government bonds and 3–6 months forclaims on banks (depending on the bank’s rating).The credit risk management is based on two sets oflimits—one for banks and financial institutions asthe CNB’s counterparties, and the other for banksand financial institutions as debtors of the CNB. Inboth the cases, the limits are calculated by using aformula that is a function of rating, capital, andsize of assets. The minimum rating of banks asdebtors is individual C, long-term A-, and mini-mum assets of US$10 billion. Any exception can bemade only by the Board of the central bank in writ-ing with a fixed termination.

Operational risk

476. Operational risk control is based on thesplit between responsibilities for execution and forthe benchmarking and settlement at the highestmanagerial level. There are two departments cover-ing the reserve management, and their executivedirectors report directly to the board. One is respon-sible for trading and execution, the second isresponsible for risk management, settlement, nostro


accounts management, and for IT support. The dataregarding the execution are passed on from thefront office to both risk management and the backoffice. The back office also provides data about thesettlements to the risk management. Within the riskmanagement department, all the data are comparedand the final position of the bank is created everyday. The back office monitors the credit limitsbefore the trades are settled, while the risk manage-ment monitors limits at the end of the day. Thedirector of risk management has the right to stopthe settlement if unauthorized trades are submittedto the back office. Since the executive directors incharge of execution and control are different, it isdifficult to manipulate the results.

Experience with external managers

477. The CNB has had quite a long experiencewith external managers. The experience has beenexpensive and rather negative. During the last sixyears there were six mandates. The first two weresigned in 1996. The goals at that time were to test ifthe internal benchmarks were realistic and to bene-fit from transfer of know-how. However, the exter-nal managers’ performance was worse than that ofthe internal managers and the activity of externalmanagers’ was almost five times lower than that ofthe internal managers. The mandates were, there-fore, terminated in 1999. In 2000, another threemandates were signed. This time the target was totest new instruments and ways of foreign exchangerisk management. One mandate was supposed totest Pfandbriefs with a maturity of up to five years;the second one U.S. agencies’ global notes; and thethird one’s role was to replicate our benchmark’sbasket of currencies of 35 percent in U.S. dollarsand 65 percent euros and to invest on a hedgedbasis in 12 other major government markets. Allmanagers ranked among the biggest firms and,except for one (FFTW), all managers were chosenby tender. The same reporting requirements wereapplied and the amounts under management werearound US$100 million. Even here the experiencewas negative since all managers had sizable prob-lems with reporting (in one case two CNB expertshad to visit the manager and help with the report-ing system) and their activity was, in general, much

lower than the activity of the internal managers andtherefore know-how transfer was very limited.Finally, the fees paid to the managers were higherthan the relative performance. The benefits of hav-ing external managers were that it helped buildcontact with the asset management industry, pro-vided the results of the tests, and confirmed theright approach to reporting. Despite the negativeexperience, we are preparing another set of man-dates that would test for U.S. corporate bond port-folio management, mortgage-backed securities(MBS), and foreign exchange trading. These arethe areas of limited capacity of the CNB.

478. The external managers’ portfolios aresubject to the same performance measurementrules and are used to verify and assess certain pro-cedures that could potentially also be used forinternal reserves management. These externallymanaged portfolios constitute approximately 2.3percent of the reserves.

Operations in efficient markets

479. The CNB currently invests its reserves inonly euro- and U.S. dollar-denominated depositsand government bonds. Almost by definition thesemarkets are considered as the most liquid and effi-cient. That is why we do not test and analyze thedepth of these markets.

480. It is important to note that one of theweak points of reserve management is that theCzech law is different from the international one,mainly the U.S. and the U.K. law, according towhich most of the agreements are governed. Thedifference means that there are not enoughlawyers familiar with the international laws andthere have been very few events where these twodifferent types of laws have been tested in thecourt. In the event of some legal dispute, theuncertainty is high.

Dilemmas in Reserve Management

481. Finally, the following is a list of dilemmasthat must be solved generally and that the CNB iscurrently working on. The first dilemma is cur-rency allocation versus the fact that the reserve’sbiggest foreign exchange risk comes from the defi-



nition of reserves (i.e., the reserves are in currencyother than the domestic and accounting cur-rency). The foreign currency risk in a floatingexchange rate regime (meaning an unhedgeableposition) is so large and hopefully the horizon solong that it is not clear if it makes sense to deal withcurrency allocation of reserves unless one takes themarket view on the reserve currencies’ exchangerates against each other.

482. The second dilemma is how to treat theratings. Once the ratings express the probability ofcompanies to default and once the central bankbases the credit limits on rating, the question isshould the central bank differentiate between rat-ings of the banks and corporates. Why is it that nocentral bank has a problem with depositing fundsin an AA bank, while only a few central bankswould purchase AAA corporate debt?

483. The other dilemma is the link between thebenchmarks and their traditional functions. Thebenchmark usually serves as the set of risk con-straints expressed in assets that can be bought in themarket (portfolio of real bonds, index, etc.).Managing the portfolio against the benchmark canmean the effort to beat the benchmark or the effortto beat the market within the limits. Beating thebenchmark means that even a wrong investmentdecision may be considered in a relative sense as avalue addition, even if the “benchmark’s” invest-ment performs worse. Beating the market meansthat the portfolio manager is able to exploit the mar-ket opportunity and by definition would performbetter than the benchmark. Our external managerstried predicting the yields within certain horizons;they went short or long and took maximum dura-tion positions, while our internal managers focusedprimarily on replicating the benchmark. The com-parison of these two approaches applied on our

benchmarks during the last six years is by far in favorof internal managers. So the question is at what levelthe asset managers should take the market view—when setting up the benchmark or when managingthe portfolio?

484. There is also another dilemma linked tothe benchmark. Today it becomes standard to mea-sure the risks by statistical methods. We can eithercompare the duration of two “portfolios”—whereone is the real portfolio and the second is thebenchmark—or we can compare two VaRs—whereone is the value at risk of the real portfolio and thesecond is just the limit number meaning how muchwe are prepared to lose. However, apart from therisk, benchmarks are used for performance mea-surement despite the fact that the benchmark maynot provide the best investment alternative.Therefore one can eliminate the benchmark port-folio for risk measurement purposes and measurethe performance against an “ex post” calculatednumber. The proposal is that every day we can forcertain markets and certain instruments (like theU.S. Treasuries market) calculate the best invest-ment opportunity. And this best investment oppor-tunity would be declared as the benchmarkedperformance for the previous day. To avoid the sit-uation where the benchmark consists of one bond,some minimum holdings would have to be applied.Also, calculating the best investment out of severalhundreds of bonds might be technically difficult.Therefore the best investment calculation wouldbe done on a narrow set of bonds (instruments)that would best represent the market moves.

485. If the above methods are put together, thenew benchmark would consist of VaR limit andreturn of the best overnight (alternatively over acertain period) investment alternative and no“benchmark as portfolio” would be needed.

486. This paper discusses the principles andpractices of reserve management in the HongKong Monetary Authority (HKMA). It further out-lines the framework of our risk management sys-tem, which helps to achieve our statutory roles and our long-term investment objectives in a risk-controlled manner.

Developing a Sound Governance and Institutional Framework

The Exchange Fund of Hong Kong

487. Hong Kong’s Exchange Fund was estab-lished in 1935 by the Currency Ordinance (laterrenamed the Exchange Fund Ordinance). Since itsinception, the Exchange Fund has held the back-ing to the note issues of Hong Kong. In 1976, therole of the Exchange Fund was expanded. Theassets of the Coinage Security Fund, which held thebacking for coins issued by the government, andthe bulk of foreign currency assets held in the gov-ernment’s General Revenue Account were trans-ferred to the Exchange Fund to enhance its abilityto regulate the exchange value of the Hong Kongdollar.

488. On April 1, 1993, the HKMA was estab-lished by merging the Office of the Exchange Fundwith the Office of the Commissioner of Banking.This was done to ensure that the central bankingfunctions of maintaining monetary and banking

stability can be performed with a higher degree ofprofessionalism and continuity, in the lead-up to1997 and beyond, to command the confidence ofthe people of Hong Kong and the internationalfinancial community.

Statutory role of the Exchange Fund

489. The Exchange Fund’s statutory role, asdefined in the Exchange Fund Ordinance, is pri-marily to safeguard the exchange value of the cur-rency of Hong Kong. Its functions were extendedwith the enactment of the Exchange Fund(Amendment) Ordinance of 1992 by introducing asecondary and subsidiary role of promoting thestability and integrity of the monetary and financialsystems, and maintaining Hong Kong as an inter-national financial center.

Objectives of reserve management

490. The investment strategies for theExchange Fund should at all times be consistentwith the objectives of the Exchange Fund. With theprimary statutory purpose to safeguard theexchange value of the Hong Kong dollar, coupledwith the need to repay the fiscal reserves moneydeposited with the Fund on demand, there is aneed to maintain a high degree of liquidity of theExchange Fund assets. As the reserves represent astore of value for the future, a secondary objective

102

8Hong Kong SAR

is to maintain the long-term purchasing power ofthese reserve assets. The four key objectives for themanagement of the Exchange Fund are:

• to preserve capital;

• to ensure that the entire monetary base will be at all times fully backed by highly liquid short-term U.S. dollar-denominatedsecurities;

• to ensure sufficient liquidity for the purposeof maintaining monetary and financial sta-bility; and

• subject to the above, to achieve an invest-ment return that will preserve the long-termpurchasing power of the assets.


491. The authority for the investments heldby the Exchange Fund rests with the FinancialSecretary, who consults with the Exchange FundAdvisory Committee (EFAC) to establish the long-term strategic investment direction of theExchange Fund.

492. While the long-term strategic investmentstrategy is set by the EFAC, the day-to-day manage-ment of the Exchange Fund is carried out by theReserves Management Department of the HKMA.In carrying out its responsibilities, the ReservesManagement Department operates under the del-egated authority from the Financial Secretary andwithin investment policy approved by the EFAC.

Management of the Exchange Fund

Portfolio segregation before October 1998

493. Prior to October 1998, the HKMA identi-fied three main operational functions of the assetsheld in the Exchange Fund. The three operationalportfolios were:

• a portfolio of assets to act as a hedge againstthe interest-bearing liabilities of theExchange Fund (i.e., deposit placementsfrom the Hong Kong Government), toensure that the Exchange Fund can at alltimes meet all of the claims upon it;

• a portfolio of liquidity reserves to be avail-able whenever required to meet marketoperational needs; and

• an investment portfolio to preserve thevalue of the Exchange Fund for future gen-erations of the people of Hong Kong.

494. The investment management styles forthese three portfolios were different. For thehedge portfolio, a mix of money market and fixedincome securities denominated mainly in U.S. dol-lars was held to match the maturity profile of theliabilities. The prime consideration in choosing theinvestments for this portfolio was the credit stand-ing of the issuers; this was to provide maximumsecurity for the assets and ensure that holders ofthe Exchange Fund’s liabilities (i.e., ExchangeFund Bills and Notes) have the greatest protectionand assurance that those liabilities will at all timesbe honored.

495. For the liquidity tranche, the ExchangeFund held prime liquid U.S. dollar-denominatedmoney market securities. The choice of U.S. dol-lars is partly because the U.S. dollar remains thebase currency for the foreign exchange markets ofthe world and for the HKMA’s market operations,and partly because the U.S. market is the largestand most liquid in the world, enabling a very largesum of funds to be mobilized, if required, withoutdisrupting the global financial market.

496. The investment portfolio was a multicur-rency portfolio invested in the major money mar-kets and fixed income markets of the world, with asmall holding in foreign equities. The majority ofthe assets was denominated in U.S. dollars, reflect-ing the fact that our base currency is linked to theU.S. dollar.

Portfolio segregation after October 1998

497. In September 1998, the Monetary Basewas redefined to include Exchange Fund Bills andNotes in addition to Certificates of Indebtedness, coinsin circulation, and the aggregate clearing balancemaintained by banks with the HKMA. In order toenhance the transparency of the operation of thecurrency board arrangements, a Backing Portfoliowas created by designating certain asset and liabil-

8 • Hong Kong SAR 103

ity items in the Exchange Fund as those specificallyrelated to currency board operation.

498. From October 1998 to date, the ExchangeFund is managed in only two distinct portfolios,namely the Backing Portfolio and InvestmentPortfolio. The Backing Portfolio was establishedsuch that the monetary base is at all times fullybacked by foreign reserves and that the changes inthe aggregate size of the monetary base corre-spond to the inflows and outflows of funds. Assetsin the Backing Portfolio are therefore short-term,highly liquid U.S. dollar-denominated interest-bearing securities to fully back the monetary base.

499. The balance of the assets of the ExchangeFund that constitutes the Investment Portfolio isinvested in OECD bond and equity markets to pre-serve the long-term purchasing power of theFund’s value for future generations of Hong Kong.

Redefining investment benchmark

500. In 1998, three events led us to conduct, atthe end of the year, a major revision of the invest-ment strategy of the Exchange Fund.

• First, the decision was taken to allow the fis-cal reserves, from April 1998, to earn areturn that is the same as that for theExchange Fund as a whole.

• Secondly, the HKMA purchased a largeamount of Hong Kong stock in August 1998through market operations.

• Thirdly, the assets of the ex-Land Fund weremerged into the Exchange Fund inNovember 1998.

501. Having regard to the above considerations,a new investment benchmark was constructed forthe Exchange Fund in 1999. This investment bench-mark has been in use since then. The principles andmethodology to construct this investment bench-mark are described in further detail in paragraphs538–542. The new investment benchmark definedin January 1999 and the previous benchmark arepresented in Table 17 in simple terms.

502. Over the years, the Exchange Fund hasembarked on a greater use of the long-term capitalmarkets by diversifying into new markets andinstruments. As shown in Table 18 below, the cur-rent strategic investment benchmarks permit theExchange Fund to invest in greater numbers ofbond, equity, and currency markets than previouslyallowed in 1995.

Adequacy of Hong Kong’s foreign currency reserves

503. As of end March 2002, the foreign currencyreserve assets stood at US$110.2 billion, whichplaced the Hong Kong SAR Government’s foreignreserves as the fourth largest in the world afterJapan, Mainland China, and Taiwan. These reserveassets represent over seven times the currency in cir-


Table 17. Investment Benchmark of the Exchange Fund

Investment Benchmark Investment BenchmarkSince 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

Table 18. Permissible Markets for Investment of theExchange Fund

2002 1995

Bond markets 26 19Equity markets 23 1Currency markets 21 13

culation, or 43 percent of Hong Kong dollar M3,one of the highest ratios in the world. Hong Kong’ssubstantial official reserves provide backing for theHong Kong dollar and offer a valuable—and grow-ing—source of security for future generations.

504. Experience suggests that Hong Kongneeds considerably more in foreign reserves thanthe bare theoretical minimum to maintain currencystability. Despite the fact that we have probably themost robust exchange rate system—by design andas a result of our continuous efforts to strengthen itever since its establishment in October 1983, it isalso true that our exchange rate system, character-ized by Currency Board Arrangements, onlyrequires our monetary base, currently at HK$233billion, to be fully backed by foreign reserves ofabout US$30 billion at an exchange rate of 7.8. It is,however, incorrect to take the view to consider thistheoretical minimum as all we need in foreignreserves.

505. The crucial lessons from the Asian finan-cial turmoil in July 1997 and the excessive volatilitythat rocked the financial markets in 1998 high-lighted the importance of strong reserves, prudentmanagement of the Fund, and the critical role ofrisk management in the investment process.

506. During the initial attack on our currency inOctober 1997, the robustness of our exchange ratesystem automatically transferred the pressure on theexchange rate to our interest rates, without the needto use foreign reserves in the Exchange Fund otherthan those dedicated to backing the monetary base.Reflecting the severity of the currency attack, ourovernight interest rate went up for a short while toover 200 percent, and interest rates for long-termmoney also rose sharply. This caused a lot of pain, tothe community and speculators alike.

507. In August 1998, the attack on the cur-rency came again and was many times more severethan in 1997. In that incident, we sold foreignreserves of about US$10 billion for Hong Kongdollars, in anticipation of the drawdown of fiscalreserves deposited with the Exchange Fund, andrelieved some of the pressure on the exchange rateand obviated the need for a repeat of the verysharp interest rate hike of 1997. We also sold largesums of foreign reserves for Hong Kong dollars forthe purchase of Hong Kong stocks equivalent to

US$15 billion. Thirdly, we made the monetary basemuch bigger in order to reduce the sensitivity ofinterest rates to inflows and outflows of funds. Thisinvolved committing another US$13 billion asadditional backing.

508. It should be noted that we had, in fact,mobilized the foreign reserves amounting to a fewtimes the then-theoretical minimum requirementof US$12 billion in the foreign reserves for the pro-vision of 100 percent backing to the monetarybase. We were able to do so without causing abreakdown of confidence in monetary and finan-cial management in Hong Kong on the part of theinternational financial community, to a largeextent because we had significantly more foreignreserves in the Exchange Fund than the sumsmobilized and we had no liabilities other than thefiscal reserves deposited there.

509. A strong position of foreign reserves cansafeguard the ability of the HKMA to deliver, whennecessary, the statutory purpose of the ExchangeFund, which is to defend the exchange value of theHong Kong dollar and to maintain the stability andintegrity of Hong Kong’s monetary and financialsystems. This also supports our role as the lender oflast resort. In order to maintain the stability ofHong Kong dollars under the Currency BoardSystem, the size of foreign reserves we need isprobably “the more the better.” This foreign cur-rency reserve involves a natural buildup processthrough inflow of capital, investment gains, orincreases in fiscal placements.


510. Hong Kong’s Legislative Council definesand limits the HKMA’s powers and responsibilities,and sets out the Monetary Authority’s accountabil-ity to the Legislative Council under Article 64 ofthe Basic Law. But the HKMA also recognizes abroader responsibility to the community of HongKong SAR, and a duty to promote an understand-ing of our role and objectives, and to keep our-selves informed of community concerns and opento public debate.

511. To this end, the HKMA pursues a policy oftransparency and accessibility. This policy has twomain objectives:


• to keep the financial industry and the gen-eral public as fully informed of the HKMA’swork as possible; and

• to ensure that the HKMA is in touch with,and responsive to, the community that itserves.

Measures to increase transparency of disclosure

512. Prior to 1992, the accounts of theExchange Fund were confidential. However, inkeeping with the commitment to greater trans-parency in disclosure, the government started pub-lishing the accounts of the Exchange Fundannually in 1992. Biannual accounts have beenpublished since June 1995, and headline figuresfor the foreign exchange reserves have also beenreleased monthly since January 1997.

513. Over the past years, we have done a greatdeal to advance the policy of transparency andaccessibility. The major milestones to enhance thetransparency of disclosure are displayed in Table19. This applies to technical matters such as theincreased transparency of the currency board sys-tem, the daily publication of the size and composi-tion of the Monetary Base, and the virtuallyreal-time publication of the Aggregate Balance ofthe Banking System. In addition, we extend the

information available for general public consump-tion in print, through the press, on the Internet,and in our programs of educational briefings, sem-inars, and large-scale exhibitions.

514. The considerations of market sensitivity,commercial confidentiality, and statutory restric-tions on disclosure of confidential informationwill, of course, place some limits on the amount ofmaterial we can make public. Given the increasingtransparency and the extremely limited discretionover the currency board arrangements, whichdraw their credibility from a strict rule-based sys-tem, a certain constructive ambiguity is also neces-sary if we are to have the flexibility to dealdecisively with sudden crises. Within these limits,we are committed to developing our policy oftransparency, and to increasing the quality andcomprehensibility of the materials we put out forpublic consumption.


Delegation and control of investmentmanagement of the Exchange Fund assets

515. The delegation of investment authorityfor managing the Exchange Fund assets is achieved


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 Fundbiannually.

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 inaccordance with IMF’s Special Data Dissemination Standard(SDDS).

• Started publishing monthly data on Analytical Accounts of theCentral Bank in accordance with IMF’s SDDS.

• Started publishing monthly Abridged Exchange Fund BalanceSheet and Currency Board Accounts.

April 2000 • Started publishing Template on International Reserves andForeign Currency Liquidity in accordance with IMF’s SDDS.

through a 3-level framework, covering three basictypes of investment decisions:

• Long-term strategic decisions controlled bythe EFAC;

• Medium-term market decisions delegated tothe senior management down to theExecutive Director level; and

• Short-term trading and anomaly tradingdecisions delegated to portfolio managerlevels.

516. This 3-level framework of investment deci-sion is reviewed every year to reflect any requiredchange or amendment to the control and delega-tion structure.

Risk management framework

517. In developing the risk management frame-work, the HKMA draws upon the best market prac-tices of asset management in the private sector andapplies these practices in determining the parame-ters for managing risks. The risk managementframework serves to achieve two main objectives:

• identify and assess the financial and opera-tional risks; and

• allow the management of risks within accept-able parameters and levels.

518. The Risk Management and ComplianceDivision is responsible for day-to-day monitoringand control of six major types of financial andoperational risks, namely:

(i) Market Risk;

(ii) Credit Risk;

(iii) Liquidity Risk;

(iv) Currency Risk;

(v) Settlement Risk; and

(vi) Operational Risk.

Market risk control

519. Overall market exposure is defined by theExchange Fund’s Preferred Neutral Position(“PNP”) and tactical deviation limits for each assetclass, market segment, and currency type. A weekly

Asset Allocation Meeting of senior executives andreserves management staff is held to review invest-ment strategies for the overall Exchange Fund andthe allocations to both internal and external man-agers as well.

520. The overall EF assets will be consistentlytested by Value-at-Risk (“VaR”) and scenario stresstesting, which are used to quantify the market risksinherent in the portfolios under normal andextreme adverse market conditions. Extremeadverse market events include a stock crash anddrastic bond yield shift in 1987 and currency crisisin 1994.

521. Using a market-based risk managementmodel, a weekly report to evaluate both absoluteand relative (to benchmark) VaR is made at a 95percent confidence level for a 1-month horizon.The calculation of expected market risk/loss takesinto account the price volatility of all asset classes,market segments, and correlation across marketsgiven a specified time horizon and decay factor. Inaddition, VaR in both U.S. dollar and percentageterms is monitored to ensure that the ExchangeFund is not unduly exposed to market risk at anypoint in time.

522. Stress testing is employed to test theimpact of a simultaneous recurrence of the worstequity, bond, and currency market crashes in thepast 20 years on the total Exchange Fund assets.

523. Both VaR and scenario stress test reportsare submitted to the EFAC meeting for review.

Credit risk control

524. With the delegation by EFAC, the CreditReview Committee (“CRC”) is established to beresponsible for the following objectives:

• Monitor credit risks within parameters set bycredit policy

• Review credit policy to meet the new invest-ment policy requirements and to controlcounterparty or issuer credit risks

• Evaluate and set the credit limits for issuer,bank, counterparty, and country

525. The Risk Management and ComplianceDivision supports the credit analysis and assessment


based on market-accessible information. The con-trol mechanism is segregated into 2 major areas:

• Centralize the credit assessment approachby standardizing the analytical framework interms of economic and financial perfor-mance, debt ratio, liquidity, capital, assetsize, and rating assessment by internationalcredit agencies; and

• Centralize credit line allocation for internaland external managers via CRC.

526. Day-to-day credit exposure control onindividual issuer, group level, and country levels isconducted through a pre-deal checking process forinternally managed assets. For external managers,we appoint the custodian managers to perform theinvestment and credit compliance checking func-tions on behalf of the HKMA, based upon the lim-its that we segregate for external managers. Atday-end, it is required to perform overall compli-ance checking on investment activities against thecredit and investment limits defined in ExchangeFund Credit Policy and Investment Policy as well.

Liquidity risk control

527. The Backing Portfolio was established inOctober 1998 to ensure that the monetary base isat all times fully backed by U.S. dollar assets. Theassets held in this portfolio should be securitiesthat have the highest liquidity and credit quality,and should at all times be available to meet theconvertibility obligation (e.g., HKMA sells US$1for HK$7.80) to all authorized institutions thatmaintain accounts with the HKMA and have accessto the local Real Time Gross Settlement system.

528. In addition, liquidity control measuresinclude the following major limits:

(i) Set percent limit of foreign currencyassets to be converted into cash within 2and 5 working days.

(ii) Set percent limits of overall ExchangeFund assets for deposit and for termdeposits over 1-month horizon.

(iii) Set bond issue or program size limits toensure efficient liquidation without dis-rupting the markets.

Currency risk control

529. The overall currency risk for the ExchangeFund can be determined with the combination ofthe benchmark currency mix and correspondingdeviation limits. The PNP of currency mix strategi-cally dictates the long-term currency exposure forthe overall Exchange Fund assets. This has takeninto account the long-term return and risk profile ofcurrency as an independent asset class, togetherwith all investment constraints such as the mainte-nance of adequate U.S. dollar assets to back themonetary base under the Currency Board System.

530. A list of authorized currencies is deter-mined on the basis of underlying investment mar-kets and the liquidity condition of each currency.At portfolio levels, we restrict the currency mix inaccordance with their respective investmentrequirements and constraints. In the case of theBacking Portfolio, it is restricted to U.S. dollarassets. Meanwhile, the currency exposures at otherexternally and internally managed investmentportfolios are subject to their underlying invest-ment benchmark and deviation limits.

Settlement risk control

531. In order to mitigate settlement risks, we standardize settlement instructions togetherwith using delivery versus payment (for bonds and equities), and payment versus payment meth-ods to reduce the potential loss from settlementfailure.

532. For externally managed assets, we use reli-able and reputable master custodians to centralizeand control the settlement workflow of externallymanaged assets by portfolio types in order to gainoperational efficiencies.

Operational risk control

533. A separation of reporting line to seniormanagement between settlement and dealing func-tions can achieve better control by avoiding poten-tial fraud or collusion of official reserve assetsamong front desk dealing staff.

534. Straight-through processing starts withdeal input, trade instruction, reconciliation of dealconfirmation, and finally to dispatch of standard-


ized settlement instructions (e.g., SWIFT mes-sages). After the deal is entered into the system,operational processing requirements, includingreport generation, account entry posting, and set-tlement, are electronically conducted in an auto-matic and uninterrupted workflow process.

535. Money market or repo facility is estab-lished at every nostro account with correspondingforeign commercial banks or central banks to rein-vest the residual idle cash balance accumulated atthe cutoff time of the domestic market. This is toensure even the unexpected account balances duefrom unsettled trades are fully invested.

536. Contingency plans for crucial modulesand off-site backup systems outside the main officeare established to control and mitigate system fail-ure risks due to unexpected system breakdown orpower failure or any disaster situation.

537. Regular and firm-wide checking of thecommunications network, including the internal e-mail system, is conducted to avoid communicationfailure risk.

Determination of investment benchmark andtactical deviation limits

538. The investment benchmark, whichdirected the long-term strategic investment, isexpected to meet the following investment objec-tives of the Exchange Fund:

(i) to preserve capital;

(ii) to ensure that the entire monetary basewill be at all times fully backed by highlyliquid short-term U.S. dollar-denomi-nated securities;

(iii) to ensure sufficient liquidity for the pur-pose of maintaining monetary and finan-cial stability; and

(iv) subject to (i)–(iii) above, to achieve aninvestment return that will preserve thelong-term purchasing power of the assets.

To quantify investment objectives and constraints

539. The investment objectives and constraintsmust be quantified for the optimization process:

(i) to preserve capital, it is required to set ahigh probability level that returns in theshort-, medium-, and long-term will notbe negative.

(ii) to ensure that the entire monetary base isat all times fully backed by liquid U.S. dol-lar assets, it is required to set a minimumpercentage of total portfolio holdings inliquid U.S. dollar assets.

(iii) to preserve the long-term purchasingpower of the assets, it is required to set areasonably high probability that theexpected benchmark portfolio returnshall exceed the long-term domestic infla-tion rate.

(iv) To measure the downside risk below thelong-term domestic inflation level, it isrequired to set the annualized shortfall inreturn against the long-term domesticinflation rate at an acceptably low proba-bility level.

To determine the permissible markets andinstruments

540. The investment management of ExchangeFund assets is expected to be conducted in well-established markets that have sufficient breadth anddepth to ensure that transactions can be efficientlyabsorbed in the market without undue effects on liq-uidity and the availability of funds. This is particu-larly the case for central banks, including theHKMA, as most transactions are typically in decentsize. We assess the liquidity of each market andinstrument by the following factors:

(i) bid/offer spread at both normal and cri-sis conditions.

(ii) dealing size at both normal and crisis sit-uations.

(iii) total portfolio holdings as a percentage ofdaily market turnover.

(iv) availability of repo market for each instru-ment type.

541. Since the monetary base requires suffi-cient backing by U.S. dollar assets under the cur-


rency board system, we maintain a minimum per-centage of total Exchange Fund (EF) asset hold-ings in U.S. Treasury products to ensure adequateliquidity. This prudent policy has proven to beessential based on the international crisis situationsexperienced in the past several years.

542. In summary, the Exchange Fund invest-ment objectives are quantified into expectedreturn, risk, and parameters of capital preservationand liquidity requirements. These parametersform the critical investment performance criteriain establishing the optimal new PNP, which istherefore expected to achieve the Fund’srisk/return objectives and other trade-offs withinthe framework of a long-term passive investmentpolicy.

Key features of optimization model to derive ourinvestment benchmark

543. A market well-tested optimization modelis used to construct the optimal mix of asset alloca-tion. Such a model overcomes the traditionalmean-variance optimization method, which suffersfrom a tendency to create unbalanced portfoliosfor closely correlated assets such as bonds.

544. Due to stringent liquidity requirements forall the securities, only the more liquid and devel-oped markets are included in the list of permissibleasset markets. All permissible asset classes and cur-rencies are included to conduct the optimizationprocess. Historical returns and correlation acrossall market segments are applied to find the riskmatrix, and such a risk structure is assumed to holdconstant to derive expected portfolio volatility. Noexpected return for individual asset class is pro-jected. We apply long-term equilibrium returns,which are consistent with market clearing levels forthe global market-cap weighted portfolio.

545. Institutional investors will typically set atarget portfolio risk for the investment benchmark.Instead of using a specific portfolio risk target, wetest the optimal asset allocation against a set of crit-ical investment performance criteria, which effec-tively reflects the control of overall portfolio risklevel.

546. With the calculation of the total portfoliorisk of investment benchmark, it is required to ana-

lyze the risk contribution of each asset class andmarket type. This process serves the following 3purposes:

(i) identify principal sources of risks by assetclasses and market segments.

(ii) ascertain that the risk exposures in theoptimal portfolio correspond to positionswhere we would like to take risk.

(ii) ensure that the portfolio risk is as evenlybalanced as possible across differentmajor international markets, includingcurrency types.

547. The risk decomposition of the investmentbenchmark is based on a risk contribution frame-work.34

548. Although the investment benchmark rep-resents an optimal asset mix for long-term invest-ment, reoptimization is required under the follow-ing scenarios:

(i) change of investment objectives and constraints.

(ii) failure to meet the critical investment per-formance criteria arising from structuralchange of market performance andvolatility structure.

Derivation of tactical deviation limits

549. The evaluation and selection of the invest-ment benchmark are based on the framework ofcritical performance criteria with return, volatility,and capital preservation parameters. We use thesame framework to stress test the tolerance of theExchange Fund PNP to additional volatility.Through incremental additional annual volatility,we establish that the PNP is able to tolerate an addi-tional level of annualized volatility and still pro-duce an acceptable performance when comparedto the critical performance criteria.


34Risk Contribution of nth asset = h(n)*Vector of Marginal Volatility______________________________ ,

σwhere h(n) is the nth element of the position vector ofMarginal Volatility = Σh/σ. (Σ: Covariance matrix)

( h: Portfolio position vector).

550. With the established overall trackingerror, a risk-based approach is used to calculate thepermissible tactical deviations for short- tomedium-term trading for currency composition,allocation by asset class, allocation by marketwithin each asset class, and duration of each bondmarket. This method is essentially a VaR approachused by institutional investors to control the risksarising from trading positions. This is also consis-tent with the risk/return optimization methodused to construct the Exchange Fund PNP.

551. All things being equal, the most volatileasset would logically be given the least permissibledeviation. In calculating the deviations, we adopt aconservative approach and apply the permissibledeviation for the most volatile market segment asthe maximum permissible deviation for the assetclass containing such market segment.

Performance measurement framework of theExchange Fund

552. The monthly performance attributionanalysis identifies the out-/under-performance of aportfolio compared to its investment benchmark.It decomposes total active return into variousreturn attributes relative to the benchmark return.Based on our current setting, attribution analysis isdivided into 2 levels: (a) fund allocation effect, (b)portfolio management effect. Each of them is fur-ther divided into various active return attributesaccording to the style of management, selection,manager skill, and other factors.

Fund allocation effect (i.e., overall assetallocation effect)

553. Fund allocation effect is the contributionto return due to the management’s withdrawalfrom or increased allocation to different (externalor internal) portfolios or investment types of port-folios. At the moment, we have over 10 types ofportfolios in different investment benchmarks.Under the fund allocation effect, there are 4 con-tribution factors, namely:

(i) Asset allocation effect

(ii) Country weighting effect

(iii) Currency effect

(iv) Benchmark adjustment effect.

Portfolio management effect (i.e., portfolio activereturn)

554. This is the active return at portfolio levelsrelative to their benchmarks. From end of 1999, webegan to use a market-based multifactor model toanalyze the active returns of bond portfolios by fac-tors of duration, curve steepness, curvature, andselection effect.

555. In the near term, another market basedmultifactor model is used to identify the sources ofactive returns from active equity mandates. The riskfactors of equity analytical models are as follows:

(i) U.S. equity model—Market cap, EPSratio, BP ratio, net earnings revision, EPStorpedo, historical beta, price reversal.

(ii) Global equity model—Market cap, EPSratio, BP ratio, earnings growth, averagedividend yield, long-term debt/assetratio, volatility of ROE, volatility of EPS.

556. In addition, we internally maintainreturn-based attribution for investment managerswith the following framework:

(i) Alpha [α]: residual return component,i.e., to measure the ability of managers inthe selection of securities.

(ii) Down-market Beta [β]: to measure port-folio exposure to benchmark in a down-market.

(iii) Gamma [γ]: to identify a manager’s skillin managing market exposure againstbenchmark at times of down-market andup-market.

(iv) Information Ratio (IR): Measurement ofrisk-reward trade-off given an investmentmanager’s added value and excess volatil-ity over benchmark.

557. We apply some quantitative methods suchas the Sharpe ratio and an information ratio torespectively measure the portfolio risk-adjustedreturn and assess the effectiveness of use of infor-mation by managers.


Challenges of reserves management in theHKMA

Increased mobility of international capital flows

558. The world economy becomes increasinglymore integrated. This is evidenced by global syn-chronization in financial markets and increased cap-ital flows among countries, particularly fromindustrialized into emerging economies. Most cen-tral banks, if not all, are therefore facing potentiallylarge and abrupt inflows and outflows of capital,especially portfolio flows. Extreme care is needed inmanaging their reserves and, in some cases, totighten the liquidity criteria to quickly respond toexternal shocks. This has disturbed the manage-ment of foreign exchange reserves and appeared tobe contradictory to the diversification requirementsuggested by the portfolio management theory.

Global financial market synchronization

559. The value-at-risk approach used by theHKMA to measure the expected market risk isbased on assumptions of a normally distributedreturn series and a stable risk structure, i.e., stablereturn correlation across asset classes and marketsover time. These notions tend to underestimateactual market loss due to a breakdown of “nor-mal” price behavior across market segments attimes of stress events. With global market syn-chronization and increased complexity of invest-

ment instruments, such risk has become evenmore evident. Stress risk management can be con-sidered to address the above issue. This is to deter-mine risk capital based on a preset high standarddeviation event and a covariance matrix with theassumption of perfect correlation across all mar-ket segments. The accumulated risk capital allo-cation should then be limited to a percentage oftotal capital size of a fund to avoid undue marketexposure.

Use of derivatives to implement reservemanagement strategies

560. In the long term, the supply shrinkage ofgovernment securities due to improving budgetpositions will cause central banks to keenly look forviable investment alternatives. While many centralbanks remain very cautious, some central bankshave made use of derivatives to better manage mar-ket risk and liquidity risk. On the asset side, throughthe use of futures, it is possible to achieve durationstrategy while maintaining a better liquidity profile.On the liability management side, central banksresponsible for this have made extensive use ofinterest rates and currency swaps for issuing debt toadjust the risk characteristics of their portfolios. Theuse of derivatives requires more advanced risk man-agement and IT system development to support thetransactional processing, account posting, and over-all portfolio risk assessment.


Reserve Management Objectives andCoordination

Reserve management objectives

561. According to the Central Bank Act, one ofthe basic responsibilities of the National Bank ofHungary (NBH) is the management of foreignexchange reserves. The primary purposes of man-aging foreign exchange reserves, as for every cen-tral bank, are the following:

• support for the monetary policy (interven-tion),

• transactional purposes (supporting debtmanagement, controlling crisis situations),

• wealth management objectives.

562. In the past couple of years, with the eco-nomic development of the country and with theimprovement of credit ratings and debt serviceratios, the direct transaction objectives—such assupporting the repayment of debt—have beengradually losing their weight. At the same time, sup-port of the monetary policy has become the princi-pal reserve management objective. One way toensure the credibility of the exchange rate system isto hold an adequate level of reserves that can sup-port the inflation targeting system in the form ofintervention, if needed. Although the cost of hold-ing reserves has significantly decreased with thecountry’s improving credit ratings, the NBH still

would not like to build reserves for the pure pur-pose of wealth accumulation. As stated above, theNBH aspires to manage reserves so as to helpachieve the goals of monetary policy efficiently,meet the requirements of debt service, and, at thesame time, try to optimize the return on thereserves without jeopardizing the above-mentionedgoals.


563. The reserve management policy of theNBH is defined by the Monetary Council (MC). TheMC decides on the currency composition of foreignreserves, and interest and credit risk exposure. Itapproves the applied investment instruments andthe list of business partners. Furthermore, accord-ing to the investment guidelines and the returnrequirements, the MC determines the benchmarkportfolio. The MC monitors the results of thereserve management activity on a quarterly basis.

564. While the MC is a strategic decision-makingbody, the Asset and Liability Committee (ALCO) isresponsible for tactical decisions related to reservemanagement. The ALCO holds a meeting at leastonce a month. The ALCO makes decisions on thedeviation from the strategic benchmark and on themodification of operational limits. The ALCO alsomonitors closely the activity of the reserve manage-ment unit in charge of the implementation of dailyinvestment and liquidity management operations.

113

9Hungary

565. An independent risk management unit isresponsible for the evaluation of daily businessactivities and monitors compliance with the opera-tional limits. This unit is in charge of the elabora-tion of the risk management policy and thereporting systems the senior management. Theunit also sets up and maintains the benchmarkindices for the portfolio managers.

Determinants of reserve management policy

566. There are four special country character-istics that guide Hungary’s reserve managementpolicy:

• small open economy

• emerging/converging country

• relatively high foreign currency debt

• quasi-ERM-II exchange rate regime with nocapital controls

567. Hungary is a small open economy with anexport/GDP ratio above 60 percent. This meansthat exchange rate developments have substantialinfluence on inflation. Hence, to run a successfulexchange rate policy, Hungary must have sufficientforeign exchange reserves.

568. Hungary is an emerging/convergingcountry, with fast developing but still less liquiddomestic financial markets. This means that thecentral bank cannot easily build up and down

reserves via foreign exchange market operations.In addition, the costs of holding foreign exchangereserves (spread between borrowing and invest-ment rates) are, although decreasing, still negative.These facts must be taken into consideration whendetermining the adequate size of reserves.

569. Around 30 percent of the state debt is inforeign currency. The primary source of theannual EUR 2–3 billion debt service is the NBH’sforeign exchange reserves. Hence, the size andcurrency structure of the debt service are animportant input to set the reserves managementpolicy.

570. The country’s primary objective is to jointhe European Union and then the Economic andMonetary Union. The NBH is already running aquasi-ERM-II exchange rate regime with no capitalcontrols. The currency is pegged to the euro with aplus/minus 15 percent fluctuation band. In orderto give credibility to the band, the NBH must haveadequate reserves in the current “quasi” and laterin the real ERM-II system.

Optimal currency structure

571. Prior to 1999, the NBH was responsiblefor the foreign currency borrowing of the country.So taking the gross currency structure first, wematch the foreign currency liabilities of our bal-ance sheet. This means we hold EUR, US$, and JPYin our foreign exchange reserves.

572. In taking the net open currency positionagainst the domestic currency, the HungarianForint, we take into consideration the followingfactors:

• currency of intervention;

• HUF basket;

• orientation of external trade; and

• macro level asset-liability considerations.

573. As stated above, Hungary is running aquasi-ERM-II system, where the central parity ofthe HUF is 100 percent pegged to the euro. As aconsequence, more than 80 percent of the inter-bank HUF/foreign currency spot market turnoveris against the euro. This means that the naturalintervention currency is the euro.


0

50

100

150

200

250

300

1994 96 98 2000 02

Spread over Bund (in basis points)

Figure 7. Hungary’s Five-Year Credit Spread over Bund, 1994 –2002

574. Hungary is becoming increasingly inte-grated into the European Union. Hence, the cur-rency structure of external trade, especially in thecompetitive sector, is more denominated in euros.This is also true for foreign direct investments andportfolio investments.

575. The currency benchmark for foreign cur-rency debt of the government, managed by theState Debt Management Office, is 100 percenteuro. To provide a hedge on a macro level, we takethis fact into consideration when determining theoptimal net currency structure to the extent it doesnot conflict with other objectives of holdingreserves.

576. To summarize, the euro has a dominantpart in the foreign exchange reserves. The domi-nance of the euro is justified by the fact that theHungarian forint is 100 percent pegged to theeuro, the objective of the country is to join the EUas soon as possible, the currency composition ofgovernment debt denominated in foreignexchange, and the fact that the intervention cur-rency in the domestic market is the euro.

Adequate size of reserves

577. In setting the adequate size of reserves, wetake the following into consideration:

• nature of present and future foreign ex-change regime;

• Guidotti rule;

• ratios to monetary aggregates;

• foreseeable and potential future cash flows;

• hot money potentially leaving the country in3–6 months;

• access to foreign exchange markets;

• access to foreign capital markets;

• cost of holding reserves; and

• international comparison.

578. The level of reserves should be sufficientlyhigh to support the current quasi-ERM-II, and thefuture real ERM-II foreign exchange regime. Toperform this task, the reserves must meet theGuidotti rule, i.e., the reserves should cover the

one-year liabilities of the whole country. Also, thelevel of reserves must be at least as high as the mon-etary base. Behind this, one can find the argumentthat to defend the currency, the system could be atany time theoretically converted into a currencyboard.

579. To keep the level of reserves in a desirablerange, we try to quantify the foreseeable andpotential cash flows. Debt principal and interestpayments account for the biggest part of foresee-able outflows, amounting to $2–3 billion in the firstpart of this decade and falling sharply in lateryears. The government’s foreign currency borrow-ings are the biggest potential inflows. The NBHcoordinates closely with the authorities responsiblefor debt management in order to harmonize poli-cies. Privatization revenues are another possiblesource of inflows. These were considerable in the1990s, but, looking ahead, NBH does not expecthuge amounts from this source.

580. Stress tests are performed to see howexternal or internal shocks can affect the size ofreserves in a three- to six-month horizon. We moni-tor nonresidents’ holdings of government securitiesand equities, the open foreign exchange positionsof the domestic commercial banks, the liquidity ofthe domestic interbank foreign exchange market,etc. Using our own and international historical evi-dence during currency crises (like the 1998 Russiancrisis and the 2001 Argentine crisis) we estimate thepotential outflow in a three- to six-month period, aperiod during which internal policy adjustmentscan be executed, or after which foreign capital mar-kets can be accessed again.

581. Rarely is the central bank entirely free insetting the exact level of reserves. Even in the caseof an efficient foreign exchange market of thedomestic currency, the central bank can purchaseor sell domestic currency for reserve level adjust-ment purposes under normal market conditions.In the case of Hungary, it was only in 2001, afterfull foreign exchange liberalization, that the liq-uidity of the HUF spot market reached a levelwhere the NBH could purchase foreign currencypurely for foreign exchange reserve managementpurposes (to cover interest payments on the for-eign state debt), without effectively affecting HUFmarket exchange rates. To minimize the impact on

9 • Hungary 115

the exchange rate, it was executed in a transparentway, in equal, market-conform preannouncedamounts (EUR 2.9 million a day, total EUR 374 mil-lion). Independent of this positive experience,when planning the future course of reserve levels,we conservatively do not take into account foreignmarket sales or purchases.

582. As the rating of the country is improving,access to international capital markets is gettingrelatively easier and easier. It means the necessarysize of reserves can be lower than before, since theNBH does not have to build high precautionarybuffers. The NBH has a formal agreement with theMinistry of Finance that for reserve replenishmentpurposes, the government is ready to execute bor-rowing transactions any time the central bankrequests it. Moreover, in the future, other sourcessuch as automatic borrowing facilities in the ERM-II system will be available.

583. Looking at the cost of holding reserves(see Figure 8. where, as a proxy, we used the rele-vant credit spread), there is a clear tendencytoward lower costs. Nevertheless, it is still negative;so, as in the past, the NBH does not intend to holdhigher reserves than necessary. The lower cost ofholding only means that the NBH can tolerate big-ger swings in the size of reserves. Going forwarduntil the prospective EMU-entry, we expect the costof holding to approach zero.

584. Finally, to verify actual levels of reserves weregularly carry out international comparisons.Taking a longer period we look at figures likeimport coverage, ratios to monetary aggregates,reserves to GDP, etc. Concentrating mainly oncountries with similar features as Hungary, weexamine how successfully different countries runmonetary and exchange rate policies with differentlevels of reserves.

Investment policy

585. With respect to the classical investmenttriad (return-liquidity-safety), the investment phi-losophy of the NBH is to achieve maximum returnon reserves while maintaining the highest attain-able liquidity and safety. Appropriate safety in thiscase relates to the obligation of the central bank topreserve the value of reserves held on behalf of thecountry. Concerning this special responsibility,reserve management is supposed to consider theappropriate risk level that allows a minimum prob-ability of loss of capital in a certain given year.Liquidity requirement means the ability to providean adequate amount of funds for a possible imme-diate foreign exchange market intervention. Theadequate amount of funds has to be available withthe lowest attainable cost and capital loss. Theobjective of maximizing returns ought to be con-sidered only if all the liquidity and safety require-ments are met. Developing this approach in theinvestment policy allows us to favor active againstpassive portfolio management.

586. In the process of developing the invest-ment guidelines, the main objective of the NBHhas been to adopt the best practices of centralbanks of developed countries. Like all centralbanks in the world, NBH has conservative guide-lines that try to avoid instruments with high volatil-ity and not permit investment in equities. Themaximum time to maturity of bonds in the portfo-lio is ten years and the required rating is AA-AAA(by the big rating agencies). Our liquidity require-ments with the mentioned maturity and rating con-siderations determine the available instruments inthe bond market. Therefore, NBH holds mainlygovernment, supranational and governmentagency issues of developed countries. The suffi-


0

2

4

6

8

10

12

14

1991 93 95 97 99 2001

Figure 8. Size of Official Foreign Exchange Reserves(1990–2002; in billions of U.S. dollars)

ciently high level of reserves and the developmentof bond markets in the last ten years allowed us togradually increase the size of AA rated securitieswith excellent liquidity features in the bond port-folio. This part of the portfolio bears higher yieldwithout adding significant risk.


587. In 1999 and 2000, IMF addressed theseissues in several proposals. The NBH joined theFund’s Special Data Dissemination Standard amongthe first central banks. According to the currentpractice, the NBH discloses the size and internalstructure of its reserves monthly with a 20-day lagusing IMF’s Data Template on InternationalReserves and Foreign Currency Liquidity.

588. The management of our bank partici-pated in meetings in Basel and Washington, D.C.,where the framework of the Guidelines for ForeignExchange Reserve Management was negotiated.Together with other central banks, we consideredthe proposed Guidelines in full detail and pro-vided our bank’s 10–15 years of experience con-cerning this issue. Since the approval of theseproposals, the National Bank of Hungary hasadopted most parts of it.


Risks incurred by the NBH

589. Risks incurred by the NBH in managingforeign exchange reserves are primarily of a credit,liquidity, and market nature. Within credit risks, wecan distinguish counterparty and spread risks.Concerning market risks, we put the emphasis onthe currency and the interest rate (yield curve) expo-sures. There is a framework in place for identifyingand managing these risks on an integrated andcentralized basis in line with best homologue35 andmarket practices, building on four key elements:

• system of partner and issuer ratings;

• system of partner, issuer, and sectoral limits;

• restrictions concerning eligible assets and trans-actions; and

• internal two-stage benchmark procedure—allowing for a certain range of permitteddeviation—concerning sectoral allocation,duration, and currency composition.

Investment instruments

590. Authorized investment instruments are

• bonds (authorized embedded options: put,call, cap, floor);

• minimum AA rated sovereign;

• supranationals (incl. BIS);

• AAA agency papers;

• AAA Pfandbrief;

• min. AA corporate bonds;

• min. AA commercial papers;

• min. AA or tri-party repos, buy-sell-back, andsell-buy-back agreements;

• AAA unsubordinated tranches of asset-backed securities;

• “plain vanilla” OTC bond options (put/call,long/short);

• interest rate futures and IRF options;

• interest rate swaps, currency swaps; and

• money market depos, rating: min. AA withcertain exemptions.

591. Among the derivative instruments, onlyplain vanilla structures are permitted. (The mini-mum criterion to be a plain vanilla instrument isthat we can price and analyze an instrument in our internal position-keeping and risk manage-ment system.) The primary condition for deriva-tive deals is the existence of ISDA MasterAgreement and mark-to-market agreement withour counterparties.

Portfolio structure

592. Similar to the practice of other centralbanks, the NBH distinguishes a liquidity and an

9 • Hungary 117

35With special attention to the ECB and the connectedEuropean NCBs.

investment portfolio. The liquidity part is held tosatisfy daily foreign exchange cash-flow needs, suchas interest and principal payments of governmentdebt, interventions, special transactions, and trans-fers. The term structure of these cash flows is partlypredetermined (by interest and principal pay-ments) and partly uncertain (foreign exchangeintervention needs). Since the investment horizonof this portfolio is very short, the NBH avoids therisk of interest rate movements in this segment.The other stable part of our portfolio has longerinvestment horizons and higher return require-ments. The fact that the probability of liquidationof this part of the portfolio is low allows our bankto hold bonds with longer time-to-maturity charac-teristics as long as the market movements and theshape of the yield curve justify this. According tothe result of our optimization process, we holdaround 20 percent of the whole amount of reservesin the liquidity portfolio and the rest in the invest-ment portfolio.

Benchmarking

593. NBH implemented a two-stage benchmark-ing system. The benchmarking policy, the actualstrategic benchmarks concerning currency, interestrate, and credit structure of the investment portfo-lio, as well as the permitted deviations from thesebenchmarks, is set by the Monetary PolicyCommittee (MPC) in the annual Risk ManagementPolicy Guidelines.

594. Tactical benchmarks, set by the ALCO, maydeviate from the strategic ones within predefinedranges. Empirical evidence shows that ALCO devi-ated from the strategic benchmark only in case ofmajor trend reversals (i.e., 1–2 times a year). Thismeans the ALCO does not alter the benchmark inperiods of normal business conditions.

595. In line with the tactical portfolio bench-marks, a separate Risk Management Departmentmaintains internal model portfolios that serve as oper-ational guidelines for portfolio managers. Portfoliomanagers may deviate from the benchmark withinthe predefined ranges so as to take advantage offavorable market conditions. Model portfolios areupdated and investment portfolios are evaluatedagainst the appropriate benchmarks and modelportfolios on a monthly basis. The bonuses of port-folio managers are linked to performance vis-à-visthe benchmark.

Use of external managers

596. In the second part of the 1980s and thefirst part of the 1990s, the NBH used externalportfolio managers. The altogether rather mixedexperience showed that the services of externalmanagers are most useful when building upreserve management activity (i.e., to learn) orwhen they can provide facilities a central bank can-not easily establish. Currently, the NBH uses exter-nal portfolio managers only for its securitieslending programs.


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10India

Introduction

597. The Indian approach to determining ade-quacy of foreign exchange reserves has evolvedover the past few years. Various factors, rangingfrom the pioneering Report of the High LevelCommittee on Balance of Payments (Chairman:Dr. C. Rangarajan) to Governor Jalan’s expositionof the combination of global uncertainties, domes-tic economy, and national security considerationsin determining liquidity at risk and thus assessingreserve adequacy (Paragraphs 23 and 24 ofStatement on Monetary and Credit Policy, April 29,2002), have contributed toward the process ofdevelopment of such an approach.

598. The three components of India’s foreignexchange reserves include Gold, Special DrawingRights (SDRs), and Foreign Currency Assets(FCAs). The last item, however, accounts for themajor portion. As of September 6, 2002, out of theUS$62.1 billion of total reserves, India’s FCAsstood at $58.8 billion; gold accounted for about$3.2 billion, the rest being SDRs. In July 1991, as apart of reserve management policy, and as a meansof raising resources, the Reserve Bank of India(RBI) temporarily pledged gold to raise loans. Thegold holdings thus played a crucial role in reservemanagement at a time of external crisis. Sincethen, gold has played a passive role.

599. In quantitative terms, the level of foreignexchange reserves has steadily increased from $5.8

billion as of end-March 1991 to $54.1 billion as ofend-March 2002 and further to $62.1 billion as ofSeptember 6, 2002.



600. India’s objectives of holding reserves, inbroader terms are:

• maintaining confidence in monetary andexchange rate policies;

• enhancing capacity to intervene in foreignexchange markets;

• limiting external vulnerability by maintain-ing foreign currency liquidity to absorbshocks during times of crisis;

• providing confidence to the markets, espe-cially credit rating agencies, to the effect thatexternal obligations can always be met, thusreducing the overall costs to the economy orthe market participants; and

• adding to the comfort of the market partici-pants, by demonstrating the backing ofdomestic currency by external assets.

601. At a formal level, the objective of reservemanagement in India could be found in theReserve Bank of India Act, where the relevant part

of the Preamble reads, “to use the currency systemto the country’s advantage and with a view to secur-ing monetary stability.” Monetary stability, in thisstatement, may be interpreted as internal as well asexternal stability, implying a stable exchange rateas one of the overall objectives of the reserve man-agement policy. While internal stability implies thatreserve management cannot be isolated fromdomestic macroeconomic stability and economicgrowth, the phrase “to use the currency system tothe country’s advantage” implies that maximumgains for the country as a whole, or the economy ingeneral, could be derived in the process of reservemanagement. This warrants taking a very dynamicview on the country’s requirements of reserves andhow best to meet such requirements.

Legal framework

602. In India, the RBI Act of 1934 contains theenabling provisions for the RBI to act as the custo-dian of foreign exchange reserves, and managereserves within the defined objectives. The powersavailable to the RBI as custodian of foreignexchange reserves are enshrined in the Preambleto the Act. The “reserves” refer to both foreignexchange reserves in the form of gold and foreignsecurities and domestic reserves in the form of“bank reserves.” The RBI Act also broadly indicatesthe desirable composition of reserves, minimumreserve requirements, and the instruments inwhich the country’s reserves could be deployed.

603. Specifically, subsections 17(12), 17(12A),17(13), and 33(1) of the RBI Act of 1934 define thescope of investment of foreign exchange reserves.The provisions, by way of severe restrictions on thecredit quality of counterparties/securities in theAct, reflect the RBI’s utmost concern about thesafety of foreign exchange reserves.

604. In brief, the law broadly permits the fol-lowing investment categories:

(i) Deposits with other central banks and theBank for International Settlements (BIS).

(ii) Deposits with foreign commercial banks.

(iii) Debt instruments representing sovereign/ sovereign-guaranteed liability (with resid-ual maturity not exceeding 10 years).

(iv) Other instruments/institutions as ap-proved by the Central Board of Directorsof the central bank.


605. The decisions on currency compositionand asset allocations are taken by the ReserveBank in consultation with Government of India.Within the RBI, while the major decisions relatingto currency/investment are made by a StrategyCommittee headed by the Governor/DeputyGovernor in charge of foreign exchange reservemanagement, the Department of ExternalInvestments and Operations is given some flexibil-ity with regard to currency composition to takeadvantage of market trends. Further, within theRBI, a “Financial Markets Committee,” comprisingheads of departments responsible for domesticdebt management, reserve management, andmonetary policies, facilitates day-to-day coordi-nated administering of policies.


606. On public disclosure, the RBI has beenconstantly endeavoring to ensure compliance withbest standards of transparency, in line with majorinternational central banks/reserve managementauthorities. Within the broader framework of mon-etary, fiscal, and financial policies, areas relating totransparency and disclosure constitute importantaspects of reserve management. The policy onreserve management as well as all relevant infor-mation are articulated through a variety of meansfrom time to time, the most significant being thehalf-yearly Monetary and Credit Policy Statementsby the Governor of the RBI. The speeches of theGovernor and Deputy Governors are importantsources of policy analysis, actions, and intentions.The Annual Reports of the RBI provide an authen-tic version of RBI’s perspective as approved by itsBoard. Periodical publications, Press Releases, andDiscussion Papers of the RBI provide additionalimportant sources of information.

607. The RBI has also been providing, on a reg-ular basis, appropriate data relating to foreignexchange market operations. The RBI publishes


daily data on exchange rates, forward premiums,and foreign exchange turnover and on a weeklybasis the movement in foreign exchange reserves,in the Weekly Statistical Supplement (WSS) of theRBI Bulletin. Data on nominal effective exchangerate (NEER) and real effective exchange rate(REER), RBI’s purchases and sales in the foreignexchange market, along with outstanding forwardpositions, are published in the RBI Bulletin with atime lag of one month.

608. The RBI has all along been ahead of cen-tral banks of many developing and industrial coun-tries in regard to publishing details on the size ofits gross foreign exchange market intervention(purchase and sale) and its net forward position.The daily reference rate of U.S. dollars and eurosas well as the middle rates for four major curren-cies, namely, U.S. dollars, pounds sterling, euros,and Japanese yen are made available by the RBIwebsite.

609. As a part of the Special Data DisseminationStandards (SDDS), the IMF has prescribed a datatemplate for disclosure of international reserves andforeign currency liquidity of countries that have sub-scribed to SDDS. India is among the 49 countriesthat have adopted the SDDS template for publica-tion of detailed data on foreign exchange reserves.The data template provides information on a num-ber of parameters, including currency composition(SDR and other currencies), deployment of foreignexchange reserves, and forward position. These dataare made available on a monthly basis, sinceOctober 2001, both through the RBI and IMF(SDDS) websites.

Principles, Policies, and Practices ofReserve Management

Reserve management operations

610. Currently, accretion to foreign currencyreserves arises mainly out of purchases by the RBIfrom Authorized Dealers. In addition, there isincome from deployment of foreign exchange assetsheld in the portfolio of the RBI. Aid receipts on gov-ernment accounts also flow into reserves. Outflow ofreserves arises mainly on account of sale of foreigncurrency to Authorized Dealers. There are occa-

sions when foreign exchange is made available fromreserves for identified users, as part of a strategy ofmeeting lumpy demand for foreign exchange. Thenet effect of purchases and sales of foreign currencyis the major determinant of the level of foreignexchange reserves. The sales or purchases alsoinclude those in forward markets, although suchtransactions are of a very small magnitude.

611. Decisions involving currency compositionand the maturity pattern of the investments aredriven by broad parameters of safety, liquidity, andprofitability. The choice of the highest possible qual-ity investment instruments and explicit constraintson critical portfolio variables, such as limits on vari-ous securities, currencies, counterparties, andsovereigns form the basic elements of reserve man-agement. Transactions are put through with coun-terparties, approved for the purpose. Counter-parties could be banks, subsidiaries of banks, orsecurity houses. Such counterparties are approvedby the RBI, taking into account their internationalreputation and track record apart from factors suchas size, capital, rating, financial position, and serviceprovided by them. While investments in securitiesare restricted to sovereign and sovereign-guaranteedinstruments, the residual maturity of these instru-ments cannot exceed 10 years. A good percentage ofreserves is invested in the money market, includingdeposits with top-notch international commercialbanks. Investments in new products/markets aredeliberated upon within the Department ofExternal Investments and Operations, by its“Investment Committee,” which meets at the start ofevery week before appropriate approvals aresought.

612. In practice, holdings of gold have beenvirtually unchanged and gold reserves are man-aged passively.

Evolution of reserve management policy in India

613. India’s approach to reserve management,until the balance of payments crisis of 1991, wasessentially based on the traditional approach, i.e.,to maintain an appropriate level of import coverdefined in terms of number of months of importsequivalent to reserves. For example, the RBI’s

10 • India 121

Annual Report 1990–91 stated that the importcover of reserves shrank to 3 weeks of imports bythe end of December 1990. Thus, the emphasis onimport cover constituted the primary concern, say,until 1993–94.

614. The approach to reserve management aspart of exchange rate management and, indeed,external sector policy underwent changes with theadoption of the recommendations of the HighLevel Committee on Balance of Payments(Chairman: Dr. C. Rangarajan) in 1992. The focusin deciding on the level of reserves was in factshifted to ensuring a reasonable level of confi-dence in the international financial and tradingcommunities in general and a plethora of factorsthat contribute to such confidence in particular.The extract given below provides evidence of thisshift in the approach.

“It has traditionally been the practice to viewthe level of desirable reserves as a percentage of theannual imports—say reserves to meet three monthsimports or four months imports. However, thisapproach would be inadequate when a large num-ber of transactions and payment liabilities arise inareas other than import of commodities. Thus, lia-bilities may arise either for discharging short-termdebt obligations or servicing of medium-term debt,both interest and principal. The Committee recom-mends that while determining the target level ofreserve, due attention should be paid to the pay-ment obligations in addition to the level of imports.The Committee recommends that the foreignexchange reserves targets be fixed in such a way thatthey are generally in a position to accommodateimports of three months.” (Paragraph 6.3)

615. In the view of the Committee:

“The factors that are to be taken into consider-ation in determining the desirable level of reservesare the need to ensure a reasonable level of confi-dence in the international financial and tradingcommunities about the capacity of the country tohonor its obligations and maintain trade and finan-cial flows; the need to take care of the seasonal fac-tors in any balance of payments transaction withreference to the possible uncertainties in the mon-soon conditions of India; the amount of foreign cur-rency reserves required to counter speculativetendencies or anticipatory actions amongst playersin the foreign exchange market; and the capacity to

maintain the reserves so that the cost of carrying liq-uidity is minimal.” (Paragraph 6.4)

616. As mentioned in the RBI’s Annual Report,1995–96, with the introduction of the market-determined exchange rate, a further change in theapproach to reserve management was warrantedand the emphasis on import cover was supple-mented by the objective of smoothing out thevolatility in the exchange rate.

617. Against the backdrop of currency crises inEast Asian countries in 1997 and in light of countryexperiences of volatile cross-border capital flows, itwas felt that there was need to take into considera-tion a host of factors, including the shift in the pat-tern of leads and lags in payments/receipts duringexchange market uncertainties. The RBI AnnualReport, 1997–98, emphasized that besides the sizeof reserves, the quality of reserves also assumedimportance. Thus, unencumbered reserve assets(defined as reserve assets net of encumbrancessuch as forward commitments, lines of credit todomestic entities, guarantees, and other contin-gent liabilities) were required to be available at anypoint of time to the authorities for fulfilling variousobjectives assigned to reserves.

618. As regards management of external liabil-ities, the policy of the RBI to keep forward liabili-ties at a relatively low level as a proportion of grossreserves and the emphasis on prudent reservemanagement were highlighted in the RBI’s AnnualReport, 1998–99.

619. The overall approach to management ofIndia’s foreign exchange reserves had undergonea further change during 1999–2000, reflecting thechanging composition of balance of payments andliquidity risks associated with different types offlows as elaborated in the RBI Annual Report,1999–2000. This is evident from the extract asbelow:

“The policy for reserve management is builtupon a host of identifiable factors and other contin-gencies, including, inter alia, the size of the currentaccount deficit and short-term liabilities (includingcurrent repayment obligations on long-term loans),the possible variability in portfolio investment, andother types of capital flows, the unanticipated pres-sures on the balance of payments arising out ofexternal shocks and movements in repatriable for-


eign currency deposits of non-resident Indians.”(Paragraph 6.30)

620. In recent years, while focusing on prudentmanagement of foreign exchange reserves, therehas been an emphasis on “liquidity risk” associatedwith different types of flows. In this context, the tra-ditional approach of assessing adequacy of reservesin terms of import cover has been broadened toinclude a number of parameters that take intoaccount the size, composition, and risk profiles ofvarious types of capital flows, as well as externalshocks to which the economy is vulnerable.

621. Governor Jalan’s statement on Monetaryand Credit Policy (April 29, 2002) provides an up-to-date and comprehensive view on the approachto reserve management:

“A sufficiently high level of reserves is necessaryto ensure that even if there is prolonged uncer-tainty, reserves can cover the ‘liquidity at risk’ on allaccounts over a fairly long period. Taking these con-siderations into account, India’s foreign exchangereserves are now very comfortable.” (Paragraph 23).. . . “the prevalent national security environmentfurther underscores the need for strong reserves.We must continue to ensure that, leaving asideshort-term variations in reserves level, the quantumof reserves in the long-run is in line with the growthof the economy, the size of risk-adjusted capitalflows and national security requirements. This willprovide us with greater security against unfavorableor unanticipated developments, which can occurquite suddenly.” (Paragraph 24)

622. The above discussion points to evolvingconsiderations and indeed a paradigm shift inIndia’s approach to reserve management. The shifthas been from a single indicator to a multiple indi-cators approach.36

623. Adequacy of India’s foreign exchangereserves at present could, however, be broadlyassessed in terms of various indicators as describedbelow:

• In terms of the traditional trade-based indi-cator of reserve adequacy, i.e., the import

cover (defined in terms of reserves inmonths of imports). While India’s foreignexchange reserves could cover only 3 weeks’of imports as of end-December 1990, theposition improved to about 11.5 months as ofend-March 2002;

• In terms of money-based indicators, the pro-portion of net foreign exchange assets of RBIto currency with the public sharply increasedfrom 15 percent in 1991 to 109 percent as ofend-March 2002 and the proportion of netforeign assets (NFA) to broad money (M3)increased more than six-fold, from 3 percentto 18 percent, during the same period;

• Debt-based indicators of reserve adequacyshowed remarkable improvement in the1990s and the proportion of short-term debt(i.e., debt obligations with an original matu-rity up to one year) to foreign exchangereserves substantially declined from 147 per-cent as of end-March 1991 to 8 percent as ofend-March 2001, whereas the proportion ofvolatile capital flows (defined to includecumulative portfolio inflows and short-termdebt) to reserves decreased from 147 percentin 1991 to 58.5 percent as of end-March 2001.Further, as part of sustainable external debtposition, the short-term debt componentdecreased from 10 percent as of end-March1991 to 3 percent as of end-March 2001.Similarly, the size of debt service paymentsrelative to current receipts decreased from 35percent in 1991 to 16 percent in 2001.


Risk management

624. The RBI has in place sound systems toidentify, measure, monitor, and control varioustypes of risk involved in reserve management.Broadly, risk management involves establishingparameters for:

(i) desirable currency mix and limits to facil-itate availability of convertible currencies;

10 • India 123

36For a subsequent substantive discussion on the issue, refer tothe Mid-Term Review of Monetary and Credit Policy for2002–2003 (paragraphs 30–34), RBI Bulletin, November 2002,available on the RBI website, www.rbi.org.in.

(ii) permissible range of investment instru-ments that meet liquidity and safetyrequirements; and

(iii) maturity or duration requirements toaddress interest rate or price risks.

625. The risks attendant on deployment ofreserves, namely, credit risk, market risk, liquidityrisk, and operational risk are detailed in the fol-lowing paragraphs.

Credit risk: Credit risk refers to risk arising outof default or delay in payment of obligations.Credit risk is addressed by putting in place aframework under which investment is made infinancial instruments issued by sovereigns,banks, and supranationals conforming to aminimum rating. For example, investments areinvariably made in papers issued by AAA ratedsovereigns and supranationals apart fromthose with BIS. As stated earlier a careful pro-cess of selection of counterparties and fixationof limits for each category of transactions isalso in place. Ratings given by internationalrating agencies and various other financialparameters are considered before grading andfixing limits regarding each counterparty. Theday-to-day developments regarding the coun-terparties are closely monitored.

Market risk: Market risk comprises currencyrisk and interest rate risk.

(a) Currency risk: Currency risk arises due touncertainty in exchange rates. Foreign cur-rency reserves are invested in multicur-rency, multimarket portfolios. In tune withinternational trends, RBI follows the prac-tice of expressing foreign exchangereserves in U.S. dollar terms. The seniormanagement is kept informed of the cur-rency composition of reserves through theweekly Management Information System(MIS) report.

(b) Interest rate risk: The central aspect of themanagement of interest rate risk for a cen-tral bank is to protect the value of the invest-ments as much as possible from the adverseimpact of interest rate movements. The

interest rate sensitivity of the reserves port-folio is measured and managed in terms ofbenchmark duration and permitted leewayfrom the benchmark. The emphasis is tokeep the duration short, which is in tunewith the approach to remain risk averse andkeep a liquid portfolio. The benchmarkduration and the leeway are suitably alteredkeeping in view the market dynamics.

Liquidity risk: The choice of instruments deter-mines the liquidity of the portfolio. Whilebonds and treasury bills of AAA ratedsovereigns are highly liquid, BIS Fixbis/ Discount fixbis can be liquidated at any time tomeet the liquidity needs. With the increasingfocus of central banks, academics, and marketparticipants worldwide on the adequacy ofreserves, the Department of External Invest-ments and Operations has been undertakingexercises based on stochastic models in order toestimate “Liquidity at Risk (LaR)” of reserves.

Operational risk: Internally there is a total sep-aration of the front and back office functions.The internal control systems ensure severalchecks at the stages of deal capture, deal pro-cessing, and settlement. The middle office isresponsible for risk measurement and moni-toring, performance evaluation, and concur-rent audit. The deal processing and settlementsystem is also subject to internal control guide-lines based on the principle of one point dataentry, and powers are delegated to officers atvarious levels for generation of paymentinstructions. To hold the dealers to a highdegree of integrity, a code of conduct has beenprescribed for them and an annual undertak-ing is obtained from each of them to ensurethat they abide by the code of conduct.

Custodial risk: A major portion of the securitiesare held by the central banks. While all U.S.Government securities are held with the FederalReserve, all gilts and Japanese GovernmentBonds (JGBs) are with the Bank of England andBank of Japan, respectively. All primary cashaccounts are with the central banks in theirrespective countries. BIS provides both custo-


10 • India 125

dial and investment services and accordinglythey are also the custodians for investments withthem. A small portion of other euro securitiesand assets managed by external asset managersare placed with carefully selected global custo-dians. The custodial arrangements are reviewedfrom time to time and the developments relat-ing to the custodians are tracked regularly toensure that the risk is kept to the minimum.

Audit and Management InformationSystem (MIS)

626. There is a system of concurrent audit inthe Department of External Investments andOperations for monitoring compliance with all theinternal control guidelines, independent of theprocess flows. Reconciliation of nostro accounts isdone on a daily basis for major currencies.

627. In addition to the annual inspection bythe Inspection Department of the RBI and statu-tory audit by external auditors, there is a system ofappointing a special external auditor to audit deal-ing room operations. The main objective of thespecial audit is to ensure that risk management sys-tems and internal control guidelines are adheredto by the Department.

628. A sound management information system(MIS) exists in the Department of ExternalInvestments and Operations for comprehensivereporting to senior management on all significantareas of activity. Reports are provided to seniormanagement, with their frequency depending onthe type and sensitivity of information.

Division of reserves into tranches

629. The guidelines for foreign exchangereserve management developed by the IMF indi-cate that a number of reserve management enti-

ties subdivide their reserves portfolio into“tranches,” namely, liquidity tranche and invest-ment tranche according to liquidity and invest-ment objectives and policy requirements. In thecase of the RBI, a system that creates an explicitdivision of the reserves of this kind is not in place.However, the RBI has two broad portfolios withindependent risk parameters, namely, the moneymarket portfolio and the bonds portfolio. Themoney market portfolio comprises instrumentswith maturity of less than one year and it is pre-dominantly guided by transaction and interven-tion needs. By its very nature (because of lowduration), the money market portfolio runs alower market risk (in relation to interest ratemovements). In contrast, the bonds portfolio con-sists of long-term holdings (up to a maximum of10-year residual maturity) of triple-A ratedsovereigns and supranationals.

External asset managers

630. A small portion of the reserves has beenassigned to external asset managers with the objec-tives of gaining access to and deriving benefit fromtheir market research. It also helps to take advan-tage of the technology available with asset man-agers while utilizing the relationship to obtain therequired training/exposure for the central bank’spersonnel dealing with foreign exchange reservemanagement. The asset managers are carefullyselected from among the internationally knownasset management companies. They have beengiven clear investment guidelines and benchmarksand their performance is evaluated at periodicintervals by a separate unit within the middleoffice. External asset managers’ views and out-look on international bond and currency marketsare examined and taken as input by operationalpersonnel.

126

11Israel

Background

631. Israel’s foreign-exchange reserves areowned and controlled by the central bank, Bank ofIsrael (the Bank), which is therefore the “reservemanagement entity,” as defined by Guidelines.Within the Bank, the Foreign Currency Department(Department) is responsible for performing thereserve management function, under the directionof the Governor of the Bank.

632. The size and role of Israel’s foreign-exchange reserves have evolved over the 17 yearssince the 1985 Stabilization Program, which markeda watershed in the country’s economic history. Theearly years of this period were characterized by afixed exchange rate, which served as a nominalanchor for the price-level and a target for monetarypolicy, accompanied by a strict currency-controlregime and the absence of significant interbanktrading in foreign currency. In this environment, thereserves portfolio served as a “buffer” for capitalflows, with the Bank intervening in the market on adaily basis.

633. Over the last decade or so, the focus ofmonetary policy moved from exchange-rate target-ing to inflation-targeting, the exchange-rate regimewas gradually liberalized, foreign-currency controlswere all but eliminated (with the last restrictions dueto be lifted at the end of 2002), and an active inter-bank foreign-exchange market, in which the Bankhas not intervened for several years, developed. The

exchange-rate regime is now defined by a band forthe value of the sheqel against a basket of curren-cies, with the lower bound fixed, while the upperbound increases by 6 percent per year. As of early2002, the width of the band, relative to its midpoint,was around 45 percent. The Bank has declared apolicy of nonintervention within the band, but iscommitted to defending the band’s limits until suchtime as it is formally abolished. The past decade wasalso witness to a substantial increase in the size of thereserves, which tripled in dollar value from 1994 to1998, while the ratios of the reserves to various otheraggregates increased by lesser degrees. This increasewas primarily due to intervention by the Bank in thelocal foreign exchange market, to defend the limiton sheqel appreciation set by the band.


Objectives, scope, and coordination of Israel’sreserves management

Objectives

634. In conjunction with the evolution of eco-nomic policies and circumstances described above,the Bank’s understanding of the purposes servedby the foreign-exchange reserves has changed anddeveloped, a process that remains ongoing. Basedon the experience of other countries and the rele-

vant academic literature, the Bank has identifiedfour principal goals that are served by holding thereserves portfolio:

• Reducing the probability of a crisis in thelocal foreign-exchange market. Although, asnoted, the Bank’s stated policy is not to inter-vene within the limits of the band, the knowl-edge that it has access to substantial reservesof foreign currency serves to reassure bothresidents and foreign investors, on the onehand, while deterring speculative attacks onthe other. However, it should be emphasizedthat the importance of the reserves in thisregard is secondary to that of sound andcredible macroeconomic policies that sup-port economic and financial stability.

• Providing a strategic reserve of liquidity, foruse in a market crisis—should one neverthe-less develop—together with other tools, suchas the interest rate, or for use in a nationalemergency. In such situations, a high level ofreserves improves the resilience of the econ-omy and expands the range of options avail-able to policymakers.

• Improving the standing of the country ininternational capital markets, where many ofthe players view the level of a country’s for-eign-exchange reserves as an important indi-cator of its financial stability.

• Providing the government with a degree offlexibility in managing the composition ofpublic-sector debt. Since the government canbuy foreign currency from the Bank at will, itcould choose to fund part of its foreign-cur-rency expenditures (debt service or otherexpenses) from local-currency sources (taxesor borrowing) rather than from income ornew borrowing in foreign currency. However,excessive use of this option could impair theability of the reserves to serve the other goalslisted.

635. In contrast with the evolving state of theBank’s purposes for holding reserves, the Bank’sobjectives in managing the reserves have remainedfairly stable over the years, although the means ofachieving them have been refined and adapted to

changing circumstances. Though not formallyadopted in this language, the Bank’s investment pol-icy has been developed on the basis of the followingobjectives for reserves portfolio management:

• Preserving the real foreign purchasing powerof the reserves. This goal finds expression inthe currency composition of the reserves, themanagement of their interest-rate risk, andthe limitations on credit risk.

• Maintaining a high degree of liquidity. Thisgoal is met mainly via limits on the types ofassets that may be included in the reservesportfolio.

• Subject to meeting the first two objectives,earning a reasonable rate of return on theportfolio. This goal has influence on thechoice of portfolio duration, the level ofcredit risk accepted, and the decision toemploy active management.

636. A further objective of the reserves man-agement process, though one clearly subordinateto the three listed above, is the accumulation ofinformation and expertise that can be of value toother core functions of the Bank, such as the for-mulation of monetary policy or exchange-rate pol-icy (as noted in Guidelines, Sec. I, Par. 2.).

Scope and coordination

637. Management of the foreign-exchangereserves is closely linked with the formulation andconduct of exchange-rate intervention policy, witha number of individuals at various levels havinginvolvement in both.37 As noted above, the reservesmanagement process also provides valuable infor-mation resources to the makers of domestic mone-tary policy.

638. Under current policy, the Bank is notinvolved in liability management,38 nor are thereserves managed with a view to hedging the inter-

11 • Israel 127

37However, under the Bank’s current policy of noninterven-tion, “conduct” of intervention policy is limited to informa-tion-gathering activities, so long as the exchange rate is withinthe band.38Other than the use of short-term repurchase agreements fortactical liquidity management.

est-rate exposure of Israel’s foreign-currency liabil-ities. Israel’s foreign-currency borrowing is man-aged by the Ministry of Finance. Traditionally, themaintenance of a “Chinese wall” between thereserve manager and the liability manager hasbeen seen as an important safeguard for thereserves’ unencumbered status, the value of whichoutweighed any advantages that might be obtainedfrom coordination between the Bank and theFinance Ministry. (This issue is currently beingreexamined.) However, the currency compositionof Israel’s short-term debt service is a factor in set-ting the currency composition of the reserves (seeparagraph 649 below).


Legal foundation and structure of internalgovernance

639. The Bank of Israel’s authority to own andmanage the foreign-exchange reserves of the coun-try is based on The Bank of Israel Law, 5714–1954,and on the legal interpretations that have beendeveloped around it over the course of the years. Itshould be noted that the law and its interpretationsprimarily address the types of foreign-currencyassets that the Bank may own and the counterpar-ties with whom it may transact.39 Thus, manyaspects of the Bank’s investment policy and gover-nance framework for the reserves are matters ofinternal Bank policy.

640. The main directives regarding manage-ment of the reserves portfolio in its various aspects,and the degree of leeway allowed to the Departmentin each aspect, are set by the Foreign CurrencyCommittee, which is chaired by the Governor andincludes senior managers from various departmentsof the Bank. The Department reports to the ForeignCurrency Committee on current developments ininternational markets, on the performance of theportfolio and the various investment decisions madeby the Department, and on any alterations in the

parameters of the Bank’s investment policy that theDepartment wishes to propose.

641. Investment decisions of the Department,within the boundaries set by the Foreign CurrencyCommittee but beyond the leeway allowed to indi-vidual portfolio managers, are discussed in theInvestments Committee, which is chaired by theDirector of the Department and attended by staffmembers of the front and middle offices and byback-office managerial staff. The InvestmentsCommittee meets weekly to review market devel-opments and front-office positions, as well as toconsider investment decisions within its purviewand recommendations to the Foreign CurrencyCommittee. It should be noted that the role of both theInvestments Committee and the Foreign CurrencyCommittee is advisory, rather than authoritative, sinceresponsibility for their decisions is ultimately borne by theofficers chairing them (the Director of the Department andthe Governor, respectively).

642. Investment decisions within the boundariesset by the Investments Committee are made by port-folio managers, with the approval of the head of thefront office (which is normally always given). Seniorportfolio managers are responsible for one or morenonoverlapping portfolios, typically defined by cur-rency and range of maturities. They are assisted inthis by junior portfolio managers, who may be givenresponsibility for part of a portfolio, and by trader-analysts (see below). No organizational separation ismade between trading and portfolio managementactivities. The application of the above principles toactive management of the reserve portfolio is dis-cussed further in paragraph 662, below.

Staff

643. As stated in the Guidelines (Sec. IV, Par.36), “appropriately qualified and well-trainedstaff, following sound business practices” are anessential element of the framework for reservemanagement. The Department’s personnel policyin recent years has been based on the followingprinciples:

• The Department’s goal is to employ tenured,long-term employees who become knownwell. Thus, staff members of the front, mid-dle, and back offices are regular employees


39In brief, the Bank is permitted—within the framework of thereserves—to own gold, foreign currency, and securities thatare issued or fully guaranteed by a foreign government, toinvest in bank deposits and CDs, and to utilize derivatives suchas futures and options, provided the underlying asset is of atype that the Bank is permitted to own.

of the Bank, governed by the same collective-bargaining agreements as staff members ofother departments.

• When vacancies occur in the front office,they are normally filled by probationaryemployees who are recent MA-level honorsgraduates in economics or finance, withoutprior financial market experience. Practicaltraining as a trader-analyst thus takes placeon a tabula rasa, and is oriented toward thespecific needs of the Bank. A combination ofinternal and external training is employed.Needless to say, all employees must be eligi-ble for appropriate security clearances.

• At the end of a four- to five-year probationaryperiod, trader-analysts who show exceptionalability are offered permanent employment asportfolio managers. Those who are notoffered permanent appointments typicallyfind that the experience gained in reservemanagement is well respected by potentialemployers in the private financial-servicesindustry. A similar employment cycle appliesto the middle office.

• Compensation is on the same pay scales asprofessional staff with graduate training inother departments of the Bank. As a matterof policy, there are no direct incentives toemployees based on trade performance.

• Front and middle office staff members withpermanent appointments generally remain intheir positions on the order of a decade (withquite substantial variation around this mean).Rotation to posts in other departments of theBank (including managerial positions) is anoption for those who come to desire a changeor suffer professional burnout. In past years,front and middle office “alumni” have alsomoved on to senior economic posts in otherbranches of the public sector.

Transparency and accountability in thereserves management process

Operational risk management

644. As a manager of public funds, the Bank isparticularly sensitive to issues of security and oper-

ational risk, and it strives constantly to maintainhigh standards of practice in this area, consistentwith the norms of the financial services industry inthe developed world and with reasonable cost-ben-efit trade-offs. Among the most important aspectsof the Bank’s control procedures are the following:

• The organization of the Foreign CurrencyDepartment and its established work prac-tices. These have been designed to reduce thepossibility of loss due either to human erroror to intentional misconduct. Standard work-ing procedures, which are documented andenforced, include routine verification andauthorization procedures. The use of com-puter systems, which include automated con-trols procedures, is extensive. And there is analmost absolute division of authority andresponsibility, on both an organizational andpersonal level, in the Department’s primarytasks—transacting trades, processing trades,sending payment instructions, accounting,and auditing—so that a single individual doesnot have the ability to process a trade, sendpayment instructions, or alter records.

• Control functions carried out by variousunits within the Department. In addition tothe back office, which performs a numberof checks in the regular course of process-ing trades, and the Department’s auditingsection, which reconciles all transactionsafter settlement, there is a staff member—the System Controller—who follows alltransactions processing on a real-time basis,and who reports directly to Departmentmanagement.

• Monitoring by authorities outside the Depart-ment. These include the Comptroller’sDepartment, which prepares the Bank’s dailyfinancial statements, checks accounts, andauthorizes the proper accounting scheme inthe general ledger; the Bank’s InternalAuditor, who performs regular comprehen-sive examinations of specific topics within theForeign Currency Department, reporting tomanagement of the Department and theBank; and the public accounting firmemployed as External Auditor by the Bank,

11 • Israel 129

which audits the Department’s activities oncea year and reports its findings in writing to theGovernor of the Bank.

• Management’s follow-up. Every irregularoccurrence in the operational process isdocumented, with instructions for correc-tive action to prevent a recurrence. Once ayear, a general overview of control proce-dures is undertaken. Needless to say, anyrecommendations of the external and inter-nal auditors are also given the most seriousconsideration.

• Codes of conduct. All Foreign CurrencyDepartment employees are subject to theBank’s rules of conduct, which include spe-cial rules on conflict-of-interest for staff withmarket contact. Such staff members are alsorequired to be familiar with, and to follow,the ethical codes of the markets in whichthey trade. The Department is currentlystudying this issue, with a view to drawing upa Departmental Code that would incorporateall the existing rules and possibly extendthem.

Disclosure

645. For many years it was the Bank’s practicefor the Department to prepare an Annual Reportfor use within the Bank, which was submitted to theGovernor and members of the Foreign CurrencyCommittee (see paragraph 640), with a very briefsummary included in the Bank’s Annual Report. In2001, the Department’s Annual Report was pub-lished separately, and in 2002 it was included in fullin the Bank’s Annual Report. These documentsprovide the public with extensive information onthe Bank’s objectives, investment policy (notincluding precise currency composition), andinvestment performance in absolute terms and rel-ative to benchmark. They can be viewed on theBank’s website, at http://www.bankisrael.gov.il/publeng/publeng.htm. Up-to-date monthly dataon the foreign-exchange reserves, in the form pre-scribed by the IMF Template, can also be foundthere, at http://www.bankisrael.gov.il/deptdata/mth/imf/imfdata.htm.

Assessing and Managing Risk

Investment policy and benchmark portfolio

646. The Bank of Israel’s investment policycomprises the standards and procedures adoptedby the Foreign Currency Committee, which ensurethat management of the reserves is in accord withthe Bank’s long-term preferences, objectives, andstrategies. It provides for conservative limits on theportfolio’s exposure to various financial risks, themain ones being currency risk, interest-rate risk,and credit risk. (There are additional risks, such asliquidity risk (paragraphs 667–669) and operationalrisk (paragraph 644).) The Bank’s investment pol-icy defines a risk-neutral benchmark portfolio forthe reserves, and limits the deviations of the actualportfolio from the benchmark in terms of the vari-ous financial risk factors. These deviations may bethe result of active management, or may be due tothe operational limitations of transacting in finan-cial markets. The limits on each risk factor areapplied independently; synergistic risk measuressuch as Value at Risk (VaR) are monitored, but cur-rently have no formal role in the investment policy.The Department investigates new risk measures asthey are developed; measures examined in recentyears include partial duration and spread duration(not adopted) and option-adjusted duration(adopted for mortgage-backed securities).

647. The sections that follow give a brief intro-duction to some aspects of the Bank’s investmentpolicy. More complete information may be foundby consulting the sources listed above in para-graph 645.

Neutral currency composition

648. The neutral currency composition of thereserves is known as the numeraire. It is defined byfixed percentages of various currencies, with thenumber of units of each one allowed to vary asexchange rates change (in contrast to a currencybasket, such as the SDR, in which the number ofunits is constant from day to day while the percent-ages vary). The composition of the numeraire isreviewed at least once a year.

649. When first adopted, the composition ofthe numeraire was based on the geographical dis-


tribution of goods and services imports. This com-position was considered to preserve the real for-eign purchasing power of the reserves, sinceimports constitute the foreign currency compo-nent of Israel’s total final uses of funds.40 A fewyears later, another element was added to the com-position of the numeraire, namely, the currencycomposition of external debt service for the com-ing year. A further consideration in determiningthe currencies included in the numeraire has beenthat they are “reserve currencies,” that is, those ofcountries with a tradition of economic stability andresponsible policies in various fields.

650. The currency composition of thenumeraire described here has changed over timeonly moderately, and it bears a reasonable resem-blance to the currency composition of the totalreserves held by official institutions. Nevertheless,over the past several years the Bank has reexam-ined the definition of the numeraire from time totime. To date, there has been no change in it, interalia because the other systems reviewed yieldedcurrency compositions that could change radicallyfrom year to year, making them very difficult andexpensive to implement.

Neutral duration

651. The interest-rate risk of a portfolio in aparticular currency is defined by its duration, andby the distribution of that duration along the yieldcurve. The Bank of Israel has defined a neutralduration for each currency in the numeraire byusing a modified shortfall approach.

652. Under the shortfall method, a portfoliomanager sets a minimum threshold for acceptableholding-period yields. Since the future course ofyields-to-maturity in the market is uncertain, it isimpossible to rule out capital losses with absolutecertainty (unless one invests in zero-duration assetssuch as cash), but only with a certain probability,known as the confidence level. The minimum

threshold and confidence level set by the portfoliomanager, on the basis of his inclinations and riskaversion, together with the assumed distribution ofyields to maturity in the market, determine themaximum allowable portfolio duration, or shortfallduration.

653. Unfortunately, for a given threshold andconfidence level, the shortfall duration can varysignificantly from month to month, as the yieldcurve shifts. In order to find a duration that wouldhave acceptable characteristics in various financialclimates, staff of the middle office conducted thefollowing study: For each month of the periodfrom January 1984, to June 1998, the shortfallduration was calculated, using a confidence level of95 percent and a minimum threshold equal to one-half the yield on a risk-free asset. For U.S. dollars,this was defined as a three-month Treasury bill andfor other currencies as the one-month LIBID inter-est rate. The resulting series of monthly shortfalldurations was then examined, and a value selectedthat is lower than 95 percent of them. This gives aduration that, 95 percent of the time, would havegiven an ex ante probability of at least 95 percent ofearning no less than one-half the risk-free rate.

654. After doing this calculation separately ineach currency, and after further minor technicaladjustments, a single neutral duration was set forthe currency portfolios comprising the reserves.This duration is 16 months.

Formulation of neutral benchmarks

655. The core element of the Bank’s invest-ment policy is the neutral benchmark of thereserves portfolio. Control of currency risk andinterest-rate risk (and, to a limited extent, creditrisk) is exercised via limits on the allowable devia-tions of the actual portfolio from its neutral bench-mark (see paragraph 662), and it constitutes arisk-free portfolio for the Department, when itdoes not wish to have open positions, and providesa criterion for assessment of the Department’s per-formance (paragraphs 664–666).

656. The overall neutral benchmark is con-structed on the basis of benchmark portfolios inthe various currencies of the numeraire, each onebeing represented in proportion to its numeraire

11 • Israel 131

40This system was based on the 1979 study by A. Ben-Bassat,The Management of Foreign Exchange Reserves, Israel’s Experience,Research Department, Bank of Israel (Hebrew), an abridgedEnglish version of which was published in the May 1981 Bankof Israel Economic Review.

weighting. Each of these component currencybenchmark portfolios has a neutral duration (seeabove), and is composed of assets that are charac-terized by low risk and high liquidity, features thatreflect the Bank’s long-term investment strategy.Each currency benchmark portfolio is based ontwo components: the first, having a short duration,includes assets of up to one year to maturity, whilethe second, which has a longer duration, includesassets of between one and five years to maturity.The weights of the two components are then setsuch that the total duration of the currency bench-mark portfolio is neutral. The assets included inthe currency benchmark portfolio are governmentbonds of the currency’s country. However, in cur-rencies where the market for government securi-ties maturing up to one year is not liquid, theshort-term component contains indices that reflectthe interest paid by the Bank for InternationalSettlements (BIS).

657. Although the Bank’s use of active man-agement (paragraph 662) implies that there is usu-ally a gap between the yield of the reservesportfolio and that of the benchmark, this differ-ence is generally small. This means that theexpected profit on the reserves portfolio is deter-mined primarily by the composition of the bench-mark portfolio, rather than by the quality of theBank’s active management. Therefore, periodicadjustment of the benchmark portfolio to ongoingchanges in the global financial environment is anecessary process, and is one of the major chal-lenges confronting the Bank.

Limitation of credit risk

658. As is true of many official institutions, theBank of Israel’s sensitivity to credit risk is greaterthan its sensitivity to other financial risks. This isprimarily due to the judgment that its ability to usediversification to limit the scope of losses is morelimited in this area than it is vis-à-vis other types ofrisk, such as interest-rate risk. Additional reasonsfor heightened sensitivity would include: the possi-bility of correlation between losses due to creditrisk in the portfolio and the need to make use ofthe reserves (e.g., in a global financial crisis), thelimitations of currently available tools for quantify-

ing credit risk, the desire to avoid having to seeklegal redress in the courts of a foreign country, andthe fact that credit risk is “optional” (in that itcould be almost completely eliminated by investingonly in the securities of sovereign states in theirlocal currencies), while other risk factors are not.

659. Investment of the reserves portfoliocauses it to be exposed to the credit risk of varioustypes of institutions—governments, internationalorganizations, clearing systems, commercial banks,and broker-dealers. Investment in the securities ofa foreign government creates exposure to the issu-ing country, while investments in bank deposits,time differentials in the settlement process, andtrades involving delayed settlement (e.g., currencyforwards) create exposure both to private firmsand to the countries in which they operate. TheBank’s willingness to assume exposure falls as therisk of experiencing a loss increases (i.e., as creditquality declines), as the time over which the riskextends increases, and as the type of entity to whichthe exposure pertains is thought to be less resilient(e.g., banks vs. governments).

660. The Bank uses a variety of tools to managethe credit risk of the reserves portfolio. Of these,the most important is the System of Limits andQuotas, which defines for each institution (bank,country, etc.) the maximum quantity of varioustypes of credit exposure that may be assumed. Itsets the minimum levels of credit quality for indi-vidual institutions of various types and also ensuresappropriate diversification across firms and coun-tries, in line with their relative size and credit qual-ity. Additional tools for control of credit riskinclude: a ceiling on the total exposure of thereserves portfolio to the world banking system, lim-its on the permitted quantity of investment in“spread assets,” such as Eurobonds, and limits onthe maximum time for which certain types of expo-sure can be assumed (e.g., on the term-to-maturityof bank deposits).

661. Once a year, the System of Limits andQuotas is updated by the Department and submit-ted to the Foreign Currency Committee forapproval. If an institution’s quota is added orenlarged during the course of the year, the changemust be approved by the Foreign CurrencyCommittee. However, the Department may cancel


or reduce a quota on its own initiative at any time,if changes in the institution’s status warrant doingso. It should also be noted that the Bank’s relationswith financial institutions are anchored in legalagreements, most of which have been signed in thepast few years.

Scope for active management41

662. In investing the foreign exchange reserves,the Department is authorized to use active manage-ment or position-taking, that is, to decide to departfrom the overall benchmark portfolio, in terms ofcurrency composition, duration, kinds of assets,and their distribution along the yield curve, withthe goal of earning a higher yield than that of thebenchmark portfolio. The leeway allowed for activemanagement is defined separately for each type ofexposure, and is based on the principle of limiteddelegation of authority and responsibility in theinvestment decision-making process from each levelto the level below. In managing any type of position,it is customary to impose a maximum potential loss(“stop-loss”), with the position being closed if thecumulative loss on it reaches the limit. In recentyears, the main focus of active management hasbeen on asset allocation and security selection,which have formed an important part of the totalcontribution from active management.

• In the area of currency risk, the numeraire isviewed as a risk-free portfolio, and any devia-tion from it is defined as a position. Currencypositions of more than limited scope must beauthorized by the Foreign CurrencyCommittee; however, the Foreign CurrencyCommittee has not utilized this authority inrecent years. The Department may decide onlimited positions around the currency compo-sition determined by the Foreign CurrencyCommittee; within this boundary, the frontoffice is permitted very limited positionsaround the currency composition set by theInvestments Committee.

• The neutral duration for all currencies is setby the Foreign Currency Committee, and adeviation from it by the Department is con-sidered a position. The Department is autho-rized to open positions of limited scopevis-à-vis the neutral duration in the variouscurrency portfolios. The range of permitteddurations is asymmetrical, as the Departmentis allowed greater leeway in reducing dura-tion than in increasing it. Within this bound-ary, the front office is permitted very limitedpositions around the duration set by theInvestments Committee.

• The distribution of assets along the yieldcurve is also a source of interest-rate risk,together with duration. The neutral distribu-tion is that of the benchmark portfolio, whiledifferences from it in the reserves portfoliorepresent positions. This type of position isnormally decided on by the front office andmonitored by the Investments Committee.

• Decisions on asset allocation may also createpositions, as part of the reserves may beinvested in types of assets that are not repre-sented in the benchmark portfolio, such asEurobonds, bank deposits, mortgage-backedsecurities, etc. Asset allocation decisions arenormally made by the front office. However,in the case of asset allocation positions thatare of unusually large scope, or that are of along-term nature, responsibility for the posi-tion may be taken by the InvestmentsCommittee.

• Finally, decisions on security selection—theactual choice from among several alternativedebt instruments to fulfill a specific role inthe portfolio—of course are made through-out each workday by the staff of the frontoffice, constituting an important componentof active management.

663. The decision to employ active manage-ment is based on a number of considerations. First,and most importantly, the cumulative experience ofthe past fifteen years or so suggests that the Bank’suse of active management has made a modest butstatistically significant positive contribution to over-

11 • Israel 133

41This section should be read in conjunction with paragraphs639–642, above.

all portfolio return. In addition, active managementrequires those involved in it to be constantly up-to-date as regards market developments. This incentivehelps to ensure that the Department’s focus doesnot, over time, become too narrow, and it hones theskills needed for periodic adjustment of the bench-mark portfolio and for other tasks, such as the for-mulation of intervention policy. Finally, the use ofactive management helps the Department to createan interesting and challenging work environmentfor front- and middle-office staff, assisting it toattract and retain highly qualified professionals.

Performance attribution

664. The contribution of various investmentdecisions to the overall difference in yield betweenthe reserves portfolio and the neutral benchmarkover a given period is measured by the middleoffice, using the capabilities of the recentlyacquired portfolio management information sys-tem (paragraphs 670–677) together with a data-warehouse system developed in-house. (For adescription of how performance attribution wasdone before the implementation of this system, seeBox 1.6 of the Department’s Annual Report for2000, at the address given in paragraph 645.) Thesystem is used to maintain portfolios that reflectthe components of the neutral benchmark andportfolios that match the Bank’s actual holdings,classified by maturity and asset type, including“leverage” portfolios, which are used to track theprofit or loss of certain types of positions.Portfolios can be aggregated in hierarchies, so thatthe aggregate of actual holdings can be comparedwith the aggregate benchmark.

665. Leverage portfolios include long and shortpositions (though in its actual holdings the Banknever sells short a security). For example, the profitand loss on a currency position would typically betracked using a leverage portfolio that includes ashort position in cash in one of the currencies ofthe numeraire and a long position in cash inanother currency (which may or may not be in thenumeraire). By contrast, the performance of a par-ticular asset class (e.g., inflation-linked securities)would be calculated by comparing the yield on aportfolio including all the Bank’s holdings in

that asset class with a component portfolio of thebenchmark.

666. The returns on portfolios are normallyavailable to management and to the front and mid-dle offices on command. An exception to the ruleoutlined above is the excess return on certain typesof spread assets (e.g., bank deposits). Due to tech-nical limitations, this is calculated only after thefact; however, the principles by which it is calcu-lated are similar. Certain elements of yield curvepositioning and security selection are necessarilycalculated as the residual of other contributing fac-tors and the total difference in return, but the mid-dle office seeks to minimize the scope of this factoras far as possible.

The role of efficient markets

667. As noted, an important goal of the Bankin managing the foreign exchange reserves is thatthey should have a high overall level of liquidity,defined as the ability to realize assets without delayand without diminishing their value. The liquidityof the various markets in which the assets compris-ing the reserves are traded is regularly assessed bythe middle office, based on two criteria. The first isthe width of the “bid-ask” spread between buyingand selling prices; a narrow spread implies lowtransaction costs, relative to the midpoint price.The second is the ability to transact in large vol-umes without affecting the market price. In anilliquid market, an investor’s attempt to buy or sellin large volumes will cause the spread to widen andthe midpoint price to move in a direction unfavor-able for the investor; thus, assets can only be sold inquantity at an average price lower than the onethat prevailed before the investor began to sell.

668. Based on these criteria, the Bank classifiesthe assets of the reserves portfolio into four groups:

1. Highly liquid, including securities with aspread of 0–2 basis points or 0–2 cents andvarious demand deposits.

2. Liquid, including securities with a spread of3–5 basis points or 4–6 cents.

3. Short maturity, including securities,deposits, and repurchase agreements withterms of less than a month.


4. All others, most of which are tradable andcan be realized, however. This group hasincluded, among others, GNMA mortgage-backed securities, TIPS (U.S. inflation-linkedsecurities), and some types of Eurobonds.

669. During the years 1999–2001, the firstgroup has typically accounted for no less than 20percent of the reserves, and the first three groupstogether for 75–90 percent of the reserves.

Portfolio management information system

670. Without doubt, the Bank’s most signifi-cant move in recent years to enhance the quality ofits reserve management and to improve trans-parency and accountability was its decision toacquire a new portfolio management informationsystem. Although space limitations do not allow afull description of this project, which extendedover more than three years and involved direct andindirect costs of well over US$1 million, the mainaspects of it can be briefly sketched.

671. Recognizing the existence of a problemwas the first task, and probably the hardest. Evenin ideal conditions, computer systems are often influx, as front, middle, and back offices adapt tochanging financial-market conditions. How, then,does one identify the transition point from rou-tine imperfection to a fundamental problemrequiring a more radical solution? One importantwarning sign was the proliferation of ad hoc solu-tions, often developed by end-users, to track riskmeasures and the profit and loss of positions.When the staff assigned to examine this problemformally mapped the Department’s workflow, andcounted between five and ten distinct manual entriesto these independently maintained programs thatwere required for a single trade, it was clear that therisks had become unacceptably large. Amongthem,

• Substantial increase in the probability ofhuman error, which could remain undiscov-ered for a considerable time.

• Inconsistency in the meaning of data acrossmultiple systems, which sometimes werebased on different concepts.

• Variation in the quality and maintenance ofsystems developed by end-users without pro-fessional IT training and responsibility.

• Blurring appropriate separation of responsi-bility, as, for example, when front-office staff,who were the only people with the expertiseand access to data feeds required, built adhoc systems to implement new compliancerules.

672. One bright spot was that the problemswere found to be concentrated in the front andmiddle offices, with the situation of the back officejudged quite acceptable.

673. Defining the needs of the Department, ina very detailed way, based on the gap between thecurrent state of affairs and the desired one, was thenext stage. This was done by an interdepartmentalteam chaired by the head of the front office andincluding senior people from the front and middleoffices and the IT Department. The high profes-sional level of this team proved essential to the suc-cess of the project. The team’s analysis served as aguide for the general RFI (Request ForInformation) and the more detailed RFP (RequestFor Proposal), which were written at a later stage.

674. Buy or build was the next decision to bemade, and it was not an easy one. Building a com-plex customized system “in-house” would havemeant recruiting or contracting for substantialadditional personnel in the IT area for a verylengthy project, with no guarantee that it wouldresult in an ideal solution. On the other hand,experience to date suggested that most of the “offthe shelf” systems in the market would not meetthe Bank’s needs. In the end, the team recom-mended that the possibility of purchasing a systemshould first be thoroughly explored, and only if adetailed examination of the available systemsshowed they were inadequate should the option ofbuilding in-house be revisited.

675. Searching for systems, sending out theRequest For Information (RFI) letter, and com-posing a short list based on the responses were thesubsequent stages of the project. The project teamidentified possible candidates through discussionswith market participants and companies, and bysearching the Internet and industry publications.

11 • Israel 135

The RFI letter included a general description ofthe Bank’s needs and the framework of reservemanagement, the layout of the IT systems in use,and a list of 12 questions that summarized therequirements of end-users and IT staff. Vendorswere strongly encouraged not to limit themselvesto just answering the questions, but rather to sendpublications, documentation, or other writtenmaterial regarding the relevant modules of theirsystems, as well as information on pricing, training,and support. During this period, the Bank did nothonor vendor requests to demonstrate their sys-tems, and also found it necessary to decline variousoffers by companies to serve as consultants orimplementation subcontractors. Based on the writ-ten responses to the RFI, a short list of candidatefirms was drawn up. Interviews with two currentclients of each short listed candidate were thenconducted by conference call, based on a list ofquestions faxed to them in advance, without theparticipation of the vendors’ firms.

676. Following these interviews, each candidatewas invited to demonstrate its system, using adetailed simulation of initial portfolios, bench-marks, and a (fictional) day of trading activities pro-vided by the Bank. Throughout the simulated day,cash flow, holdings, risks, and performance weremeasured. The simulations took place at the Bank’spremises, with each vendor receiving three days inwhich to conduct its presentation. The program ofthree days was divided into carefully defined ses-sions, with each session relating to one of the mainissues (e.g., markets, compliance, performancemeasurement, etc.). Each vendor was required toinstall its system at the bank for the occasion, so thatthe entire simulation was performed and demon-strated on each system. The simulation was of criti-cal importance to the process. It gave the vendorsgreatly improved insight into our needs and thesuitability of their systems to meet them. As a result,two companies realized that their systems wereunable to perform the simulation, thereby reduc-ing the short list. The simulation also enabled theproject team and management to have the closestlook possible at the suitability of each system to theBank’s requirements.

677. The competitive tender or Request forProposal (RFP), required by Israeli law for pur-

chase of goods or services by public sector bodiessuch as the Bank, was issued to the three candi-dates that participated in the simulation. The ten-der was very detailed with regard to the contractualterms of purchase (including warranty and main-tenance issues), as well as the criteria for choosinga system and the future milestones of projectimplementation. An integral and important part ofthe tender was the Specification Matrix, consistingof about 500 specification line items regarding thequality and functionality of the system. In theirreplies, the vendors were expected to define theextent of their systems’ capabilities by entering pre-defined codes for each line item (Supported, NotSupported, etc.). Where relevant, they could alsoadd free-form comments. This detailed list helpedto rank the proposals, and served as the basis forthe implementation of the chosen system later on.The final choice of system was made based on con-siderations defined in the tender documents, withthe weight of each component set prior to thereview of the proposals. These included, amongothers, the quality of the system and its suitabilityfor the Bank’s intended uses, its price, warrantyterms, and reputation.

Conclusion

678. The preceding sections have not attemptedto provide a comprehensive description of the Bankof Israel’s reserve management process, but only tothrow light on a few aspects of it that may be of par-ticular interest to other official institutions. TheBank continues to explore numerous issues influ-encing reserve management. Some of these havebeen noted in the text; others include aspects oflegal risk, operational risk, definition of the universeof permissible assets, and the process of benchmarkspecification. It should be emphasized that theBank’s approach to reserve management was notestablished in its present form all at once, but is theresult of a long-term process of growth and develop-ment. In this regard, and bearing in mind that everyinstitution’s needs are unique to it, leading to vari-ous approaches, it is worthwhile to mention some ofthe fundamental conditions that underlay the devel-opment of reserves management at the Bank ofIsrael:


• An absolute commitment, at all levels of theorganization, to maintaining the higheststandards of integrity and professionalism.

• An organizational culture that encouragescreativity and does not penalize those whoquestion the “conventional wisdom.”

• A collegial working environment, encourag-ing full discussion of major decisions beforetheir implementation.

• A commitment on the part of both staff andmanagement to the professional develop-ment and continuing education of membersof the organization.

679. An institution that is able to nurture thesevalues will most likely enjoy excellent prospects forsuccessful fulfillment of its responsibilities,whether or not the specific solutions it arrives atare similar to those described above.

11 • Israel 137

Developing a Sound Governance and Institutional Framework


680. The Bank of Korea (BOK) holds foreignexchange reserves to maintain a capacity for inter-vention in the foreign exchange market, to copewith internal and external shocks, and to preservethe value of the national wealth. Therefore, theBOK puts the focus on safety and liquidity, whilealso endeavoring to generate high returns.

681. Subsequent to the Asian financial crisis in1997, the foreign exchange regime in Koreamoved from a market average exchange rate sys-tem to a free-floating rate system, and this reducedthe central bank’s need to intervene in the foreignexchange market. However, it became imperativeto increase the volume of foreign reserves, sincethey play an important role in alleviating shock intimes of financial crisis and can also enhanceKorea’s national credibility.

682. Although the current level of foreignreserves is sufficient to make any necessary foreignpayments, such as for short-term foreign debtredemption or for withdrawal of foreign investmentfunds from the equity market, we believe that it isdesirable to increase the amount of our foreignreserves even more, considering the efforts beingput into improving the Korean financial system aswell as our developing relationship with NorthKorea.

Scope of reserves management activity, andcoordination with monetary and external debt policy

683. The foreign reserves that the BOK cur-rently manages are the portion of government andBOK assets that are readily available for foreignpayments, and consist of foreign-currency-denominated fixed income instruments, deposits,gold, and SDRs (see Table 20).

684. The BOK manages its foreign reserves ina manner so as not to hinder domestic monetarypolicy. When the BOK intervenes in the foreignexchange market, it observes the domestic interestrate and currency flows carefully so as to be in har-mony with the open market operations.

685. The currency composition of the BOK’sand the Government’s foreign debt and its dura-tion are taken into consideration when determin-ing the currency composition and target durationof the foreign reserves, so that foreign exchangerate and interest rate risk can be reduced.


686. As outlined in the pertinent laws, Korea’sforeign reserves are comprised of funds from theBOK and the Government (Foreign ExchangeStability Fund).

• The BOK’s authority to hold and managethe foreign reserves is outlined in the Bank

138

12Korea, Republic of

of Korea Act and the Foreign ExchangeTransaction Act, which are open to the public.

• In accordance with the Foreign ExchangeTransaction Act and the Budget and AccountAct, the Government maintains the ForeignExchange Stability Fund in order to stabilizethe foreign exchange rate, and has entrustedthe fund to the BOK to manage.

• Hence, the BOK, founded in June 1950, hasbeen the sole reserves management entity forKorea’s foreign reserves.

687. On the other hand, the BOK works closelywith the Government on issues pertaining to policydecisions such as intervention in the foreignexchange market and monitoring foreign debt, inaccordance with the Foreign Exchange TransactionAct.

688. In accordance with the regulations setforth by the Monetary Policy Committee, thehighest decision-making body in the BOK, theReserves Management Department (RMD) andthe International Department of the Bank areresponsible for foreign exchange management-related tasks. One Assistant Governor overseesboth Departments (see Figure 9).

689. The RMD oversees all aspects of reservesmanagement, including benchmark selection,investment guidelines establishment, risk manage-ment, portfolio management, accounting, and per-formance attribution. The department isstructured based on the three major functions(front, middle, and back office), and is dividedinto 6 teams.

• The Reserves Management Planning Teamformulates investment guidelines and the

benchmark, and determines the currencycomposition and range of investment products.

• The Risk Management Team establishes therisk limits on the commercial financial insti-tutions, monitors various types of risk, andcarries out performance analysis.

• Reserves Management Teams 1, 2, and 3manage the portfolio in accordance with theinvestment guidelines and benchmark.

• The Settlement and System Service Teamcarries out settlement and accounting andlooks after the IT systems.

690. Some of the major responsibilities of theInternational Department include the monitoringof foreign exchange transactions and of supply anddemand, intervention in the foreign exchangemarket, and reviewing the volume of foreignreserves and reporting on this to the public.

Accountability and transparency

691. To minimize the investment risk andachieve greater investment efficiency, the BOKassigns responsibilities in a hierarchical manner, inaccordance with the BOK’s internal regulations setforth by the Governor.

• The Governor determines the investmentguidelines and the benchmark, including thecurrency mix and range of investment prod-ucts, and approves the annual managementplans.

• The Assistant Governor establishes the quar-terly management plans within the parame-ters approved by the Governor. He also

12 • Korea, Republic of 139

Table 20. Reserves and Foreign Exchange Rates

End of End of End of End of End of End of1996 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

mediates to harmonize the foreign reservesmanagement plan and the foreign exchangepolicy that the International Department isresponsible for.

• The Director of the Reserves ManagementDepartment and the heads of the threereserves management teams set and executethe weekly and daily investment plans.

• The Benchmark and Management Plans areestablished after approval of the ReservesManagement Committee and the InvestmentCommittee.

692. The major tasks of foreign reserve man-agement are carried out in accordance with the“Regulation on Foreign Reserves Management”determined by the Governor, and the detailed

procedures are performed in accordance with the “Code of Foreign Reserves ManagementProcedures” set forth by the Director of the RMD.

693. The segregation of the accountabilities isachieved through defining the responsibilities ofeach function clearly, as described above.Moreover, strict firewalls have been establishedbetween each function, and each team has an inde-pendent reporting line.

694. The Risk Management Team prepares therisk management reports and submits them to theAssistant Governor on a monthly basis and reportsthe detailed management transactions and perfor-mance to the top management on a quarterly basis.

695. The auditing of Reserve Managementactivities is performed in two different ways, bymeans of internal audit and by external audits asfollows:


Bank of KoreaCoordinationGovernment

Monetary PolicyCommittee*

Governor*

Deputy Governor Auditor*

Assistant Governor

Reserves ManagementDepartment

InternationalDepartment

AuditDepartment

Middle Office- Reserves Management Planning Team- Risk Management Team

Front Office- Reserves Management Team 1- Reserves Management Team 2- Reserves Management Team 3

Back Office- Settlement and System Service Team

Figure 9. Organizational Chart

*Appointed by the nation’s president.

• The internal audit is performed by the Risk Management Team and the AuditDepartment. The Risk Management Teamreviews reserves management details on adaily basis to check for any breach of theinvestment guidelines or excess of risk limit,and ensures that the accounting is per-formed properly. In addition, it also mea-sures the VaR numbers. The team reports theresults to the Director.

• The Audit Department of the BOK reviewsthe management details daily, through theBank’s internal IT network, and performs anaudit annually. The department is operatedindependently under the supervision of theAuditor appointed by the President, and theresults of the annual audit are reported tothe Governor and the Monetary PolicyCommittee as well as to other Governmentbodies.

• An external audit is performed at least oncea year by the Board of Audit and Inspection,which is directly responsible to the President.Its purpose is to review both the accountingprocedures and the foreign reserves manage-ment. The National Assembly also audits theforeign reserves management annuallythrough the national audit.

696. The BOK calculates the size of thenation’s foreign reserves daily and reports on thisto top management and the Monetary PolicyCommittee on an ad hoc basis. In compliance withthe IMF’s SDDS, the BOK discloses the size of itsforeign reserves twice a month, to the public as wellas the IMF.

697. The general investment philosophy anddirection are disclosed to the public throughannual reports. However, we do not disclosedetails such as our benchmark, currency mix,portfolio composition, or portfolio returns, as todo so might adversely affect our foreign reservesmanagement.

698. The BOK publishes an annual financialstatement expressed in the domestic currency;however, this statement does not include the com-ments of the external auditors.

Retaining qualified staff

699. Staff are selected from among the existingBOK staff based on the BOK’s general humanresources guidelines, and trained. No external pro-fessionals are hired.

700. The staff selected are encouraged toremain in the department long-term, in order tostrengthen their expertise. They are also encour-aged to participate actively in the training pro-grams sponsored by various domestic and foreigninstitutions.

701. The BOK has not adopted a perfor-mance-based compensation system. Therefore,the professionals in the foreign reserves manage-ment teams are subject to the same compensationand promotion system as other staff members ofthe Bank.


Risk management

702. To monitor the different types of risk asso-ciated with foreign reserves management, the BOKhas the following procedures in place:

• Credit Risk: Investment is only permitted ininstruments with credit ratings of AA orabove, and the trading counterparties areselected based on strict criteria.

• Liquidity Risk: The size of the liquiditytranche is maintained at an appropriate levelat all times, and all investments are made inliquid and marketable securities such assovereign bonds.

• Market Risk: The criteria for the currencymix and target duration and the permitteddeviation range are determined in advanceand monitored closely on an ongoing basis.The VaR system is also utilized to track andmonitor the greatest possible loss at a certainconfidence level.

703. Since 1997, the BOK has separated itsreserves into three different tranches and estab-lished different benchmarks for each tranche.


• The liquidity tranche is managed to meet thead hoc foreign payment demand using U.S.dollar-denominated money market instru-ments. The optimal size of the liquiditytranche is determined quarterly based on thestatistical analysis of the foreign reserves cashflow.

• The investment tranche is managed for thepurpose of enhancing returns, and its assetsare usually invested in mid- to long-termfixed income instruments.

• The trust tranche is the assets outsourced tointernationally recognized asset manage-ment companies for the purpose of transferof investment knowledge or know-how as wellas enhancement of returns.

704. The currency composition of each trancheis determined based on the following principles:

• The entire liquidity tranche is composed of asingle currency, the U.S. dollar, as most ofthe foreign exchange transactions are settledin U.S. dollars, and the U.S. money market isvery well developed.

• The investment tranche is determined con-sidering (1) the currency composition of theGovernment’s and the BOK’s foreign debt,(2) the currency composition of the currentaccount payments, and (3) the size of theglobal sovereign bond market. In addition,other central banks’ currency compositionsare also used for reference.

• The trust tranche maintains the same cur-rency compositions as the market indexbenchmarks employed for the respectiveinvestment strategies.

705. The BOK does not hedge its currencyexposure, following the generally accepted princi-ple that currency exposure is neutral if the cur-rency composition is maintained as determined inadvance. The BOK employs a strategic currencymanagement strategy on a long-term basis for thepurpose of rebalancing (adjusting) the portfolio,rather than engaging in short-term (tactical) cur-rency trading.

Investment instruments

706. In accordance with the BOK’s internalregulations, investment in deposits and marketablesecurities are permitted for reserves managementas follows:

• For marketable securities, investment is lim-ited to securities with AA or above credit rat-ings—sovereign bonds, agencies, supra-nationals, and financial debentures. Stocks,corporate bonds, ABSs, and MBSs are notpermitted.

• With regard to deposits, they may be madeonly with financial institutions having creditratings of A or above.

• However, outsourced assets are allowed to beinvested in corporate bonds, ABSs, andMBSs, provided that their crediting ratingsare AA or above.

707. Although strategically the BOK adopts apassive investment strategy that usually does notdeviate much from the benchmark, active strate-gies are undertaken occasionally depending onmarket conditions.

708. To facilitate such active investmentstrategies, the deviation range of the benchmarkis determined in advance for the currency composition and duration, and sufficient range is permitted for achieving the optimal activestrategies.

709 In addition, the BOK measures and moni-tors absolute VaR and relative VaR numbers on adaily basis, as a complementary tool for more effec-tive risk management.

Recent trends and challenges

710. The globalization of the securities mar-ket has deepened the coupling effect of interestrate risk, resulting in a diminished diversificationeffect in bond investments. Portfolio managersaspire to maximize diversification through care-ful analysis of the correlations between bond markets.

711. The BOK employs the book value systemas part of its accounting standards, but perfor-mance and risk management are measured using


the daily market prices. Therefore, we do notforesee any problem even if the accounting standard is changed to the market price valuationsystem.

Benchmark selection

712. The BOK uses different benchmarks fordifferent tranches, and they are determined by theGovernor.

• For the liquidity tranche, we have developeda benchmark composed of deposits andshort-term U.S. treasuries.

• For our investment tranche, we have modi-fied the JP Morgan Government Bond Indexto suit our investment guidelines.

• For our trust tranche, the Lehman BrothersGlobal Aggregate Index and LehmanBrothers U.S. Intermediate Government/Corporate Index are employed.

713. The benchmarks are reviewed annually inconsideration of changes in the market environ-ment. However, we try to keep the strategic bench-mark stable, unless the market environmentchanges are significant.

Assessment of performance

714. The performance of our reserve man-agement activities is measured using market valu-ation and compared to the performance of thebenchmark. Starting in 2002, the informationratio is used to measure risk-adjusted returns.Performance is evaluated quarterly. The performance evaluation is reported to theAssistant Governor quarterly and to the Governor annually.

External management

715. Along with a benchmark, the BOK pro-vides very strict investment guidelines to the fundmanagement institutions to manage the risk.Separating the fund management bodies and thecustodian banks also helps to reduce the opera-tional risk.

716. In addition, the transaction details arereceived from the custodian banks and fund management companies and reconciled daily, tomonitor risk as well as any breach of investmentguidelines.

Management information systems

717. The daily risk reports are submitted to theDirector of the RMD and the monthly risk reportsare submitted to the Assistant Governor. The quar-terly performance reports to top managementinclude some of the risk-related indexes such ascurrency composition, duration, VaR numbers,and risk adjustment measurement index, as well asthe performance figures.

718. The BOK conducts stress tests and mea-sures the changes in asset value of the foreignreserves daily using scenarios in which historicalevents that had significant impact on the market(e.g., Black Monday, the Asian financial crisis, andthe September 11 terrorist attacks) recur, or hypo-thetical scenarios in which market conditionschange dramatically (such as the yield on U.S. trea-suries goes up by 50 basis points). The results aresubmitted to top management regularly throughrisk reports.

719. To reduce operational risk, the BOK hasestablished strict firewalls between functions,which provides a system of checks and balancesamong the teams. In addition, all dialogues overthe phone are recorded.

720. The custodians and counterparties areselected based on strict guidelines, and their creditratings and corporate governance are closely mon-itored and reported to the Director of the ReservesManagement Department.

Efficient markets

721. In order to maintain the liquidity of theforeign reserves, the BOK trades in the marketswhere large-sized transactions can be executedwithout severe price distortions. The BOK tradesin the regional markets located in the same timezone—Tokyo, Hong Kong SAR, Singapore—andin some of the European markets such as Londonand Frankfurt that have time zones that over-


lap with Korea. For the New York market, which is in a different time zone, the BOK’s New Yorkrepresentative office just executes the orders from the headquarters, in the name of the headoffice.

722. The BOK’s investment instruments arerestricted to high-investment-grade bonds that areusually very liquid and marketable, and thereforetraded actively in all major international financialcenters.


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13Latvia



723. Reserves at the Bank of Latvia are man-aged according to three primary requirements:stability, liquidity, and income. Clearly, there aretrade-offs between income versus stability (or cap-ital protection) and liquidity. In practice, the Bankof Latvia has set an investment benchmark thatrepresents and communicates the Board ofGovernors’ views on these three conflicting goals.The specific aspects of this strategy will be dis-cussed later; but it is important to note at the out-set that the Bank of Latvia puts relativelysignificant emphasis on the income portion ofreserves management.

724. Any analysis of appropriate risk/returntrade-offs for central bank reserves managementneeds to incorporate reserves adequacy andpotential intervention needs. Latvia’s foreignexchange and monetary regime is a quasi-currency board. The bank pursues a fixedexchange rate target (vs. the SDR), with a ±1 per-cent intervention band. Latvia is a quasi-currencyboard because we also have and use a number ofopen market instruments to manage domestic liq-uidity, which wouldn’t be the case in a traditionalcurrency board.

725. On the one hand, automatic interven-tions at relatively tight intervention bands wouldnecessitate the need for highly liquid reserves. Onthe other, it is highly unlikely that we would eversee interventions of such size that would entail thesale of the entire money base; and therefore, itwould appear that we have a good deal of reservesthat would not be necessary for intervention pur-poses, that could be invested with a higher degreeof risk, in exchange for increased expectedreturns.

726. The use of reserves in Latvia is generallyrestricted to maintaining the defense of the foreignexchange policy, and generating income for thecentral bank and the State Budget (through exist-ing profit retention arrangements). Since Latviahas a vibrant banking sector with a large amount ofinternational business, official reserves are rarelyneeded for current account needs or to provideforeign exchange for local enterprises. Theamount of foreign exchange in local bank balancesheets is more than enough to satisfy the needs ofimporters, exporters, and other financial institu-tions. All of these factors have been analyzed at theBank of Latvia, and influence the specific reservesmanagement practices, which will be discussedlater.

727. As stated in the law on the Bank of Latvia,the central bank has the sole mandate to managethe foreign exchange reserves of the country (themandate also permits us to engage external man-

agers to manage a portion of the reserves). As aquasi-currency board, the size of the reserves isentirely dependent on automatic interventionoperations, and therefore coordination with mon-etary policy is not much of an issue. The Bank ofLatvia has, at times, offered foreign exchange swapproducts to the local market, and these operationsare always coordinated with monetary policy.

728. The Bank of Latvia works closely with theState Treasury and Finance Ministry to coordinatedebt policy, but reserves management is not influ-enced by the currency composition or maturity ofthe government’s external debt. Each institution isresponsible for managing its foreign exchange andinterest rate positions. The Bank of Latvia is the fis-cal agent for the State Treasury and FinanceMinistry, however, and frequently manages moneyon behalf of these institutions, but these funds aremanaged in separate portfolios and do not influ-ence the central bank’s reserves portfolio. Anynon-reserve foreign exchange in the central bank’sbalance sheet (such as Finance Ministry money orfunds from foreign exchange swap operations) isrun on a matched-book basis, to minimize anyadverse effects on the bank’s income statement.While requiring the management of several portfo-lios with different investment characteristics com-plicates the foreign exchange management processat the bank, this arrangement allows a very clearunderstanding of every risk taken on the balancesheet from foreign exchange operations.

Organizational and decision-making structure

729. Investment guidelines for reserves man-agement are set by the central bank’s Board ofGovernors. More specific guidelines (such as allow-able risk parameters for other portfolios, for exam-ple) are set by the Executive Board. All reservesmanagement operations are undertaken in theForeign Exchange Department. Great care is takento ensure that all levels of management are awareof the results of reserves management operations.Monthly performance reports are given to theExecutive Board. The Board of Governors analyzesthe effects of reserves management on the bank’sbudget at its meetings, and all management hasaccess to daily accounting reports on the bank’s

intranet. The central bank is currently installing anew treasury system, which will provide moredetailed management information. The systemshould be live by year-end 2002. Furthermore, theGovernor of the Bank of Latvia and theChairperson of the Executive Board are membersof the bank’s Investment Committee (along withmembers of the Foreign Exchange Department),which meets weekly. Therefore, the highest levelsof management are always informed of any devel-opments positively or negatively affecting thereserves portfolio.


730. Foreign exchange reserves operations areaudited by external auditors and the State Controlannually and by internal auditors more frequently.Disclosure of performance and positions is quitetransparent. The central bank’s published monthlyfinancial statements will reflect all market valuechanges in all portfolios, and the annual statementsare quite specific, offering detailed reports of cur-rency position and also credit quality. While theBank of Latvia, like most central banks, does notpublish results in accordance with InternationalAccounting Standards, the amount of transparencyis very high, with footnotes to the financial state-ments being very detailed, providing any reader ofthe financial statements possessing a modestamount of accounting knowledge with all the infor-mation necessary to analyze the true performancefrom reserves management. And while relative performance numbers versus the benchmark arenot specifically published, the benchmark itself isnot confidential, and all of the data that would be needed to make such an analysis are publiclyavailable.


Risk management and benchmark portfolio

731. As the Bank of Latvia uses reserves todefend a fixed exchange rate target (against theSDR), the neutral currency composition mirrorsthis target. Specifically, the reserves benchmarkconsists of the components of the SDR currency


basket, weighted as in the SDR. When the reservesportfolio is invested according to the neutral cur-rency weights, then there are no valuation fluctua-tions due to currency movements.

732. Regarding interest rate risk, the bench-mark consists of the 1–3 year government bondindex in each component currency. This maturitysector was chosen for various reasons. First, extend-ing duration, and having a market, not cash,benchmark, markedly increases the return onreserves over the long run. Obviously, increasingexpected return leads to an increase in expectedvolatility. However, the 1–3 year sector was chosento mirror the risk tolerance of the Board ofGovernors of the Bank of Latvia. The 1–3 year sec-tor offers notable return enhancement, but volatil-ity is limited—during the time periods available inmost financial databases, the 1–3 year maturity sec-tor has never ended a 12-month period with a neg-ative return. Clearly, sub-zero returns can beobserved in shorter time periods.

733. Liquidity is, of course, a primary concern.The Bank of Latvia has several liquidity constraintsin its reserve management guidelines, which resultin the purchase of instruments that can be realizedin times of market stress. Unlike other centralbanks, however, the Bank of Latvia does not main-tain separate liquidity and investment tranches inits reserves portfolio. We have found that the addi-tion of extremely liquid short-term instruments fora liquidity portfolio is not economically justified inour case. The instruments we hold in longer-termmaturities are more than liquid enough to satisfyany intervention (or even working capital) needs,and any perceived negative effects from increasedtransaction costs from liquidating market instru-ments in times of stress are more than offset byincreased long-term returns. Maintaining separateliquidity and investment tranches in effect puts thereserves portfolio in a “barbell” strategy. And whilesuch a strategy offers increased portfolio convexity,convexity has a price, and such a portfolio will besuboptimal in the long term, as it will not outper-form a duration-neutral “bullet” strategy.

734. Within limits set by the Board of Governorsand the Executive Board of the Bank of Latvia, theportfolio managers are allowed to take active posi-tions away from the benchmarks, in the aim of prof-

its from expected rate moves. The long-term strate-gic benchmark is set by the Board of Governors, andthe Investment Committee (comprised of ForeignExchange Department staff, the Chairperson of theExecutive Board, and the Governor of the Bank)meets weekly to set tactical benchmarks. TheInvestment Committee also holds a quarterly meeting to discuss strategic themes. Individual port-folio managers are free to trade instruments in arange around the tactical benchmark set by theInvestment Committee.

Instruments

735. The central bank uses futures, options,swaps, and other derivatives in the management ofcurrency, interest rate, and credit risks. Derivativescan be used for hedging purposes, to quickly andefficiently restructure the risk parameters of theportfolio, and for taking active positions. Leveragelimits are set by the Board of Governors’ invest-ment guidelines.

736. A certain portion of reserves tends to beinvested in “spread product”—agency and supra-national paper, corporate bonds, mortgage-backedand asset-backed securities, commercial paper, andsimilar products. Our studies have shown thatgreater long-term risk-adjusted expected returncan be gained from “moving down the creditcurve,” than by adding duration, or taking activecurrency positions. Our investment guidelineslimit the amount of credit risk allowable in theportfolio, and limit liquidity and concentration riskas well. With a minimum allowable long-term rat-ing of A-, all of the instruments the Bank of Latviapurchases for its reserves portfolio are safely in the“investment grade” category.

Staff

737. The management of a portfolio with suchdiverse products requires front, middle, and backoffice staff that can understand, measure, andmanage the various risks involved. The Bank ofLatvia has been able to attract and maintainextremely competent staff; turnover in the reservesmanagement department has been limited. Thecentral bank is able to offer its reserve manage-

13 • Latvia 147

ment staff sufficient salaries—while not necessarilyexceeding those available in the private sector,salaries are at least competitive. It is also possiblefor reserves management staff in some cases toearn higher salaries than senior managementmembers, or department heads in other bankareas. Furthermore, we have found that allowingmore complicated investments tends to keepreserves management staff interested and moti-vated—it would be much harder to retain our bestspecialists if the reserves portfolio were limited to,say, only government paper.

738. To maintain a high standard of profession-alism in the reserves management staff, every singlemember of the front and middle offices (and thedepartment head), as well as some back office staff,are enrolled in, or have completed, the Associationfor Investment Management and Research’s(AIMR) Chartered Financial Analyst (CFA) pro-gram. This program is a series of annual exams(three years’ minimum) that cover all aspects of theinvestment process, including accounting, taxes,corporate finance, fixed income, equity manage-ment, derivatives, portfolio management, ethics,financial analysis, etc. All AIMR members alsoadhere to a Code of Conduct regarding conflicts ofinterest in asset management and analysis, andannually sign professional conduct statements.


739. Information systems are also crucial to themanagement of these risks. The Bank of Latvia cur-rently has specialized systems covering positionmanagement, risk analysis, performance attribu-tion, exception reporting, and accounting require-ments for all reserves management operations.Obviously, these systems are capable of processingall the allowable instruments in the bank’s reservesand other foreign exchange portfolios. The centralbank is currently installing a new bank-wide trea-sury system, which will further integrate these pro-cesses, and a new risk management package willfurther supplement our existing risk managementefforts.

740. The Bank of Latvia employs external assetmanagers to manage portions of the reserves port-folio. These managers are subject to the same invest-

ment guidelines and limits as our internal man-agers, and every external manager transaction is alsoentered into our in-house information systems.As a result, the managers provide good externalbenchmarks for our internal managers, and every-one’s performance is measured using the same dataand methodology. We have found our external man-ager program to be quite successful—at first, themanagers provided valuable technical assistance andtraining; now, besides providing external bench-mark data, they can be used to discuss investmentstrategies and ideas. Since every manager has thesame goals, in trying to outperform the same bench-mark, these discussions can be more fruitful thanwith some sell-side counterparties that may notknow our specific needs at best, or may be trying tosell their specific inventory at worst.

741. Compliance with limits and guidelines ismonitored constantly, for both internal and exter-nal manager portfolios. Exception reporting isautomatic; in the case of a limit breach, the depart-ment head, Chairperson of the Executive Board,and Governor are notified electronically. Dailyasset mix reports, which show various deviationsfrom strategic and tactical benchmarks (within per-missible limits), are also distributed electronically.

742. Portfolio performance is measured on anabsolute basis (for accounting purposes), and rela-tive to the benchmark (for investment managementpurposes). Our performance attribution system dis-aggregates composite returns into returns from spe-cific strategies, and these reports are always availableonline in our information systems, and e-mailedweekly to reserves management staff, the Governor,and Chairperson of the Executive Board.

743. Operational risk and legal risk are con-stantly managed, and also addressed in severaldepartment and Executive Board procedures doc-uments. All reserves management operationsundergo an annual external audit, and specificaspects are audited more frequently by the Bank’sInternal Audit department.

Conclusion

744. The Bank of Latvia places a focus on thereturn aspect of reserves management, whichnecessitates excellent staff, excellent systems, and


13 • Latvia 149

the willingness of senior management to under-stand and sanction relatively higher risk levels. Wefeel the systems and staff at the Bank of Latvia aremore than capable of managing the assumed risks,

and our performance to date has tended to justifythis attitude. The nature of reserves management isalways evolving, and the Bank of Latvia will con-tinue to invest resources in staff and systems.



745. The main objective for Banco de Mexico(the Bank) in the management of its reserves is themaximization of returns subject to liquidity needsand constraints. With the implementation of a float-ing exchange regime in 1995, the Bank has beenincreasing the weight that it places on returnenhancement, while also placing high attention onother risks involved in its investment decisions.

746. There is no explicit coordination betweenmonetary policy decisions and external debt man-agement. However, in the past, when the Bank hadliabilities with the IMF, reserves were split to allowthe synthetic purchase of an SDR-denominated port-folio in order to hedge the currency risk.Additionally, the Bank, as a financial agent for theFederal Government, has a mandate to invest andmanage the resources that were pledged as collateralin the Federal Reserve Bank after the 1989 negotia-tions of the Mexican Brady Bonds; in performingthese duties, the Bank must observe restrictionsimposed under the “Collateral Pledge Agreement.”


747. The Bank publishes its Reserves on aweekly basis in its Summarized Balance, and its

Assets and Liabilities on a monthly basis in theData Template on International Reserves (foreigncurrencies).

748. However, with respect to a more detaileddisclosure, the Bank considers the effort requiredto explain the technical issues related with reservemanagement to the public to be very costly.Instead, that effort should be placed in addressingmore important topics of national interest.

749. External audits are performed once a yearand the results are delivered only to the Congressand the President.42

750. Internally, the audit department monitorsoperations on a daily basis to verify if the banknorms are being met. However, the middle office isresponsible for monitoring whether investmentscomply with the guidelines set by the Board ofGovernors on a daily basis as there are degrees offreedom that allow some deviations from thebenchmarks. These deviations are limited using aValue-at-Risk approach.

751. The Bank keeps formal documentation ofevery topic approved by the Board of Governors.The General Direction of Central BankingOperations also gives authorizations in writing.

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14Mexico

42 Chapter VII, Article 51, subindex III of Banco de Mexico’sLaw (BDML) states: “In April of each year, a report on theimplementation of monetary policy during the secondsemester of the previous year and, in general, on the activitiesof the Bank throughout said year, within the context of thedomestic and international economic situation.”

Finally, both the General Director and the Directorof Operations are constantly informed of everyinvestment strategy put in place, and of the perfor-mance generated against the benchmarks on adaily basis.

752. Recruiting employees with high businessethics and high professional skills is the way toensure sound management of internal operations.Due to the confidential nature of the work withinthe Direction of Operations, a particular effort istaken in selecting personnel. Training the staff bysponsoring them to graduate studies, as well assending them to highly recognized Central BankSeminars, are ways of confronting the difficulty ofretaining high-quality staff. In the end, however,the most efficient tools to avoid this situation havebeen a challenging work environment and anincreased level of responsibility.


753. The Constitution of Mexico gives totalautonomy to the central bank and defines the con-trol of inflation as its main objective.

754. According to Banco de Mexico’s Law(BDML), reserves are wholly owned by the Bank inorder to facilitate the accomplishment of the objec-tive mentioned above.

755. The BDML also gives power to the Bank’sBoard of Governors to define policies and stan-dards in order to perform its duties, including themanagement of reserves. The types of operations,the definition of reserves, and the authorizedassets in which to invest are defined in BDMLArticles 7, 19, and 20, respectively (see Box 1).

756. Even though the “Exchange RateCommission” (composed of members from theMinistry of Finance and Banco de Mexico) is thehighest decision authority on exchange rate policyand the management of foreign reserves, in prac-tice, it is the Bank’s Governing Board that autho-rizes the main investment guidelines. TheGoverning Board is informed semiannually of theinvestment performance; nevertheless, reports areavailable daily at their request.

757. An Investment Working Group formed bysenior operating staff is responsible for the over-sight of ongoing operations. Weekly meetings are

held to evaluate and decide on the investmentstrategy to be followed by headquarters-based staff.

758. External fund managers act indepen-dently based on the same guidelines placed by theBoard for internal operations. There are no prede-termined proportions on the amount of reservesthat can be placed with external managers;although currently approximately 5 percent oftotal reserves are delegated to five different institu-tions. These institutions provide a list of all theoperations executed on a daily basis, and deliver aperformance report on a monthly basis.

759. In addition to the Investment WorkingGroup, a Risk Management Unit, which is inde-pendent from the Operations Department, super-vises to ensure that risks and limits in themanagement of reserves are met on a daily basis byboth the external managers and the OperationsDepartment. Within the Operations Department,foreign exchange dealing operations are executedindependently from the investment reserves man-agement activities.

760. A Counterpart Working Group thatassembles every six months, led by the GeneralDirector of Operations and formed by theOperations Department and the Risk ManagementUnit, is responsible for evaluating and approvingthe addition or deletion of counterparts from apredefined authorized list.


Risk management

761. The main risks that the Bank faces are liq-uidity, credit, currency, and interest rate risks. Todeal with all of them the Bank has a specificapproach. The Board of Governors defines thestrategic asset allocation embodied in two bench-mark portfolios: one for the investment portfolioand the other for the foreign exchange diversifica-tion of reserves. Once the benchmarks have beendefined, the Board sets the guidelines that willapply to the active management of the interna-tional reserves.

762. The investment benchmark has beenmodified several times; currently it is composed of

14 • Mexico 151

U.S. Treasury instruments (65 percent), U.S. agen-cies debt (32.5 percent), and AAA credit card ABS(2.5 percent), and is of a 1.25 year duration.Securities lending is permitted and is executedthrough three securities lending agents (that hap-pen to be three of the Bank’s custodians) and theincome generated is considered part of the returnthat is compared against the performance of thebenchmark.

763. The foreign exchange benchmark is nor-mally modified on a yearly basis, and currently it iscomposed of 88 percent dollars and the remaining

12 percent in other G-7 currencies and Swissfrancs, but historically the average has been 90 per-cent dollars vs. 10 percent non-dollars. The use ofderivatives is authorized as part of the foreignexchange active management.

764. For both benchmarks Value-at-Risk (VaR)methodology is used to estimate on a daily basis theportfolios’ exposure to market risk. VaR is esti-mated for a one-month horizon period with a 95percent confidence interval. The maximumamount of risk allowed is equivalent to 0.25 per-cent of the difference portfolio VaR. Additionally if


Box 1. Banco de Mexico’s Law

BDML ARTICLE 7 states, among other things, thatBanco de Mexico shall be entitled to perform activi-ties such as:

I. Deal with securities;

II. Make deposits in either domestic or foreigncredit institutions or security depository insti-tutions;

III. Purchase those securities provided for inArticle 20, Section II, issued by internationalfinancial institutions or legal entities with for-eign domiciles;

IV. Carry out transactions involving foreign cur-rency, gold, and silver, including repurchaseagreements.

BDML ARTICLE 19 states: The reserve providedfor in the previous article shall be composed of:

I. The foreign currency and gold, property ofthe Central Bank, that are free of all lien andwhose availability is not subject to any restric-tion;

II. The amounts resulting from the differencebetween Mexico’s participation in the Inter-national Monetary Fund and the balance ofunpaid contributions to said institution thatare payable by the Bank, when this balance isless than the aforementioned participation;and

III. The foreign currency procured throughfinancing obtained for exchange regulatorypurposes from the legal entities referred to inArticle 3, Section VI. To determine the amountof the reserve, the foreign currency not yet

received from the sale of domestic currencywill not be taken into consideration; and theBank’s liabilities in foreign currency and gold,except for those liabilities with maturities oversix months and those corresponding to thefinancing referred to in Section III of this arti-cle, will be deducted.

BDML ARTICLE 20 states that reserve investmentsmust be made in securities, deposits, or other obliga-tions issued by highly rated foreign institutions.

Pursuant to this Law, the term foreign currencyincludes foreign bank notes and metallic coins, bankdeposits, negotiable instruments, securities, and alltypes of credit documents payable abroad anddenominated in foreign currency, as well as interna-tional means of payment in general. The foreign cur-rency qualified to be part of the reserve is only thefollowing:

I. Foreign bank notes and metallic coins;

II. Deposits, negotiable instruments, securities,and other liabilities payable outside nationalterritory that are considered to be first rate ininternational markets, denominated in foreigncurrency, and payable by international financialinstitutions, foreign entities, and governmentsother than the Mexican Government, providedthey are highly liquid or redeemable within aterm no longer than six months;

III. Credits payable by central banks, redeemablewithin a term no longer than six months, andwhich are current; and

IV. The special drawing rights issued by theInternational Monetary Fund.

the maximum cumulative underperformance inany calendar year, or any part of a calendar year,reaches 50 basis points (or more) below the returnof the fixed income benchmark (or 100 milliondollars (or more) worse than the foreign exchangebenchmark) the portfolio will be managed pas-sively thereafter so as to replicate the benchmarkfor the remainder of the calendar year. For bothbenchmarks, the middle office marks to marketthe positions daily in order to verify that invest-ments comply with the guidelines set by the Boardof Governors.

765. In relation to liquidity, credit, currency,and interest rate risk:

• Liquidity risk: The Board has chosen G-7 cur-rencies and Swiss francs for foreign exchangeoperations and as those that constitute theCentral Bank Forex Benchmark. For invest-ment decisions the Board has chosen assetswith deep secondary markets and high creditquality (such as U.S. treasury instruments,agencies, and industrialized country debt).Additionally the Bank splits its reserves intoseveral tranches. Out of the 88 percent of theinternational reserves that are held in U.S.dollars, 6 percent are in a liquidity portfoliowith a very short duration.43

• Credit risk: The investment guidelines donot allow the purchase of sovereign securi-ties lower than Aa2 as rated by S&P in theirlong-term debt, placements with foreignbanks must be in A2, P2 institutions as ratedby S&P and Moody’s, respectively, in theirshort-term debt, and the total exposure tobank risk cannot exceed 50 percent of theinternational reserves. Finally, the invest-

ment in AAA credit card asset-backed securi-ties is allowed. Ratings are reviewed semi-annually as well as limits for individual bankexposure. These limits are based on theirrelative credit rating against the rest ofauthorized bank institutions and also basedon their market competitiveness.

• Currency risk: Due to the nature of theBank’s Balance expressed in Mexican pesos,foreign exchange movements in the peso-dollar market have a direct impact on theBank’s results. In the internal managementof international reserves, however, currencyrisks arise from deviations against the foreignexchange benchmark.

• Interest rate risk: The exposure to interestrate risk arises from deviations against theinvestment benchmark, even though in thisparticular portfolio the use of derivatives isnot allowed. The Value-at-Risk methodologydescribed above is used to monitor and con-trol risk. Additionally, the investment staff isnot authorized to buy more than 10 percentof any individual security and the maximummaturity investment is 10 years.

Operations in efficient markets

766. The Bank agrees that undertaking trans-actions in deep and well-established marketsensures that reserve-related transactions can beeasily absorbed at market-determined prices with-out undue distortions or adverse impacts on thelevel and availability of foreign exchange reserves.That is why the currencies and assets used by theBank comply with this requirement. Nevertheless,the Bank recognizes that there could be extremesituations such as LTCM or September 11 eventsthat can cause liquidity to disappear at any time,making it impossible to avoid these distortions forthe management of international reserves.

14 • Mexico 153

43The liquidity portfolio considers investments with maximummaturities of three months (although investments in instru-ments such as U.S. treasuries and U.S. agencies can be madeliquid on a same-day basis).

154

15New Zealand

767. This report outlines the framework formanaging foreign reserves in New Zealand. Wecover matters raised in the IMF’s guidelines onreserves management under two broad themes:developing a sound governance and institutionalframework and establishing a capacity to assess andmanage risk.


768. The responsibility for foreign reservesmanagement rests with the central bank—ReserveBank of New Zealand (the Bank). Two major bene-fits arise from this arrangement. First, synergisticbenefits arise with a single organization takingresponsibility for monetary policy, financial systemoversight, and foreign reserves management.Second, the Bank’s independence from the govern-ment means that the management of foreignreserves is undertaken at arm’s length from thepolitical process.

769. The Minister of Finance has importantroles in setting the range within which the Bankmust maintain foreign reserves and can direct theBank to intervene in the foreign exchange market.

Objectives and strategies

770. The Bank’s reserve management objec-tives are to actively manage the foreign reservesportfolio to:

• Meet the immediate liquidity needs for anyforeign exchange market intervention.

• Maximize risk-adjusted net returns (or mini-mize risk-adjusted net costs), subject to thefirst objective.

• Develop and maintain a broad skill base in for-eign securities and foreign exchange dealingto support the Bank’s capability for conduct-ing foreign currency market intervention orresponding to other crises, and to enhancethe Bank’s general understanding of financialmarkets, instruments, and practices.

771. These objectives are long-standing—theywere first developed in the late 1980s. The objec-tives have been subject to review since then, buthave remained substantially the same because theprinciples that underlie them have remained rele-vant through time. These principles are that theBank should:

• have both the funds and expertise to be ableto intervene effectively in times of extrememarket disorder; and

• manage public assets prudently and cost-effectively.

772. These underlying principles are reflectedin the reserves management objectives in the fol-lowing ways. First, the primary objective forreserves management is to maintain liquid assets sothat even in the event of extreme market disorder

in both the foreign exchange market and globalbond market the Bank has the capacity to under-take effective foreign exchange intervention.

773. Second, the Bank actively manages for-eign reserves. It does so because it believes thatactive management:

• generates positive returns (in excess of com-pensation for risk and of active managementoverheads) and so reduces the costs of hold-ing reserves; and

• encourages the dealers to actively participatein a wider range of instruments and marketsthan would otherwise be the case and soimproves the Bank’s market intelligence andcontacts, knowledge of market practices, andforeign exchange intervention and risk man-agement skills. The skills and experiencegained from reserves management have beenof value to the Bank in the context of its otherroles too. For instance, foreign reserves deal-ers were able to provide valuable input whenthe Bank, in the context of its financial systemoversight responsibilities, was managing thesale of a derivatives portfolio of a failed finan-cial institution. It is not possible to be preciseabout how much added value is obtainedfrom active management but, in times ofcrises, extensive market knowledge, contacts,and experience become invaluable.

774. The key strategic issues arising from NewZealand’s reserves management center around twoissues: the level of reserves and the funding ofreserves.

Level of reserves

775. The Bank manages reserves at a levelagreed with the Minister of Finance—currently thisis SDR 1.5b–SDR 1.8b. The level of reserves isdetermined in the context of our exchangerate/monetary policy implementation strategy andforeign exchange intervention strategy. NewZealand operates a free-floating exchange rateregime—the Bank does not enter the New Zealanddollar (NZD) market to support a level or range forthe NZD that it may consider appropriate in thecontext of monetary policy.

776. The level of reserves also reflects ourintervention strategy. We hold reserves to preservethe functioning of the market for NZDs in time ofcrisis—i.e., when the market ceases to make a two-way price (bid and offer) for NZDs. If price-makersexit the NZD market, the Bank may enter the mar-ket as a temporary “price-maker of last resort.” Theaim would be to facilitate early reentry of price-makers, by taking on foreign exchange risks thatarise in price making in times of heightened for-eign exchange or financial market uncertainty,until a new price-clearing level for the NZD isdetermined. The Bank would maintain controlover the transaction sizes used to determine a mar-ket clearing price. The Bank has not had to inter-vene in the foreign exchange market since theNZD was floated in March 1985.

777. Our base-line level of reserves was firstapproved in the late 1980s. Much has happenedsince then, including the Asian crisis and a greaterunderstanding internationally of factors influenc-ing macro-financial stability. The Bank is embark-ing on a review of reserves levels with these lessonsin mind.

Funding reserves

778. The Bank funds its foreign reserves by wayof foreign currency borrowing. The benefit of thisstrategy is that the Bank is not as exposed to signifi-cant foreign exchange risk as it would have beenhad it funded reserves from NZD liabilities (includ-ing notes and coins).44 This assists the Bank in main-taining its independence as it is less exposed topolitical risks that arise (rightly or wrongly) when agovernment or public sector entity reports largelosses from risk positions. A strategic issue for theBank to consider in the future is whether costs ofholding reserves could be reduced by financingreserves from notes and coins and/or fixed rate bor-rowing in the local market (where theGovernment’s AAA rating gives it a competitive

15 • New Zealand 155

44This funding arrangement requires the Bank to spread itsborrowing requirements to minimize its exposure to refinanc-ing risk—i.e., minimize the risk that the Bank has to finance asubstantial portion of reserves at a time when an extremeevent in international markets has a significant adverse effecton borrowing (refinancing) costs.

advantage). The Bank would enter into a currencyswap to continue to hedge its foreign exchange risk.


779. As noted at the outset, the Bank is theentity responsible for foreign reserves manage-ment; however, it has a working relationship withthe Treasury and in particular the Treasury’s DebtManagement Office (DMO) in two respects. Wediscuss this relationship and then outline the insti-tutional arrangements within the Bank.

The Bank and Treasury

780. The relationship with the Treasury arises intwo contexts. First, the Minister of Finance has thepower to direct the Bank to intervene in the foreignexchange market. It is anticipated that in a foreignexchange crisis, the Bank will be intervening withthe approval of the Minister of Finance, althoughthe Bank has the power to intervene in the foreignexchange market of its own accord, if required.

781. The Bank also has a close working rela-tionship with the DMO in the context of fundingreserves (among other functions—e.g., govern-ment cash management and bond tendering). TheBank decides on the timing and nature of reservesfunding (i.e., fixed or floating rate, maturity, cur-rency), consistent with its reserves managementstrategy, but it is the DMO that raises the funds(borrowing is undertaken in the Government/Crown name). The proceeds of the borrowing arepassed to the Bank by way of loans from the DMOto the Bank and in this way the risks arising fromthe reserve assets and liabilities are managed by theBank.

Arrangements within the Bank

782. Foreign reserves management is carriedout across two departments. The Financial MarketsDepartment conducts front-office operations (e.g.,dealing, portfolio and asset/liability management,counterparty relationship management) and somemiddle-office operations (e.g., risk managementpolicy, contract maintenance, counterparty creditrating reviews). The Financial Services Group con-

ducts back-office operations (e.g., settlements,treasury, and financial accounting) and some mid-dle-office operations (e.g., compliance monitor-ing, risk and exposure reporting, risk systemmaintenance).

783. Other departments and committees alsoplay important roles in the management of foreignreserves. The Risk Assessment and AssuranceDepartment (RAA) participates in high-level strate-gic reserves management issues, acting as theGovernor’s advisor on risk frameworks and archi-tecture. This department also contains the internalaudit function. The Reserves Oversight Committee(ROC) comprises Governors and senior managersand reviews the appropriateness of the portfoliostructure, approves new business initiatives(including new financial instruments), and moni-tors active management and passive benchmarkperformance. The Risk Management Committee(RMC) comprises Governors and senior managersand reviews the risk management arrangementswith respect to all the Bank’s operations, includingreserves management.

Accountability through governance andtransparency

784. Accountability for the cost-effective man-agement of reserves in accordance with perfor-mance expectations and risk tolerances is achievedthrough formal governance arrangements andtransparent reporting of results and processes.

Governance

785. The Bank’s powers, authorities, andaccountabilities are contained in the Reserve Bankof New Zealand Act 1989 (the Act). The Bank’s pow-ers and authorities are vested with the Governor,who delegates appropriate authorities to relevantstaff. The Bank conducts its foreign reserves opera-tions in accordance with a mandate from theGovernor. The Mandate for the Management of theForeign Reserves Portfolio (the Mandate) containsthe purpose, objectives, reserves level, performanceexpectations, risk management policies, and keymanagement responsibilities and delegations withrespect to reserves management. The Mandate,


which was implemented in September 2000, wasdesigned to avoid any misdirection of focus towarddetailed and immaterial risk and procedural issues.It was felt that a succinct, high-level mandate mod-eled along funds management industry lines wouldemphasize high-level, strategic focus on risk andreturn issues with respect to the foreign reservesmanagement function. Based on the experience oftwo years of operations, the Mandate appears to beserving its purpose.

786. The Bank’s Board of Directors45 (whichcomprises a majority of independent directors) hasresponsibility for, among other matters, keepingunder constant review the performance of the Bankin carrying out its functions. Unlike boards of mostentities, which have a capacity to direct and influ-ence the entity’s functions and operations, theBank’s board may only advise the Governor withrespect to matters relating to the Bank’s functionsand exercise of its powers. However, if the boardconsiders that the Bank is not adequately carryingout its functions, it may recommend to the Ministerof Finance that the Governor be removed fromoffice. Senior managers report to the Boardmonthly on the financial results of foreign reservesmanagement. The Board’s Audit Committee alsomeets regularly to monitor the audit function withinthe Bank, receive reports from the Bank’s externalauditor, review the Bank’s financial statements, andadvise the Board on the Bank’s accounts.

787. The Head of Financial Markets, whoreports to the Governor, is accountable for reservesmanagement performance and compliance withrisk management arrangements. The ROC assiststhe Governor in monitoring performance and port-folio structures at a high level. The Chief FinancialOfficer (who heads the Financial Services Groupand reports to the Deputy Governor) is accountablefor, among other matters, settlement operations,reserves accounting/financial reporting, and moni-toring the Financial Markets Department’s compli-ance. Reserves operations in both the Financial

Markets Department and Financial Services Groupare subject to both internal and external audit.

Transparency

788. The Bank publishes an annual report thatlays out the governance arrangements, reports onthe key performance indicators with respect to itsfunctions (including reserves management), con-tains a report from the non-executive directors,and includes audited financial statements pre-pared in accordance with New Zealand generallyaccepted accounting practice (GAAP). NewZealand GAAP requires compliance with NewZealand accounting standards, which are at least asrigorous as international accounting standards. Inaddition, the Bank applies relevant financial riskdisclosures recommended by the Basel Committeeon Banking Supervision. The key financial report-ing implications of these policies are:

• Foreign reserve assets and foreign currencyliabilities funding those assets are valued inthe Statement of Financial Position (BalanceSheet) on a marked-to-market basis withgains and losses booked to the Statement ofFinancial Performance (Profit and Loss).This fair value methodology is employedbecause we regard the reserves as availablefor sale (intervention). Liabilities are valuedusing the same methodology as the assets sothat the financial statements capture theeffects of the quality of our financial riskmanagement—gains/losses from unhedgedrisk positions are booked to P&L.

• Extensive disclosures are provided in thenotes to the accounts on a range of reservemanagement matters—e.g., risk managementpolicies, quantitative risk exposures (includ-ing credit risk and market risk losses, includ-ing from tail (extreme) events), net reservesmanagement income (active managementperformance and passive or risk neutral per-formance are separately identified).46


45The Bank’s Board is about to undergo a restructuring—anon-executive director will replace the Governor as Chair ofthe Board, and Deputy Governors will no longer hold Boardpositions. This follows an independent review of the operationof monetary policy in New Zealand.

46Note, the effect of translating reserves management perfor-mance back into NZD is not material (but is separately dis-closed) because foreign reserves are funded by foreigncurrency liabilities.


Benchmark portfolio and instruments

789. The Bank’s framework for managing allrisks arising from foreign reserves management isdocumented in the Risk Management Document.The main risks the Bank faces from this activity arebusiness risk, liquidity risk, credit risk, market risk(interest rate and foreign exchange risk), andoperational risk (including custodial risk). The keyelements of the strategy for managing these risksare outlined below. This section concludes with adiscussion of active management performancemonitoring and controls.

Business risk

790. This encapsulates the political and infra-structural risks arising from the markets in which,and instruments with which, we manage reserves.We aim to minimize reputational risk by limitingauthorized instruments to “plain-vanilla” fixedincome instruments and derivatives. The deriva-tives activities encompass only futures and swaps.We do not invest in non-fixed income instrumentssuch as equities. Nor do we invest in options orfixed income securities with material option risksuch as mortgage-backed securities.

791. The markets in which we operate are inessence restricted to those of well-developed coun-tries (mainly the U.S. and Germany although wehave scope to participate in G-10). We do not oper-ate in emerging markets.

Liquidity risk

792. Reserves are not divided into tranches tomeet different objectives per se. However, reservesare actively managed within the overriding con-straints that reserves must be liquid and diversifiedprimarily across the U.S. and Germany. This meansthat the base level of reserves must be invested inspecified classes of liquid assets in these markets—i.e., Government securities (including central bankdeposits), reverse repos (with Government securitycollateral), and CD/CPs (primarily by issuers ratedAA- or better). In broad terms, at least a third of

the liquid reserves must be held in Governmentsecurities and no more than a third of the liquidreserves can be held in CD/CPs. The investment ofa significant proportion of reserves in CD/CPsinstead of Government securities significantlyreduces the cost of holding reserves (the CD/CPinvestment yield is close to the funding costs), with-out significantly reducing credit quality (given thecredit rating criteria we apply and the short matu-rity of the instruments) or materially altering ourliquidity (since our holdings represent a small pro-portion of turnover and amount on issue).

793. The currency composition of reserves isdetermined by the intervention strategy and riskpreferences. The U.S. dollar is our interventioncurrency so the majority of our liquid assets aredenominated in this currency. The proportion ofreserves held in other major currencies variesdepending on prevailing risk conditions and netborrowing costs. Depending on local market con-ditions we may hold reserves in only one currencyother than the U.S. dollar. Currently, we hold liq-uid reserves in U.S.dollar- and euro-denominatedassets.

794. The instrument composition of reserves isreviewed periodically in the context of liquidity riskstress scenarios—e.g., widening of credit spreadsand bid/offer spreads. The Risk ManagementCommittee reviews underlying assumptions aboutextreme market conditions, our intervention strat-egy under those conditions, and the financial costof liquidating reserves under such conditions.Based on this analysis, the instrument compositionof liquid assets is determined.

Credit risk

795. The risk of loss from counterparty defaultis managed by way of individual counterparty andaggregate credit risk limits. Individual counter-party limits are determined in accordance with theGovernor’s strategic tolerance for loss—the lossfrom default of a non-sovereign counterpartyshould not exceed the Bank’s capital. In practice,this means we set the counterparty limit forAAA/AA+ rated entities at a level just below Bankcapital. Limits for counterparties with a lower rat-ing are assigned a proportionately lower limit


based on the relative default rate for entities withthat lower rating. For instance, if the probability ofdefault of a single-A rated entity was three timeshigher than that of an AA+ rated entity, the limitfor the single-A rated entity would be one third thelimit of the AA+ rated entity. We do not permitcredit exposures to entities rated lower than A-.

796. Concentration of credit risk is controlledby aggregate credit limits—primarily country limitsand, in some cases, bank or corporate sector limitswithin countries. The thresholds for aggregatecredit limits are set on the basis of judgments aboutpolitical risks arising from losses in the event of sec-tor or country crises. We are in the process of sup-plementing these judgments with a quantitativeanalysis of counterparty default correlation. Ouraggregate credit limits also include a cap on theaggregate amount of credit exposure we have to allsingle-A rated counterparties to ensure that thecredit quality on the reserves portfolio is main-tained at a high level.

797. Credit exposures relative to limits are gen-erally reported on a gross basis—exposures areonly reported on a net basis where there is a legallyenforceable netting contract.

Market risk

798. The market risks the Bank is exposed toare interest rate risk and foreign exchange risk.Both these risks are controlled by the same marketrisk limit framework. The (parametric) Value-at-Risk (VAR) methodology is used to measure andcontrol market risk. The VAR limits are set wellwithin the Governor’s stated tolerance for marketrisk losses in a year to allow for both accumulatedmarket risk losses over a year under normal marketconditions and losses from extreme movements inmarket prices or “tail-events.” The accumulatedlosses over a year allow for poor active manage-ment performance and (mark to market) losses onthe passive portion of reserves due to adverse inter-est rate trends (narrowing credit spreads). Theallowance for tail-events is based on an analysis ofsimulated worst single day losses on a diversifiedportfolio over the 1990s, scaled up to allow forunobserved tail-events. This simulation/stress testanalysis is conducted annually. Given that we invest

in instruments that are highly liquid (even inextreme/stress scenarios) we believe it is appropri-ate to measure market risk (including tail-eventmarket risk) with only a one-day holding period.

799. Actual daily P&L results are comparedwith estimated gains and losses from the VARmodel each month. The results of the “back-testing” analysis are reported to the ReservesOversight Committee quarterly.

800. The VAR-based framework for managingmarket risk has been in operation since 1998. It is aconsiderable improvement over our in-house dura-tion and convexity market risk model, which itreplaced, because VAR captures spread risk and FXrisk. We have found VAR a very useful “commonruler” for measuring market risk on a range of dif-ferent instruments and positions and most helpfulin communicating to senior management about thequantum of risk (under normal market condi-tions). VAR presents challenges for us in terms ofunderstanding where our market risk exposures lieand what are our key risk factors (nature of andchanges in interest rate and exchange rate volatili-ties and correlations). We are in the process ofdeveloping management reports to get betterinsights into our risks that lie behind VAR. Seniormanagement are aware of market risks that liebeyond VAR—the results of the annual tail-eventanalysis are reported to them and estimates ofextreme losses are published in the annual report.We also find (parametric) VAR less useful for cap-turing the risks over time on the passive portion ofreserves because the main market risk on this por-tion of reserves—credit spreads—is mean-reverting.This means scaling parametric VAR by time over-states risk. VAR derived from historical simulation isour preference for the future, but system anddatabase management issues constrain our desire tomove in this direction in the foreseeable future.

Operational risk

801. Minimizing operational risks in the man-agement of reserves is of critical importance in tworespects:

• Maintaining a continuous intervention capac-ity; and


• Minimizing financial loss and reputationdamage from fraud.

802. In order to maintain a continuous inter-vention capacity the Bank sets internal controlsand processes with respect to system and dataintegrity (e.g., data reconciliation), disaster recov-ery planning (including maintaining an off-sitecapacity and crisis procedures and contacts), andkey-person risk (including succession planning,mentoring, knowledge sharing, and informationdissemination). The Bank is also dependent on itssecurities custodians effectively managing theiroperational risk. We review custodians’ controlsbefore we place securities with them and, on anongoing basis, test their systems (with their coop-eration) by executing securities transfers instruc-tions from time to time to simulate cash raising intime of intervention. In addition, we have a policyof diversifying our security holdings across a fewcustodians so that our intervention capacity is notentirely exposed to operational risks or disaster sce-narios with respect to a single custodian.

Fraud

803. The Bank has in place a number of oper-ational controls to minimize financial and reputa-tional damage from fraud. These includeseparation of front- and back-office operations,logged dealer phones, tracking of deal tickets,transaction and position reconciliation across P&Land risk reporting, and confirmation and settle-ment instruction matching with counterparties.The Bank also places considerable importance onfront-, middle-, and back-office operations having agood understanding of the nature of, and risks aris-ing from, the instruments in which we deal, sotransactions will be subject to reasonablenesschecks along the process chain. The aim here is tonot rely too heavily on any one person (particularlyin the front office) for advice on appropriate pro-cessing of transactions. This widespread under-standing of appropriate processes is an objectivewe are continually striving to achieve.

Active management

804. As noted above, the Mandate includesprovisions for active management of reserves and

clearly outlines the performance expectations thatmust be met to continue this activity. Active man-agement takes the form of interest rate and cur-rency trading over short-term (ranging fromintraday to up to three months) and medium-term(three to 24 months) horizons. Positions areentered into at the discretion of dealers and on thebasis of rule-based analytics. Given the rather lim-ited range of instruments and markets in which wecan operate, we strive for diversification by tradingwith different investment horizons and by usingdifferent decision processes (dealer discretion andrule-based analytics).

805. Active management returns and risks aremeasured against a benchmark (comprising bothassets and corresponding liabilities), which is con-structed within the Bank, independently of thefront office, to reflect the composition of reservesand funding under passive management—the risk-neutral position. The benchmark is managedwithin broad risk parameters defined by theGovernor and with the objective of minimizingcosts, consistent with a passive management strat-egy. Portfolio managers must actively managereserves in a manner that adds value—i.e., gener-ates a return that exceeds the benchmark and cov-ers charges for additional risks from activemanagement as well as additional costs arising fromactive management. Performance is measured on arolling three-year basis, but attention is also paid toperformance in a financial year to monitor theBank’s political risk exposure that may arise when itpublishes results of operations in the annual report.Active management performance is also monitoredrelative to that of comparable (external) fund man-agers, six monthly. Information ratios are used forthis purpose. This enriches our understanding ofour portfolio managers’ performance; however, it isnot the relative performance of portfolio managersthat determines whether we continue with thisactivity; it is their absolute performance—they mustadd value (as defined above).

806. Active management risks are controlledusing the same framework used to control therisks on the entire reserves (active and passivereserves), as outlined above. Market risk is theonly area where we have separate active manage-ment limits. VAR and stop-loss limits are applied


at the portfolio and aggregate (all portfolios com-bined) level.

807. The Bank does not currently use externalfund managers as we believe that this would con-strain our capacity to meet the objective of reservesmanagement to increase the Bank’s knowledge ofinstruments and market practice and maintainmarket contact; divert scarce resources to manag-ing the relationship; and not significantly increasereturns if the managers were subject to the samerisk constraints as our portfolio managers.

808. However, we would consider using externalfund managers if there were markets or instrumentsin which we wished to participate but did not havethe expertise to do so directly. In these circum-stances, we would expect that external fund man-agers would not only improve active managementrisk-adjusted performance, but also provide a meansby which we could learn from their activities.

809. We do make use of overseas investmentbanks’ bond lending services. The Bank under-takes this activity itself, but time zone differencesmean that it is economical for us to outsource this

activity to entities that operate in markets at nightin New Zealand.

Conclusions

810. The Bank’s management of foreignreserves is continually evolving. There are a num-ber of strategic issues that underlie reservesarrangement and it is the Bank’s (and govern-ment’s) practice to review these issues periodically.Reserves management in New Zealand also evolvesin light of market developments in financial instru-ments and risk management practices, and of ourown experiences and lessons. We recognize thatour practices differ in many significant respectsfrom the practices in other countries (there arealso significant similarities too). We believe thatthis is appropriate because, while there are coreprinciples underlying reserves management, thepractices adopted in meeting those core principlesshould vary according to countries’ public policy,institutional frameworks, skills, and resources.


Background

811. At the end of 2001, Norway’s central bank,the Norges Bank (the Bank), managed funds worthNKr 795 billion (US$88 billion) in the internationalcapital markets. The bulk of this capital was theGovernment Petroleum Fund (NKr 613 billion/$68 billion), which is managed on behalf of theMinistry of Finance, and the Bank’s internationalreserves (NKr 170 billion/$19 billion). NorgesBank’s international reserves comprise the foreignexchange reserves, gold reserves, and claims on theIMF. In addition, the Bank manages theGovernment Petroleum Insurance Fund (NKr 11billion/$1 billion) on behalf of the Ministry ofPetroleum and Energy.47

812. The foreign exchange reserves (NKr 157billion/$17 billion) are split into four sub-portfolios;

• the liquidity portfolio (NKr 37 billion/$4 bil-lion), which is to be used in connection withthe conduct of monetary policy (for poten-tial foreign exchange interventions and toinfluence liquidity and interest rates in theNorwegian money market);

• the long-term portfolio or investment portfolio(NKr 106 billion/$12 billion), which shouldalso be available for market operations, butshould be invested on the basis of more long-term considerations;

• the immunization portfolio (NKr 6 billion/$1billion), which is equivalent to governmentforeign currency debt and is intended toneutralize foreign exchange and interest raterisk associated with this debt; and

• the Petroleum Fund buffer portfolio (NKr 7 bil-lion/$1 billion), which receives capital daily,and is transferred to the GovernmentPetroleum Fund on a monthly basis.

813. The liquidity portfolio is managed byNorges Bank Monetary Policy (NBMP) by theMarket Operations Department (MOD). All otherfunds/portfolios are managed by Norges BankInvestment Management (NBIM), which was estab-lished as a separate wing in January 1998 to meetthe Bank’s challenges of having been delegated theresponsibility for managing the Petroleum Fund.NBIM’s sole purpose is to function as investmentmanager and thereby take advantage of the bene-fits inherent in being a large institutional investor.Economies of scale made it natural to assign NBIMthe responsibility for handling a large part of theforeign exchange reserves. To prevent duplicationof internal resources, NBIM delivers settlementand IT services to NBMP/MOD.

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47Guidelines and performance reports for the foreignexchange reserves and various funds managed by the Bankand invested in the international capital markets are pre-sented on Norges Bank’s website (www.norges-bank.no).

814. In addition to being responsible for themanagement of the liquidity portfolio, NBMP/ MOD also carries out the purchases of foreignexchange to the buffer portfolio. This ensures thatthese responsibilities are viewed in conjunctionwith the department’s activities in implementingmonetary policy.

815. The way the Bank carries out the missionof managing the Petroleum Fund has also con-tributed to a more professional management of theforeign exchange reserves with more focus on per-formance, and has influenced the investment strat-egy of the long-term portfolio (as compared to theold strategy back in 1998, equities are nowincluded, the number of markets is larger, and theduration of the fixed income portfolio is higher).



816. The objectives of reserves managementare: (i) funding intervention, (ii) managingnational wealth (high return), and (iii) immuniza-tion of government foreign currency debt.

817. In the monetary policy, a formal inflationtarget was adopted in March 2001. The interestrate is the main monetary policy instrument, butinterventions may be considered in special circum-stances. Measured in months of imports, Norwayhas quite large reserves. Both the size of thereserves and the change in the monetary policyimply that it is more appropriate with a longerinvestment horizon.

818. The Executive Board of the Norges Bankestablishes guidelines for the management of theforeign exchange reserves. The aim of the man-agement is to maximize the return within the con-straints specified in the guidelines. From 2001onwards, a part of the long-term portfolio (20 per-cent) has been invested in equities. The ExecutiveBoard has decided to further increase the equityshare, and to include nongovernment securities inthe bond portfolio.

819. The management of the foreign exchangereserves is coordinated with the Ministry of

Finance’s management of government foreigndebt. The way this is carried out is that a small partof the reserves—the immunization portfolio—hasbeen set aside to be equivalent to government for-eign currency debt. In 2004, the existing govern-ment foreign debt (worth only NKr 6 billion atend-2001) will be settled in its entirety.

820. One may therefore conclude that objec-tives (i) and (iii) mentioned above have becomeless important over time and (ii) more important.


821. Pursuant to the Norges Bank Act, NorgesBank shall invest the official foreign exchangereserves with a view to maintain the foreignexchange policy that has been established. TheKing in council may issue rules concerning theinvestment of the official foreign exchangereserves. In practice, however, Norges Bank’sExecutive Board has laid down guidelines for theinvestment of reserves.


822. There is a clear division of responsibilities,which is reflected in the organizational setup andwell documented in written guidelines, mandates,and job instructions. The overall responsibility foroperations rests with the Executive Board, whichsets the overall strategic guidelines (includingmajor risk limits) and receives quarterly manage-ment reports.48 The Board has delegated to theGovernor to set supplementary guidelines. TheGovernor has in turn delegated further specifica-tions to the responsible manager (wing leader).

823. Instrumental to the establishment of aclear distribution of roles and responsibility is thedivision between strategy formulation on the onehand and operational management with a clearresponsibility for performance on the other. A sepa-rate unit within the Governor’s staff has been given

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48Until 2000 the Executive Board delegated to the Governorto define the benchmark portfolios and the limits for relativerisk (tracking error), as well as credit risk (minimum ratinglevel). These fundamental limits are now placed with theBoard itself.

the responsibility for preparing advice on the strate-gic guidelines and benchmark portfolios of thereserves and the Petroleum Fund.49 The leader ofthe respective wing has responsibility for the perfor-mance results of the portfolio(s) under manage-ment. This principle of decentralized managementis an important characteristic of Norges Bank’s gen-eral management model. This may contrast with var-ious other central banks where investmentmanagement decisions may be based (more or less)on investment committees with members from dif-ferent parts of the organization. Responsibility forinternal control lies with the wing as part of the line-based management model.

824. NBIM is a separate management unit thatdoes not have access to market-sensitive centralbank information (“Chinese walls”). The managerreports directly to the Governor, like the other wingleaders. Within NBIM, there is a sharp line betweenthe departments that make decisions regardinginvestment, and the Investment Support Depart-ment, which takes charge of transaction settlement,risk measurement, return measurement, andaccounts. Responsibility for control rests with thefront office departments. These constantly monitorthe internal and external management. Independ-ent control of market and credit risk is carried outin the Investment Support Department. The Legaland Compliance Department oversees the internalcontrol functions, and is a primus motor in compli-ance work.

825. NBIM’s most important objective is toachieve the highest possible return pursuant toapplicable mandates and limits. It is easy for thedelegating authorities and other observers to assesswhether the performance targets are attained.Assignments are clearly defined in written man-dates, and NBIM’s results can be compared withdefined benchmark portfolios. The establishmentof NBIM as an independent unit in Norges Bankmakes its responsibility for performance moretransparent.

826. In NBMP/MOD, risk control and returnmeasurement are carried out in a separate unitindependent of the front unit. The middle officeunit reports to the head of MOD.

827. Outside NBMP/MOD and NBIM, theGovernor of Norges Bank has a staff to superviseand monitor compliance and, as mentioned, to for-mulate strategy. Previously the Governor also had aspecial advisory committee from departments otherthan NBIM, NBMP/MOD, and the Governor’s staffto assist the Governor in this work. Recognizing thatthe work of the advisory committee was overlappingwith the work of the Governor’s staff, the commit-tee was removed in 2001.

828. External auditing is performed by NorgesBank’s separate Audit Unit, the Central BankAudit, which reports to the Bank’s SupervisoryCouncil, which is appointed by the Parliament.The Central Bank Audit is responsible for the oper-ational auditing of investment management, aswell as the statutory financial audit of the Bank’saccounts. In its mandate the Central Bank Audit isalso asked to do work that is ordinarily consideredthe responsibility of an internal auditor. The auditis carried out in accordance with recognized audit-ing standards in Norway, which are based on inter-national auditing standards.

829. The Supervisory Council is responsiblefor ensuring that the rules for the Bank’s activitiesare observed, including general monitoring andfollow-up of the Executive Board. The ExecutiveBoard and the Supervisory Council receive a quar-terly report on the management of the reservesconsisting of detailed reports on each of the sub-portfolios and a concentrated report extracting themost relevant information in the sub-reports (seebelow). It may also be pointed out that theGovernor receives a monthly report from NBIM onthe performance of all NBIM portfolios. TheGovernor also has a special monthly follow-upmeeting with NBIM, where performance and othertopics relevant for the Governor in evaluatingNBIM are addressed.

830. Detailed accounts of the foreign exchangereserves are presented in the Bank’s annual report,including book value (i.e., market value) andreturn in Norwegian kroner (NKr) of the totalreserves and the different sub-portfolios, as well as


49For the reserves, the guidelines prepared by the Governor’sstaff are set by the Executive Board or the Governor. For thePetroleum Fund the guidelines are given by the Ministry ofFinance, except supplementary guidelines for credit risk,which are set by the Governor.

the currency composition of the total foreignexchange reserves. The annual report also con-tains a separate chapter describing investmentmanagement in Norges Bank, including the percentage return attained on each of the sub-portfolios and compared with the benchmarkreturn.

831. Since 2001 Norges Bank has, via theInternet, extended to the public informationabout the reserves.50 The reason for the change inpolicy is that the Norwegian Government applies aprinciple of transparency to the Bank’s manage-ment of the Petroleum Fund. The foreignexchange reserves may also be considered as partof public funds subject to openness. The new infor-mation includes guidelines for the investment offoreign reserves issued by the Executive Board, aswell as supplementary guidelines set by theGovernor. In addition, the quarterly concentratedmanagement report mentioned above is presentedon the web as of 2000/Q4. This report displays sizeand return of the different sub-portfolios (and rel-ative return compared to the benchmark portfo-lio) as well as actual asset class and currencycomposition, and portfolio risk exposure com-pared with limits. Returns are measured both inthe currency basket of the benchmark portfolioand in NKr. The more detailed managementreports for each of the sub-portfolios in thereserves are not made public.

832. Norges Bank is aware that managing theGovernment Petroleum Fund and the foreignexchange reserves requires active use of salary andpersonnel policy incentives. The market for per-sons with experience in financial and investmentmanagement is characterized by a high salary levelwith an element of performance-related pay incombination with extraordinary demands forfocused work. The Bank’s success in achievinggood management results will depend verystrongly on its ability to recruit, develop, and retainhighly qualified personnel from this market. TheBank is very conscious of developing the compe-tence of its own employees.

833. Part of the salary of employees withresponsibility for the results of investment deci-sions is based on performance. In 2001, this wasthe case for more than one third of the NBIMemployees. This pay system has been extended tokey personnel in investment support functions.

834. To a lesser degree, NBMP/MOD hasimplemented a payment structure where paymentpartly is based on performance (on a broad basis).

835. It is part of the IT strategy that top skillsare bought where they are found, whether by ownemployees or outsourcing. All technical supportand a large part of systems development and appli-cations support are performed by external suppli-ers, both outside and inside Norges Bank’spremises. NBIM has defined the type of core com-petence the unit would like to have. Other func-tions will be outsourced if possible.


Benchmark portfolio

836. The level of risk derived from the invest-ment strategy comes from two sources: the long-term strategy specified by the benchmark portfolioand the short-term strategy or the permissible devi-ations from the benchmark. By far the most impor-tant is the benchmark portfolio. The level of risk inthe benchmark is determined by the currency dis-tribution, asset classes (equities, bonds), type ofsecurities, and duration of bonds. The benchmarkfor the liquidity portfolio reflects that the portfoliois to be used for interventions: high liquidity, shortduration. The benchmark for the long-term port-folio reflects the intention of managing wealth(high return): bonds and equities, global diversifi-cation. Risk is also affected by the maximum allow-able deviations from the benchmark. This ishandled in the strategic guidelines by specifyinglimits for tracking error, asset class mix, currencyand market distribution, duration, and minimumlevel of ratings, etc. See our website for the detailedbenchmarks and limits.

837. The investment strategy for the long-termportfolio (which includes equities) is based onanalysis of portfolio return and risk, using an in-

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50Most of the web pages are available in English.

house simulation model. In the calculations esti-mates of expected portfolio return are based onhistorical data and, alternatively, on simplified sub-jective judgments. Risk is measured as the annual-ized standard deviation of the portfolio return,based on a covariance matrix of historical returns.In addition, the probability of having a negativeportfolio return in any single year is calculated.The analysis showed that including a small part ofequity exposure would enhance the portfolioreturn without significantly increasing the risk.

838. The asset weights of the benchmark port-folio float with the market prices, and rebalancingthe benchmark weights means that managers willincur transaction costs in the actual portfolio. Aspecific risk analysis has therefore been performedto determine optimal rules for rebalancing thebenchmark.

839. The liquidity portfolio is to be used inconnection with the conduct of monetary policy. Itis important that the portfolio is invested in liquidcurrencies. The euro is the most relevant currencyfor interventions and the U.S. dollar is the mostrelevant currency for operations in currency swapsto influence liquidity and interest rates in theNorwegian money market. Currency swaps areonly a supplementary instrument in domestic liq-uidity operations. Because of diversification pur-poses the liquidity portfolio is also invested insterling and Japanese yen. The distribution of theliquidity portfolio is as follows: 50 percent in euros,25 percent in U.S. dollars, 20 percent in poundssterling, and 5 percent in Japanese yen. The man-aging wealth motive of the long-term portfoliomeans more emphasis is placed on global diversifi-cation, with eight currencies in the fixed incomebenchmark and 12 currencies (22 markets) in theequity benchmark.

Instruments

840. The guidelines set by the Executive Boardspecify the allowable asset classes for each portfo-lio. Within the asset classes there is no list of allow-able instruments, given that certain generalrequirements are fulfilled: Sound risk systems andcontrol routines must exist for the instrumentsused in the management of the foreign exchange

reserves. In addition, it must be ensured that thereis sufficient expertise in all areas of activity.

841. Interest-bearing securities in the liquidityportfolio shall be issued by nation states, enterpriseswith government guarantees, or international orga-nizations with a high credit rating. Investment isalso permitted in bonds from other issuers relatedto the public sector, which may be included in theLehman Global Aggregate Government Index.Permissible interest-bearing securities in the long-term portfolio are bonds that may be included inthe Lehman Global Aggregate Index (investmentgrade), including corporate bonds, mortgage-backed, and asset-backed bonds. Bond issuers andcounterparts in bank deposits etc. are subject to aminimum rating level. Equities in the long-termportfolio must be listed on a stock exchange in oneof the countries listed by the Board.

842. Before trading in a new instrument com-mences, documentation must be available that iden-tifies the various types of risk associated with use ofthe instrument, and that confirms that provision hasbeen made for adequate expertise, risk systems, andcontrol routines. Derivatives may be used to theextent that the ensuing financial exposure does notexceed the exposure that would have resulted frominvesting directly in the underlying instruments.Overall risk management is to be undertaken inwhich the exposure in derivatives is integrated withthe exposure from underlying instruments.

843. In practice it will be up to the leader ofthe respective wing to specify a list of allowableinstruments.

844. Both interest rate and equity derivativeshave been used extensively to attain desired posi-tions in a cost-effective manner. In the transition in2001 from 0 to 20 percent equities within the long-term portfolio, equity index futures were appliedbefore converting the equity exposure to physicalshares. Interest rate derivatives include bondfutures, LIBOR futures, options on futures, andinterest rate swaps. Activity in derivatives must obeythe rules mentioned above.


845. As mentioned, the objectives of holdingreserves are multiple. Therefore the reserves are


divided into four different sub-portfolios, and sep-arate guidelines are drawn for each portfolio.

846. Market risk is calculated as the expectedannual standard deviation of the portfolio returnsbased on portfolio holdings and time series of his-torical market prices. Credit risk is primarily mea-sured by the ratings from the leading ratingagencies.

847. Interest rate risk is measured by modifiedduration. The liquidity portfolio has a short dura-tion (about 1.5 years). The level of duration for thelong-term portfolio (approximately 5.5 years) mir-rors the duration of the market (indices), andreflects both the long-term investment horizon andthe fact that in some bond markets empirical stud-ies indicate that the maturity premium has beenpositive and rising for durations up to 2–3 years,with the rise in premium slowing thereafter andeven stabilizing.

848. The reserve portfolios are, as mentioned,split between two different wing leaders, and theresponsibility for managing risk in Norges Bank iswith the wing leader. Therefore we do not quantifythe expected return and risk for the total reserves.Instead, the Bank’s return/risk objectives arereflected in the way reserves are divided into dif-ferent sub-portfolios and the way the separateguidelines are designed.

849. The main strategic choices for both theliquidity and the long-term portfolio are defined bymeans of benchmark portfolios. These are con-structed portfolios with a given country distribu-tion and specific securities from the varioussub-markets. A benchmark portfolio is used tomanage and monitor risk exposure, and also servesas a point of reference for evaluating the actualreturn achieved on the reserves.

850. We use external benchmarks (LehmanBrothers for bonds, FTSE for equities). For ease ofcomparing portfolios the policy is to use the sameindex provider for the various portfolios unless wehave good reason to deviate. Benchmarks for theliquidity portfolio and the long-term portfolio aredefined by the Executive Board and are to someextent made more precise by the Governor. Thewing leaders are measured against the “official”benchmark, but they are free, of course, to applysub-benchmarks for their different sub-activities.

851. Possible criteria for choice of an index areease of access, transparency, clarity of selection cri-teria, investibility, breadth of coverage, quality ofdata, availability of historical data, customer service/support, quality of analytics, and ability to customize.

852. The Executive Board has stipulated thatmanagement of the foreign exchange reservesshall be aimed at achieving the highest possiblereturn within the limits set out in the guidelines.Far the most important factor influencing returnsis the benchmark portfolio. There are two reasonsfor allowing deviations from the benchmark port-folio. One is cost-effective management (index-related). The other is active management.

853. An upper limit has been set for the actualportfolio’s deviation from the benchmark. Thislimit is a measure of relative risk (tracking error).In practice, this means that the difference inreturns on the actual portfolio and the benchmarkwill normally be small. The upper limit forexpected tracking error is 0.5 percentage point forthe liquidity portfolio and 1 percentage point forthe long-term portfolio.51

854. In NBIM, internal fixed income manage-ment is divided into two main areas: indexing andother index-related management on the one hand,and active management on the other. Within thesetwo areas, activities are further divided into variousspecial functions.

855. The objective of index management is toefficiently purchase the benchmark, while takingadvantage of special pricing situations to achievesome excess return (enhanced indexing). Theearnings potential of lending fixed income instru-ments from the portfolio is utilized. Anotherimportant task is to correct undesirable deviationsfrom the benchmark in the most efficient way possible.

856. One objective of active management is totake advantage of systematic price differencesbetween bonds with almost identical properties inorder to achieve an excess return. Another strategy

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51In simplified terms, a tracking error of 1 percentage pointmeans that the actual difference between the returns on thebenchmark and the actual portfolio will be between –1 and +1percentage points in 2 out of 3 years on average.

for achieving an excess return is to take positionsthat depend on future interest rate movements. Animportant objective of management is to ensurebreadth in the active fixed income managementpositions so that the return will not be overlydependent on individual explanatory variables.

857. The equity portfolio of the long-termportfolio was established in 2001. The entire port-folio has until March 2002 been managed inter-nally as an enhanced index portfolio, takingadvantage of special pricing situations, as for exam-ple in relation to the significant changes in theFTSE-index that occurred in June 2001. As forfixed income the earnings potential of lendingequities is utilized. In March 2002 part of theequity portfolio was converted to external equitymandates. See below for a discussion of externalmanagement.

858. The total level of active risk within thelong-term portfolio has until now been quite mod-est, mostly within the interval 20–40 basis points asmeasured by expected tracking error. In practicethe liquidity portfolio has tracked the benchmarkportfolio very closely, around 10 basis points asmeasured by expected tracking error.

859. Returns on the actual portfolio and thebenchmark portfolio are calculated according tothe market value principle.52 For the long-termportfolio multiple historical performance horizonsare applied to measure the average excess return.Monthly data go back to the beginning of 1998when NBIM was established. An information ratiois calculated for the long-term portfolio.53

860. Management costs for the sum of thethree reserve portfolios managed by NBIM are pre-sented in quarterly reports. The costs incurred byNBIM’s management activities consist partly of feesto external managers and custodian institutions,and partly by Norges Bank’s internal operatingcosts. Similar calculations of the costs of managingthe liquidity portfolio have not been made. One of

the reasons for this is that portfolio managers inNBMP/MOD perform other tasks in addition toinvestment management.

861. For the long-term portfolio the Governorhas set a target (in basis points) for the yearlyexcess return above benchmark. When comparedwith the target, the actual excess return is adjustedfor taxes and transaction costs that may haveresulted from changes in investment strategy. Inthe management of the liquidity portfolio, a part ofthe narrow risk limit of 50 basis points is utilized. Itis set a target (internally) for yearly excess returnthat reflects the use of tracking error.

862. In Norges Bank’s accounts, foreignexchange reserve items are valued based on their“fair value,” i.e., their market value in Norwegiankroner. The accounting profit/loss includes bothunrealized and realized gains and losses (in NKr).This means changes in market prices of currencies,bonds, and equities will impact the Bank’sprofit/loss account and the Bank’s own capital.Though NKr is the relevant currency in theaccounts, the return on the long-term portfolioand the liquidity portfolio is measured both in NKrand by local currency (weighted by the benchmarkportfolio’s currency basket). The reason is thatreturn measured in NKr is not relevant to an eval-uation of developments in the international pur-chasing power of reserves, which is of particularinterest for the long-term portfolio.

External managers

863. According to the guidelines, external man-agers may be used in the management of the long-term portfolio. Such managers must have adequateinternal ethical guidelines for their own activity.

864. In NBIM there was internal fixed incomemanagement from the start, while equity manage-ment on behalf of the Petroleum Fund was out-sourced to external managers. Subsequently,external managers have been assigned responsibil-ity for portions of the fixed income management(both on behalf of the Petroleum Fund and thelong-term portfolio), while internal equity man-agement has been built up. Today NBIM managesequities internally on behalf of the PetroleumFund and the long-term portfolio.


52The detailed methodology for calculating the returns on thevarious portfolios Norges Bank manages are described in theappendix of the Government Petroleum Fund quarterlyreport. The report is accessible on our website.53We define “information ratio” as the average monthly excessreturn over time divided by the standard deviation. This figureis annualized.

865. At the end of June 2002 about 10 and 47percent of the long-term portfolio’s fixed incomeand equity portfolios, respectively, were managedexternally. These are all active mandates, except forone enhanced index equity mandate. The reason forusing external managers in the reserves is to con-tribute to the objective of maximizing returns (abovebenchmark). It is natural to take advantage of theexperience Norges Bank has gained in selection andfollow-up of external managers in the PetroleumFund also in the management of the reserves. Whenselecting individual managers Norges Bank appliesthe same general standards for the managers in thereserves as for the Petroleum Fund.

866. Requests for applicants are posted on theInternet. Manager selection is based on a four-stage process: (1) screening of applicants by 10 cri-teria (based on questionnaire one), which resultsin a short list of candidates; (2) analysis and selec-tion by four groups of criteria (based on question-naire two and interviews) give a further reductionto the finalists; (3) optimization process to selectthe managers (by a manager combination tool);and (4) ongoing monitoring and control.

867. The external portfolios form an integralpart of the risk management of the long-termportfolio, and are subject to the following princi-ples of monitoring: (i) performance and risk posi-tions are monitored daily; (ii) all transactions aremonitored weekly; (iii) monthly analysis of riskprofile, value statistics, and earnings expectations;(iv) monthly/quarterly transaction monitoring(trading, momentum, and liquidity risk); and (v) yearly due diligence.

Management information systems

868. An integrated risk measurement system isused to assess and monitor relative and absoluterisk. Expected annualized tracking error is calcu-lated weekly for the long-term portfolio and the liq-uidity portfolio, to keep risk exposure within thelimits. The system is also used to measure absoluterisk (standard deviation) of the actual portfolioand the benchmark portfolio, as well as the modi-fied duration of the fixed income portfolio.

869. Important elements in the Norges Bank’suse of management information systems are:

(i) daily updated information on holdings andprices in both internal and external portfolios;(ii) daily measurement of performance relative tobenchmark; and (iii) daily/weekly monitoring ofrisk. Information on all internal and externalmanaged portfolios is updated daily in the centraldata warehouse.

Stress tests

870. Apart from the quantitative analysis per-formed when strategy is reviewed, we do not useformal ongoing stress tests for the potential impactof specific scenarios. If we judge that a change inmarket conditions may have a negative impact onthe reserve portfolios, we are prepared to amendinvestment strategy to protect the reserves frompotential losses.

Operational risks

871. The degree of operational risk willdepend on the organizational structure chosen (asdescribed above), the procedures and technicalsystems used, and the expertise in the organiza-tion. Norges Bank places emphasis on managingthis type of risk by establishing sound internal con-trol procedures, a sound organization of activitieswith clear authorizations and a clear distribution ofresponsibility, recruitment of specialists with prac-tical and theoretical qualifications, satisfactorytraining of personnel, technical standby solutions,and a sound set of legal agreements.

872. Once a year each wing makes a specialreport to the Governor’s staff on the quality of theinternal control. The objective is to detect majorrisks that may potentially be an impediment to thewing in reaching its goals, and to ensure that man-agement is focused on managing those risks. Anexample of a risk that is given attention is NBIM’sfollow-up of external suppliers of various services.

873. Examples of measures established toreduce operational risks are routines for prevent-ing unauthorized transfers and securities transac-tions, guidelines for staff involved in investmentmanagement to restrict their personal affairs andpotential conflicts of interest, and contingencyplans (e.g., in case activities at the head office in

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Oslo should be prevented, NBIM’s managementoffice in New York is prepared to step in andundertake simplified management services).

Efficient markets

874. The part of the reserves that is the first tobe drawn upon in interventions—the liquidityportfolio—is invested only in the very liquid cur-rencies/markets: euro, pound sterling, U.S. dollar,and Japanese yen. The 50 percent weight in eurosin the benchmark portfolio is split equally betweenthe liquid bond markets of Germany and France.

875. Liquidity is of less importance for the long-term portfolio, but even this portfolio should beavailable for interventions. Compared to the liquid-ity portfolio, the fixed income part of the long-termportfolio has a few additional, minor currencies,considered to have liquid bond markets.

876. The equity part of the long-term portfoliois invested in 22 markets, which are all classified asdeveloped markets (i.e., they all meet some speci-fied minimum standards related to settlement sys-tems, legislative regulation, size, and liquidity). Asfor bonds, the liquidity of equity investmentsdepends both on the possibility of selling largeamounts in a short time, and the possibility ofusing repo markets. The opportunity for sellingshares on short notice without impacting pricesdepends, inter alia, on the turnover in the sec-ondary market. It is not easy to judge precisely theliquidity of equities vs. bonds. Normally a diversi-fied bond portfolio will be more liquid than adiversified equity portfolio. A moderate proportionof reserves invested in equities spread among manymarkets would not, to any substantial degree,weaken the possibility of raising liquidity whenneeded.




877. The objectives of management of reserveare three-fold:

• Provide liquidity for intervention in the localforeign exchange market.

• Earn reasonable rates of total return withoutexposing the reserves to excessive credit andmarket risks.

• Earn good current income so as to achievehealthy accounting profit.

878. Oman is a small oil exporting countrywith its currency pegged to the U.S. dollar.Maintenance of the credibility of the fixed peg is ofparamount importance for macroeconomic stabil-ity. The reserve management policy objectives havebeen designed primarily with a view of optimizingU.S. dollar resources to provide a credible cushionagainst current and capital account shocks, while atthe same time clearing the local foreign exchangemarket on a day-to-day basis. These objectives haveremained in place since the inception of theCentral Bank of Oman (the Central Bank) over 25years ago.

879. The Central Bank does not target any par-ticular level of reserves. The current level of for-

eign exchange reserves at around US$2.5 billionprovides import cover of about 4.5 months, whichis considered adequate, given the fact that externaldebt of Oman is very low and is declining.

880. The scope of reserve management activityis confined to achieving the objectives of liquidityand growth/current income.

881. For the Central Bank, the most importantmonetary policy goal is to maintain the fixed pegof the rial Omani with the U.S. dollar. This is rec-ognized as such in reserve management policy.Moreover, reserve management operations takenotice of domestic liquidity conditions and theposition of government balance with the CentralBank. Local banks are allowed short-term U.S. dollar-rial Omani buy-sell swaps as a mechanism foraugmenting rial Omani liquidity, in case of need.

882. The imperatives of the monetary policyare reflected in the manner in which the foreignexchange reserves portfolio is structured.Currently, the external reserves are divided intofour sub-portfolios or tranches:

(i) Liquidity Tranche: This is an all U.S. dol-lar portfolio that is meant for providingliquid resources for market intervention.As such, this tranche is invested in veryshort-term high-quality instruments, suchas deposits and CDs of top-class banks andU.S. Treasury Bills. All inflows/outflows(which do not represent income/realized

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17Oman

profit) with respect to the externalreserves take place in the LiquidityTranche.

(ii) Bridge Tranche: This is also an all U.S.dollar portfolio that is intended to pro-vide support to the Liquidity Tranche incase of need. The size of the BridgeTranche is generally kept within a maxi-mum of 25 percent of the externalreserves, excluding gold and SDRs. Thistranche is invested in short- to medium-term high-quality instruments, such asdeposits and CDs of top-class banks andU.S. Treasury Bills as well as U.S. Treasurynotes with remaining maturity up to andincluding three years.

(iii) Income Tranche: This represents the sta-ble portion of the reserves, which is amulticurrency portfolio, with the neutralshare of U.S. dollar at 75 percent. Theother permissible currencies are eurosand pounds sterling. Until recently, theJapanese yen was also a permissible cur-rency for this tranche. However, effectiveJanuary 1, 2002, Japanese yen ceased tobe a permissible currency in light of thecontinuing weakness of the Japaneseeconomy. The permissible instrumentsfor the Income Tranche include bankdeposits, CDs, treasury bills, and datedsecurities representing debt obligationsof top-quality sovereign and suprana-tional institutions whose residual matu-rity does not exceed 10 years.

(iv) Bullion Tranche: This tranche containsthe gold holdings of the Central Bank,which currently constitute around 3 per-cent of the external reserves. The gold,which is located at an overseas center, isplaced in short-term lease (deposit) withtop-quality banks.

883. There are performance benchmarks forthe Liquidity, Bridge, and Income Tranches, whichtake into account investment objectives, liquidityrequirements, and constraints. The investment pol-icy with respect to the external reserves is reviewed

from time to time, taking into account, amongother things, fixed income and foreign exchangemarkets outlook.


884. Reserve management activities of theCentral Bank are carried out under the overarch-ing provisions of the Banking Law, which also cov-ers other activities of the Central Bank. The Lawmandates a fixed par value for the rial Omani andalso stipulates maintenance of a minimum ratiobetween external reserve and currency in circula-tion. This Law has specific provisions regarding eli-gible currencies and instruments for deploymentof reserves. The Law also mandates that interna-tional accounting standards be applied foraccounting purposes with respect to the externalreserve. The Board of Governors of the CentralBank is the highest body for policy decisions withrespect to management of external reserves. Therelevant provisions of the Banking Law with regardto the above are quoted below:

Level of external reserves

885. Article 31 states that the Central Bankshall at all times maintain a reserve of externalassets that shall be related in value to the value ofcurrency notes and coins in circulation in suchratio as may be prescribed from time to time by theBoard of Governors, subject to approval of HisMajesty, The Sultan.

Categories of external assets

886. As per Article 32, the reserve of externalassets may consist of any one or more of the fol-lowing, provided they adhere to all limits, classifi-cations, constraints, restrictions, and qualificationswhatsoever laid down by the Board of Governors:

a. Gold or silver coins, which are legal tender.

b. Bullion of gold, silver, or such other pre-cious metals as may, from time to time, beutilized as a monetary asset and freelytraded on international exchanges.

c. Foreign currencies or basket of currencies.


d. Bank demand and time deposits, certificatesof deposit, and acceptances denominated infreely convertible foreign currencies.

e. Treasury bills, commercial paper, and anyother short-term money market instrumentdenominated in freely convertible foreigncurrencies and issued by foreign banks, for-eign governments, foreign public agencies,or supranational organizations.

f. Floating rate notes denominated in freelyconvertible foreign currencies and issued byforeign banks, foreign governments, foreignpublic agencies, or supranational organiza-tions.

g. Fixed interest securities and notes denomi-nated in freely convertible currencies andissues guaranteed by foreign banks, foreigngovernments, foreign public agencies, andsupranational organizations.

h. Any internationally recognized reserveasset, including SDRs issued by the IMF.

Accounting

887. Article 38 provides that the amount ofprofits, losses, credits, debits, depreciation, fundedand unfunded reserves, and other financial analy-sis . . . shall be determined according to the gener-ally accepted principles of accounting, includingthe International Accounting Standards insofar asthey do not contradict any provisions of the Law,agreed by the Auditors appointed pursuant toArticle 18(c) of this Law and approved by theBoard of Governors.

Parity

888. Article 41 specifies that:

a. The par value of the rial Omani shall bedetermined from time to time by HisMajesty, The Sultan.

b. The par value of the rial Omani, or anychange thereof, shall be declared in termsof gold, units of SDR, a foreign currency,or a basket of currencies or an interna-tionally recognized unit of account for cur-

rencies, provided, however, that any suchdetermination shall be in accordance withthe conditions of any international mone-tary agreement to which the Sultanate (ofOman) is then a party.

889. In Oman, foreign currency revenues ofthe government, arising mainly out of export of oiland gas with unit sales realization up to the price ofoil and gas fixed annually for budget purpose (thebudgeted price) are generally sold to the CentralBank against rials Omani, which serve as inflowsinto the reserves and are thus monetized. Any rev-enue of the government in excess of the budgetedprices of oil and gas are kept separately in a fund tobe utilized if there is a budget shortfall subse-quently. This portion of the external reserve of thecountry is owned and managed directly by the gov-ernment. The name of the fund is State GeneralReserve Fund (SGRF). There is an institutionalarrangement for consultation between the CentralBank and the SGRF on various investment-relatedissues, such as composition of benchmark, portfo-lio performance, etc.

890. There is a well-defined organizationalstructure within the Central Bank for all decisionsregarding the external reserves. As mentioned ear-lier, the Board of the Central Bank is empoweredto make all decisions with regard to investment pol-icy and investment guidelines, including perfor-mance benchmark, etc.

891. The highest decision-making body for allinvestment decisions, in terms of the policy/guide-lines approved by the Board, is the Reserve AssetManagement Committee (RAMC), which ischaired by the Executive President (CEO of theCentral Bank). The composition of this Committeeis detailed in Table 21.

892. The RAMC decides on all issues concern-ing reserve management, including fixing ofmedium-term strategic (MTS) benchmarks withregard to currency allocation and duration.

893. The responsibility of the Central Bankwith regard to management of external reservesarises exclusively out of the provisions of theBanking Law. The external reserves are owned bythe Central Bank and as such there is no agencyarrangement between the government and theCentral Bank for this purpose.

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894. The three main aspects relating to invest-ment of external reserves, namely, guidelines, decision-making process, and procedure for opera-tions with respect to transactions in the front officeand their follow-up at the back office, have beenestablished and documented. There is a system forperiodic review of these documents.

895. There is a good deal of decentralization ofdecision-making power for risk decisions. TheCentral Bank has adopted a document delineatingthe powers and responsibilities of officials at vari-ous levels connected with decision making. Thedelegation of power and the chain of authority arewell documented.

896. Internal control and audit systems for thereserve management functions and operationshave been designed on sound governance lines.Major elements of the internal control systems are:

(i) Management Information Reports withrespect to transactions, risk exposure, andexceptions (breach of guidelines, dele-gated powers, and procedure for opera-tions) have been prescribed. These areintended to cause flow of critical informa-tion from the reserve management depart-ments to the senior management(including CEO) on a regular basis. TheBoard of Governors is kept informed at

periodic intervals about all importantaspects of reserve management, includingportfolio performance vis-à-vis benchmark.

(ii) There is an internal audit system that peri-odically examines the operations at thefront office and the back office and reportsto the CEO. Compliance with audit obser-vations within a time frame is ensured.

897. Financial accounts of the Central Bank,including accounts relating to reserve manage-ment, are audited by external auditors at leastonce a year. Effective January 1, 2002, the CentralBank has implemented the provisions ofInternational Accounting Standards 39 withrespect to all its financial assets and liabilities,which are in conformity with the Banking Lawreferred to earlier. The audited accounts and thefindings of the external auditor are reported tothe Board of Governors. The Central Bank’s pol-icy and procedure with respect to internal controland audit are well documented.

898. Information on foreign exchangereserves is provided in annual audited accountsand reports of the Central Bank. The present pol-icy of the Central Bank does not envisage more dis-closure with respect to reserve management.

899. Staff involved in reserve management aresubject to a code of conduct and guidelines onconflict of interest regarding the management oftheir personal affairs.

900. The staff of the departments responsiblefor reserve management are all well trained andexperienced. New staff are taken on the basis of very strict criteria for academic qualificationand after thorough and comprehensive screen-ing. The Central Bank devotes considerableresources to upgrading the knowledge and skill ofits personnel. The Central Bank has not foundfeasible the idea of offering a better compensa-tion package to reserve management personnelin order to attract and retain reserve manage-ment specialists. The present policy of uniformservice rules and compensation packages for staffof all the departments of the Central Bank isworking satisfactorily.

901. Retention of experienced staff has notbeen a problem so far, although some movement


Table 21. Committee Composition

Executive President Chairman

Senior Vice President (In charge of Treasury,Investment, and SettlementDepartments)

Manager (In charge of Treasury andInvestment Department)

Senior Manager (In charge of FinancialManagement Department,which is responsible formaintenance of accounts for theCentral Bank)

Senior Manager (In charge of Systems,Procedure, and OperationsDepartment, which performsmanagement service functions)

Investment Expert In-house consultant on reservemanagement

of staff, in search of better and well-paid jobs in theprivate sector, has been noticed in recent years.The present policy is to offer better career oppor-tunities in the Central Bank for the talented andwell-performing staff.

Establishing a Capacity to Manage Risk

902. The external reserves are exposed to cur-rency, credit, liquidity, as well as interest rate risks.The approach toward risk exposure has beenshaped by the following elements:

• Provisions of the Banking Law with regard to currency diversification and choice ofinstruments.

• Low appetite for downside risk with regard tocurrency revaluation, mark-to-market portfo-lio valuation, and income.

• An empirically observed fact with respect tointerest rate risk that the expected risk-adjusted return is optimal around a portfolioduration of 2.5 years for major markets.

• Aversion to credit risk so as to keep the prob-ability of getting involved in any default to aminimum.

903. The current investment guidelines embodythe above approach with regard to prescriptions for the different types of risk exposures. The rele-vant provisions of the investment guidelines are asfollows:

Currency diversification

904. In the Income Tranche, the proportion ofholdings in the approved currencies shall alwaysremain within the maximum and minimum limitsas indicated in the table below.

Neutral Maximum MinimumApproved currencies (percent) (percent) (percent)

U.S. dollar 75 100 60Euro 20 30 0Pound sterling 5 10 0

Duration

905. The neutral duration of investments inthe Bridge Tranche shall be one year around whicha maximum deviation of plus or minus six monthswill be permitted. The neutral or benchmarkweighted-average duration of investment in thethree approved currencies (in the IncomeTranche) shall be as indicated in the table below:

Benchmark Maximum MinimumApproved currencies (in years) (in years) (in years)

U.S. dollar 2.5 3.5 2Euro 2.5 3.5 0Pound sterling 2.5 3.5 0

Credit risk

906. At the time of purchase, short-termmoney market instruments shall be rated not lowerthan F3 and the issuing banks rated not less than C(individual) and 3 (legal) by FITCH-IBCA or theirequivalent. At the time of purchase, long-terminstruments shall not be rated lower than A byMoody’s or its equivalent.

907. The current thinking with regard to theIncome Tranche envisages a gradual elimination ofdiversification into non-U.S. dollar currencies andnon-U.S. markets over a period of time. This isdriven by a desire to stabilize earnings in U.S. dol-lar terms, with low downside risk.

908. Forward foreign exchange contracts arethe only permissible derivative instruments. Shortsale is prohibited. Further, although repo is a per-mitted instrument, it has not been used so far.However, in recent years bond lending activity hasbeen undertaken for a large portion of the exter-nal reserves, including lending against cash collat-eral for the U.S. Treasury portfolio. The objectivehere is to earn additional income, while keepingthe risk exposure at a low level. The approach withregard to any new activity has been to first under-stand and internalize the risk characteristics, put inplace the necessary IT systems and internal con-trols, and then undertake it. This has been fol-lowed in the case of bond lending against cashcollateral by ensuring that the risk on investment

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of cash collateral is always at an acceptably low levelby prescribing suitable investment guidelines forthis purpose.

Liquidity risk

909. Liquidity risk has been addressed by cre-ating a three-tranche structure, as described ear-lier. In creating this structure, historicalinflow/outflow data were analyzed to find out theliquidity requirement for undertaking interventionin the domestic market under a “worst-case” sce-nario. Further, to avoid issue concentration, whichcan have adverse liquidity implications, maximumholdings for individual issues of debt securitieshave been prescribed.

Benchmarks

910. There are performance benchmarks forLiquidity, Bridge, and Income Tranches. All of thesehave been constructed on the basis of publicly avail-able market indices. For the Liquidity Tranche, thebenchmark is the one-month U.S. Treasury Bill rate.For the Bridge Tranche, as also for the IncomeTranche, the performance benchmarks are a com-posite of market indexes, reflecting the neutral cur-rency and duration configurations. The criteria forselection of the performance benchmarks are thefollowing:

• The benchmarks should correspond to thepassive or neutral risk profile.

• The benchmarks should reflect the broadpattern of investments.

• The benchmarks should not have any inher-ent bias for over/under performance.

911. The performance benchmarks are pre-scribed in the investment guidelines for externalreserves, which have been approved by the Boardof Governors.

912. For the purpose of calculation of rates ofreturn, the U.S. dollar acts as the base/numerairecurrency. Calculation of return with respect to theinvestment portfolios and also the benchmark isoutsourced at present. This is done primarily witha view to ensuring that the returns are calculated

independently by an external agency. Return cal-culation is accompanied by full attribution analysisonce in a quarter to highlight the factors responsi-ble for over/under-performance vis-à-vis thebenchmark.

913. Active risk taking for value addition vis-à-vispassive configurations with respect to currency andduration is also undertaken. For this purpose, thereare two levels of decision making. At the level of theReserve Asset Management Committee (RAMC),monthly currency and duration benchmarks(known as Medium-Term Strategic Benchmarks orMTS) are set, which are intended to beat the neutralperformance benchmarks. At the level of theDepartment, deviation from the MTS benchmarks ispermitted within prescribed limits in order to addvalue vis-à-vis the MTS.

914. Although the Central Bank is essentially along-term investor, especially with respect to theIncome Tranche, the investment horizon for allintents and purposes is one year at a time, reflect-ing the accounting year (January to December).The broad accounting principles currentlyapplied in terms of IAS 39 with respect to theLiquidity, Bridge, and Income Tranches are thefollowing:

• All coupon and discount earnings as well asrealized profit/loss on sale of securities aretaken to the P/L.

• All unrealized gain or loss on currency reval-uation is booked under an equity head.

• All unrealized gain/loss on mark-to-marketvaluation of securities/outstanding forwardexchange contracts is booked under anotherequity head.

915. Premiums/discount on bonds andTreasury Bills at the time of purchase are amor-tized following an effective interest rate method.

916. Interest earnings on gold deposits andrealized gain/loss (against cost price) on the saleof gold are taken to the P/L. Unrealized gain/losson revaluation of gold holdings is booked underthe same equity head as for currency.

917. As the rial Omani is pegged to the U.S.dollar, rates of return in terms of domestic cur-rency are similar to those in U.S. dollar terms.


918. Gist of quarterly performance and attribu-tion analyses is reported to the Board of Governors.

919. The Central Bank has a policy of engagingexternal managers for discretionary managementof a small segment (there is a ceiling of 10 percentfor this purpose) of the external reserves. Theinvestment guidelines prescribed for the externalmanagers have been given higher duration andalso different performance benchmarks. Externalmanagers can hold debt securities with remainingmaturity up to and including 30 years. This hasbeen done on the basis of the fact that they havethe requisite expertise and advantage of location toassume higher interest rate risk for the purpose ofvalue addition.

920. A management information system toassess and monitor risks consists of the following:

• A daily statement showing the portfolio sum-mary with respect to the three tranches,which provides details, such as duration andcurrency composition vis-à-vis their respec-tive neutral and MTS benchmarks, aggregateinvestment pattern, etc.

• A monthly statement giving a stress test forinterest rate risk.

921. There is a plan to set up an independentMiddle Office with well-defined responsibilities formanaging various risks with respect to externalreserves. Also, steps have been taken to identifyoperational risks for the Central Bank as a wholefor setting up appropriate systems and mechanismsfor managing them. At present, custodial risks areminimized by appointing only the most reputableinstitutions as custodians.

922. For the purpose of undertaking buy/selltransactions in currencies and securities and forplacement of deposits, etc., there are approvedcenters, most of which are in major OECD coun-tries. Also, there are concentration limits for expo-sure to banks located in different centers.Moreover, transactions in currencies and securitiesare required to be undertaken only with approvedcounterparties, which are selected on the basis oftheir credit, reputation, market share, and rela-tionship with the Sultanate of Oman in generaland the Central Bank in particular.

17 • Oman 177


Objectives and coordination

923. The strategic reserves management objec-tives of the Central Bank of Tunisia (CBT) arebased on the following key points:

• Guarantee of the external liquidity of theeconomy;

• Preservation of the reserves holdings; and

• Maximization of return on reserves.

Liquidity

924. Liquidity of reserves is the main manage-ment objective of the CBT. Liquidity is required toensure financing of external payments imbalancesand to intervene in the local exchange market, inorder to avoid sharp adjustments of the Tunisiandinar exchange rate.

925. The liquidity objective is met by targetingappropriate investment instruments and currencystructure. The currency structure of reserves is setin accordance with the currency structure of thesettlement balance as well as CBT and governmentliabilities.

Security

926. In order to safeguard reserves, the CBT hasimplemented a rigorous selection policy of markets,

assets, and counterparts. In addition, an operatingcontrol system is in place to monitor exposure limitsfor credit and market risks. Furthermore, the CBThas forbidden short position taking and financialinstrument short sale practices. The use of deriva-tives is only allowed for hedging needs.

Return

927. The CBT aims to maximize reserves port-folio return subject to its liquidity and security con-straints. Investment policy focuses on a dynamicallocation of reserves, using permissible instru-ments, in line with international capital marketsoutlook.

928. Tunisia has low foreign exchange inter-vention needs, given the floating managedexchange rate regime of the Tunisian dinar andcapital movement restrictions. This provides someflexibility in reserves investment policy. Thus, theCBT has stretched the upper limit on money mar-ket from three to six months and has extendedinvestment activity to international bond markets.In an attempt to limit the exposure to bond marketrisks, especially with respect to the two primaryobjectives of liquidity and security, the investmentscope has been limited to government and supra-national bond markets with a deep and liquid sec-ondary market, which guarantee the highest levelof security (i.e., U.S., German, and French govern-ment bond markets).

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929. According to Tunisian law, managementof foreign reserves comes under the TunisianCentral Bank’s purview. There is no other inde-pendent entity in charge of it. Governance, man-agement, and surveillance of the Central Bank of Tunisia are undertaken by the Governorappointed by the President of the Republic, theBoard of Directors, and a censor who is appointedby decree, respectively. The Governor sets thebank’s organization. The lastest administrativechart gives the following configuration of thereserves management department:

Governor

Deputy Governor

General Manager of External FinanceDeputy General Manager charged with Payments

and Follow-UpManager of External Financing and Market OperationsDeputy Manager of Market OperationsDepartment of International Market OperationsDepartment of Domestic Market Operations

Deputy Manager of External FinancingDepartment of Private Financing and

Specialized OrganizationsDepartment of Public Financing

Manager of International Relations and TreasuryDeputy Manager of International Relations

Department of International OrganizationsDepartment of Banking Relations and

Counterparts Follow-UpDeputy Manager of Treasury

Back OfficeDepartment of Treasury Projections

Manager of Payments and External DebtDeputy Manager of Current PaymentsDeputy Manager of External Debt

Manager of External Transactions Follow-UpDeputy Manager of External Payments

Follow-UpSWIFT and Messages Unit

930. Strategic decisions on overall objectivesand principles of reserves management policy areset by the Governor on proposal of the concerneddepartments (currency distribution, asset classes,limits, risk monitoring, etc.).

931. The operational framework of the policiesadopted, and all decisions regarding investment

strategy, currency exposure, credit risk, dealingcounterparties, custodian arrangements, permissi-ble instruments, etc., have to be approved by seniormanagers and by the Governor, on proposals of theconcerned departments.

932. The managers of the reserve managementdepartment ensure that all operational guidelinesare followed, and senior management is keptinformed of all deals done, on a daily basis.Portfolio position is communicated daily to seniormanagement, and weekly to the Governor.

933. There is an explicit separation among thefront office, back office, and the entity responsiblefor SWIFT and messages. Pursuance of Treasuryorders is immediately checked by the back office.Observance of limits (credit limits, permissibleinstruments, etc.) is checked through controlsfrom the chief dealer, the back office, senior man-agement, the banking relations department, andthrough frequent reporting to the GoverningBoard.

Management of operational risk and controls

934. Supervision of risks is conducted througha system of formal limits and several controls.

935. First, dealing is centralized in a singlelocation: the dealing room. Dealing risks are min-imized by a formal separation between the frontoffice, back office, and SWIFT and messages unit.Formal deposit limits are set for each counter-party in terms of amounts and maximum depositperiods. Settlement risk for bond operations isreduced through a systematic and immediatechecking of a counterparty’s confirmations (secu-rity type, accrued interest, nominal and netamounts, value date), prompt processing, and settling through receive (or deliver) against pay-ment settlement procedures. Custodial risk is reduced by choosing good international clear-ing institutes (Federal Reserve Bank of New York, Euroclear, Clearstream, Bank of TokyoMitsubishi), and by undertaking a thorough cus-todian follow-up and systematic control of custo-dian statements.

936. Information technology risk is reduced bylimiting access to data files and information system,

18 • Tunisia 179

a daily backing up of data files, and similar precau-tions. Financial errors are minimized throughprompt transaction processing and recording,back office control measures, as well as accountingchecks on a daily basis.


937. To enhance the efficiency of reservesmanagement policy and to trim down operatingrisks, the CBT has implemented an appropriateoperational system based on risk exposure limits,cautious and prompt settlement processing, con-trol measures, and frequent reporting. This opera-tional system is managed by means of a computersystem.

938. Regarding settlement processing, short-term investment operations on the internationalmoney market are generally settled the next day.Long-term deposits and foreign exchange transac-tions are treated on a spot value date basis.Concerning securities, transactions are done on athree-day settlement basis. Nevertheless, instruc-tions of all the transactions have to be processedthe same day in order to provide the required timeto follow up on the settlement and to intervene incase of misstatement.

939. In other respects, the CBT has central-ized settlement processing through the main cor-respondent for each currency to have standardsettlement instructions. This has allowed cuttingthe misstatement risk, especially from the counterparty’s side. The CBT has also diversifiedcustodial risk by holding three security custodyaccounts with different institutions (FederalReserve Bank of New York, Euroclear,Clearstream, Bank of Tokyo Mitsubishi). Theterms and provisions governing the relationshipof the CBT with these correspondents and cus-tody institutions point out clearly their responsi-bilities vis-à-vis the CBT and the reportingarrangements.

940. To improve the reserves managementoperational efficiency (either at the processinglevel or at the monitoring one), the CBT hasimplemented an integrated computer system.This system integrates the management of frontand back office functions, and accounting of the

operations in international capital markets. Thesystem guarantees real-time transaction process-ing. It produces all the required statements toconfirm and settle the transactions done by thefront office, updates the treasury statements, generates book entries, and manages formal lim-its. The system also produces a variety of report-ing statements for control and follow-up of thecommitments.

941. The system also provides a large range ofactivity, treasury, and statistical reports. Thesereports allow control of transactions processing,and follow-up of risk and return management toolssuch as limits, duration, and performance.

942. The system structure separates front andback office functions. At the front office level,transactions done are booked into the system.The back office has the charge of checking thedeal’s accuracy and entries before the final valida-tion of the transaction. The SWIFT and messagesunit is independent from the back office, offeringthus an additional way to reduce settlement risks. The back office also copes with the follow-up of accounting records, and the reconciliationof all received reports from correspondents andcustodians.

943. This computer system provides a hierar-chical authorization system, based on passwordsand random codes access controls, which restrictthe scope of access of operators according to theirfunction needs. Besides, the system referential iscentralized and managed exclusively at the backoffice level.

944. Data backup is performed on a daily basisinto the general specified server and periodicallyon separate magnetic supports. Furthermore, thesystem is highly protected with sophisticated virusdetection software, and with an auxiliary server. Inaddition, the CBT dealing room is protected with acard access system and equipped with fire detec-tion instruments.

945. Audit function is led by an internal entity.This entity undertakes periodic missions in order toassess reserves management operations processing,in accordance with objectives, principles, and oper-ational procedures approved by the GoverningBoard of the Bank. No external auditing has untilnow been undertaken.



Risk management

Liquidity risk

946. Liquidity is guaranteed through an appro-priate asset allocation and an adequate time hori-zon for investment operations. About 5 percent offoreign currency reserves is maintained liquid tomeet unanticipated treasury needs. Excess liquidityis invested daily in short-term bank deposits(TomNext or OverNight). About 65 to 70 percentof the reserves are invested in the money market,through bank deposits of 1-week to 6-month peri-ods, on the basis of anticipated fund flows. Theremaining 25 to 30 percent of the reserves areinvested in AAA sovereign government and supra-national bonds.

Credit risk

947. Credit risk is managed through an ade-quate choice of counterparties with sound finan-cial backgrounds. These counterparties areconstantly followed, especially through several rat-ing agencies reports. Quantitative limits on depositamounts and investment periods are set for eachcounterparty according to its rating. A continuousfollow-up of the counterparties is ensured by anindependent department, and limits are updated

accordingly. Credit risk is controlled through con-straints on permissible investment instruments.Only sovereign AAA government and suprana-tional issues are allowed. Agencies and corporatebonds are excluded from the bank’s assets.

Market risk

948. Foreign exchange risk is managed bymatching the structure of reserves currencies tothe currency structure of the balance of settle-ments. Adjustments are made when major discrep-ancies from the objective structure arise, or to takeprofit from substantial differentials in interestrates, or following the Governor’s decision afterproposals of the reserves management depart-ment. Equities are completely excluded from theasset portfolio, making the portfolio immune fromstock market risks.

949. Interest rate risks are diminished througha choice of double duration limits: one on theglobal portfolio of reserves (nine months), and thesecond on the bond portfolio (two to three years).Long-maturity bonds (above 10 years), which aremost sensitive to interest rate movements, areexcluded from the portfolio. Constraints on per-missible instruments are also a factor diminishinginterest rate risks.

950. The use of financial derivative instru-ments (swaps and options) is made only for hedg-ing purposes.

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951. Before 1980, Turkey had a fixed exchangerate regime with strict foreign exchange controls.Reserves were used mainly for current needs. Withthe liberalization policies of the early 1980s,exchange controls were eliminated and banks aswell as other institutions and individuals wereallowed to hold foreign exchange. With thesechanges, reserves began to serve additional pur-poses, such as intervention in domestic currencyand providing a level of confidence to domesticand international markets.

952. The accumulation of foreign reserves dur-ing the second half of the 1980s made clear theneed to improve portfolio management skills at theCentral Bank of Turkey (the Central Bank). To thisend, the Central Bank employed a few externalfund managers to manage fixed income portfoliosas part of the learning and training process for itsown staff. The main function of those managerswas training and providing advisory services aboutthe developments in international markets.External manager services were discontinued in1995.

953. With the liberalization of the Turkisheconomy, there was growing need to keep up witha rapidly changing financial environment and cen-

tral banking principles in the rest of the world.Accordingly, the reserve management concept hasfully evolved into a new stage at the Central Bankwith the implementation of modern managementprinciples. The Central Bank takes into accountthe priorities of safety, liquidity, and return, in thatorder, while managing reserves. Risk awarenessand management have become primary concerns.

954. Reserve assets managed by the CentralBank consist of readily available and marketableforeign assets that are controlled completely by theCentral Bank.

955. The reserve management strategies at theCentral Bank are influenced by different factors.One such factor is the Central Bank’s liability struc-ture, which is somewhat different from most cen-tral banks. The Central Bank carries a relativelylarge amount of liabilities in foreign exchange,which consists of savings deposits opened byTurkish citizens living abroad. These accounts wereopened in the late 1970s to help Turkey overcomeforeign exchange bottlenecks. They proved to be astable source of foreign exchange over the years,even in times of financial crises. The Central Bankalso has other liabilities in foreign exchange todomestic (e.g., reserve requirements) and interna-tional institutions. These liability accounts have amajor impact on the design of the reserve man-agement strategies.

956. Another factor that influences the reservemanagement strategies is the monetary and

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exchange rate regimes that are in place. The cur-rent Central Bank Law dictates that reserves shouldbe managed in line with the monetary policy objec-tives. In the last 20 years or so, Turkey adopted dif-ferent forms of intermediate exchange rateregimes between fixed and floating, all of whichneeded liquid reserves to be sustained. Therefore,providing liquidity for intervention had been thedriving factor in designing reserve managementstrategies. At the end of 1999, Turkey announced adisinflation program, supported by the IMF. Underthis program, the Central Bank started implement-ing a preannounced crawling peg and a rule-basedmonetary policy. During that period, reserve man-agement was structured in such a way that the liq-uidity aspect of reserves was even morepronounced because of the need to defend thecrawling peg. Hence, the reserve managementstrategy was based mainly on liquidity. However,the crawling peg regime had to be abandoned inthe aftermath of the two crises and the Turkish lirawas floated on February 22, 2001.

957. Under the current floating exchange rateregime, the Central Bank is committed to inter-vene only to smooth out extreme movements inexchange rates, which allows for a more efficientliquidity management of the foreign exchangereserves portfolio.

958. Another important factor that influencesthe reserve management strategies is the externalcash flows that arise mainly from foreign debt pay-ments executed on behalf of the Turkish Treasury,which is responsible for debt management. Underthe current institutional framework, asset and lia-bility management functions rest with differentinstitutions. While the Treasury manages the gov-ernment’s foreign debt, the Central Bank isresponsible for the management of foreignreserves. This framework makes sovereign riskmanagement a challenging task. However, theCentral Bank solves this problem by takingexpected foreign debt payments within the nextyear into account when designing the globalbenchmark and by establishing close coordinationwith the Treasury. The coordination between thetwo institutions is expected to develop even furtherwith the new Debt Management Office, which hasrecently been set up within the Treasury. The Debt

Management Office is responsible for managingthe government debt and associated risks.

Legal and institutional framework

959. The current legal framework of reservemanagement is defined by the Central Bank Law,which gives the Central Bank the authority and theresponsibility to manage the country’s foreignexchange and gold reserves. The Law, which wasrecently amended in order to strengthen theCentral Bank’s independence, cites the reservemanagement objectives as safety, liquidity, andreturn in that order, and authorizes the CentralBank to do transactions in international financialmarkets.

960. The Central Bank is the only institutionauthorized to manage the official foreign reservesof the country, with principles and investment cri-teria determined by the Bank Board. The CentralBank acts as a financial agent for the Government.In this capacity, the Central Bank accepts foreignexchange deposits from and executes payments onbehalf of the Government.

Organizational Structure

961. The Central Bank Law defines the CentralBank’s Board as the highest decision-making bodywithin the Bank. Based on this authority, theCentral Bank’s Board has made several decisions inthe past with regard to the reserve managementoperations, including the current investmentguidelines. The Investment Guidelines includeallowable financial instruments and transactions,minimum external credit ratings, and transactionlimits for different groups of counterparties.

962. Following recent trends in internationalmarkets, the Central Bank restructured its reservemanagement process in 1998 in order to separaterisk and investment management functions. TheForeign Exchange Risk and Investment Committeewas set up to shape the strategy and to make first-layer strategic investment decisions in reserve andrisk management. The Committee is composed ofa Vice Governor, the General Manager, and the twoAssistant General Managers of the MarketsDepartment, who are responsible for reserve and

19 • Turkey 183

risk management. The Committee approves theglobal benchmark, sets and monitors risk limits,and reviews performance reports.

963. Also in 1998, the Foreign Exchange RiskManagement Division was created within theMarkets Department to be responsible for manag-ing financial and operational risks inherent inreserve management operations. Based on theBoard’s and the Committee’s decisions, ForeignExchange Transactions and Foreign Exchange RiskManagement divisions of the Market Departmentcarry out front, middle, and back office functions.


964. Transparency and public disclosure of theCentral Bank operations have gained importancein recent years. Turkey provides weekly data onreserves through weekly balance sheets, monthlyinformation on foreign currency reserves, andshort-term possible drains through the IMF’sSpecial Data Dissemination Standards (SDDS), theReserve Data Template, and annual reports.Additionally, the Central Bank has had its financialstatements audited by an external auditor accord-ing to internationally accepted accounting stan-dards since 2000.

965. Finally, the Central Bank is currentlyworking on an entirely new approach to internalauditing, which will include the reserve manage-ment operations in the regular audit reports, as aneffort to further improve the reserve managementaccountability. This project is planned to be putinto practice in late 2002.


Sources of risks

966. Considering the management policyobjectives and the financial markets that theCentral Bank is involved in, liquidity, credit, andmarket risks have been identified as major finan-cial risks inherent in the reserve management pro-cess. It has also been accepted that the CentralBank is exposed to certain operational risks duringthis process.

967. For most central banks, especially inemerging market countries such as Turkey, it isvery difficult to estimate the timing of a possiblerun on foreign reserves, which makes liquiditymanagement very difficult. Therefore, liquidity is arequired criterion for any instrument to beincluded in the reserve portfolio. The CentralBank faces credit risk in the form of direct creditrisk, settlement risk, and replacement risk arisingfrom its operations in international money, cur-rency, and securities markets. As for the marketrisk, fluctuations in foreign exchange rates andinterest rates constitute the two main sources ofrisk for the Central Bank.

Risk management

968. The Central Bank Law dictates that for-eign reserves should be managed with safety andliquidity objectives ahead of return. To this end,the Central Bank has adopted an asset-liabilitymatching strategy for minimizing currency andinterest rate risks in reserve management opera-tions. Although this may not be the best optionfor every central bank, it provides a good approx-imation toward a minimum risk exposure portfo-lio for the Central Bank since its balance sheet issomewhat different from that of a typical centralbank in that it carries a relatively large amount ofsavings deposits in foreign exchange that belongto Turkish citizens living abroad. However, theCentral Bank has also considerable amounts ofexternal cash flows such as foreign debt paymentsexecuted on behalf of the Treasury, foreignexchange inflows from the Treasury’s borrowings,and foreign exchange interventions that makeasset-liability matching somewhat difficult. Thisobstacle is overcome to a certain extent by treat-ing such outflows as if they were liability accounts.The currency distribution and duration target ofthe global benchmark are set to match the cur-rency distribution and maturity structure of theon-balance-sheet liabilities and expected externalcash flows within the next year. Duration and cur-rency limits are used to control deviations fromthese targets. An overall bank limit is alsoincluded in the global benchmark to control thecredit risk.


969. The global benchmark also includes theeligible instruments and transactions that can beused in reserve management. These instrumentsand transactions currently include:

• Sovereign bonds with minimum AA or equiv-alent credit ratings and maturities up to 10years,

• Supranationals and BIS instruments withmaturities up to 10 years,

• Time deposits placed with central banks andcommercial banks with minimum A1/P1 orequivalent credit ratings,

• Spot and forward foreign exchange transac-tions with commercial banks with minimumA1/P1 or equivalent credit ratings.

970. The Central Bank is currently in the process of expanding the range of products used in reserve management to achieve morediversification.

971. The liquidity risk is also addressed withinthe global benchmark in two steps. First, consid-ering the extremely high costs of possible liquid-ity shortfalls, only the most liquid instrumentssuch as certain government obligations and veryshort-term bank deposits are included in theglobal benchmark as permissible asset classes.Second, the reserve portfolios in major reservecurrencies are divided into “tranches,” each pro-viding liquidity in different time horizons. Whilethe operational portfolios meet day-to-day liquid-ity or working capital needs, the liquidity portfo-lios provide liquidity in the short term. Althoughthey are relatively small in size, the investmentportfolios are managed with a return maximiza-tion objective while staying within the overall risklimits.

972. Once the global benchmark is deter-mined as a long-term passive investment strategy,the sub-portfolio benchmarks are constructed inorder to communicate the risk/return targets ofthe global benchmark to the investment unit(Foreign Exchange Transactions Division). Thesub-portfolio benchmark compositions are deter-mined with optimization of return and risk (returnvolatility) based on historical return statistics ofexternal indices.

973. Portfolio managers are allowed to deviatefrom the target duration to reflect their marketstrategies. However, such deviations are controlledthrough the use of portfolio duration limits, whichare set in accordance with the global benchmarklimits.

974. In order to further control the credit risk,the overall bank limit set within the global bench-mark is distributed into individual credit limits foreach counterparty. These limits are determinedusing an Internal Scoring Model. The InternalScoring Model incorporates information about thecounterparties, such as external credit ratings bydifferent rating agencies, financial data, countryratings, and support status of the institution, inorder to calculate a composite score. Based on thisscore and the capital size, each counterparty isassigned a certain credit limit.

975. The custodial risk is also addressed withinthe credit risk management. The Central Bankprefers other central banks and international cus-todians for safekeeping its reserve assets.

976. In recent years, the Central Bank has paidspecial attention to eliminating any deficiencies thatmay create operational risks. Within this context,the Central Bank restructured its existing backoffice in order to prevent possible operational lossesdue to human or system errors. As an additionalmeasure against operational risks, the Central Bankhas recently set up a “Disaster Recovery Site” thatcould become operational in a very short time incase the current systems become unusable for anyreason. Finally, the risk management unit is workingon issuing a “Code of Conduct” for reserve manage-ment staff.

Reporting and monitoring

977. Once the overall level of risk that theCentral Bank is willing to bear has been decided onthrough the global benchmark, current risk expo-sure is measured, monitored, and reported on aregular basis. As mentioned before, the portfoliomanagers are allowed to take positions againsttheir benchmarks based on their short-term invest-ment strategies. However, these positions shouldnot go beyond the preset limits both on the sub-portfolio and the global levels. The currency risk is

19 • Turkey 185

monitored through the use of currency limits,which are set within the global benchmark in orderto control deviations from the target currency com-position. The interest rate risk is controlledthrough duration limits that are set both at theglobal and the sub-portfolio levels. The usage ofthese limits is reported to the Foreign ExchangeRisk and Investment Committee on a regular basis.

978. As a future step, the Central Bank is plan-ning to use Value-at-Risk limits to improve the mar-ket risk control. Value-at-Risk has been used at theCentral Bank for reporting purposes for the lastcouple of years.

979. The monitoring of credit risk is done by the“Real Time Limit Monitoring System,” which is devel-oped in-house. This system is designed to warntraders if the trade exceeds the remaining limit andcaptures each deal in terms of amount and exposureperiod by counterparty. The system not only takesinto account the direct credit risk arising fromdeposit transactions but also considers “replacementrisk” and “foreign exchange settlement risk.” Thesystem tracks limit usage and violations, and pro-duces related reports by counterparty, rating cate-gory, and country.

980. As for the performance measurement, theCentral Bank has adopted a risk-adjusted perfor-mance measurement methodology that considersadditional risks taken to achieve the realized return.

Human resources

981. The Central Bank employs highly quali-fied staff in the reserve and risk management areaand gives considerable importance to further train-ing of the staff. In addition to the in-house trainingprograms, the staff benefits from seminars held byother central banks and major financial institu-tions. The Central Bank has also adopted a policyof providing selected staff members with scholar-ships for postgraduate programs at major universi-ties abroad.

Information technology

982. As for the information system needs, theCentral Bank has adopted a policy to develop itsown systems where possible. The Central Bank hasa relatively large IT Department with highly qual-ified staff. The IT Department has developed thecurrent systems used in reserve and risk manage-ment. However, for meeting sophisticated andspecific software needs, such as certain risk mea-surement tools, developing products in-housemay not be the most efficient option. In suchcases, the Central Bank prefers outsourcing thisservice by trying to search for the most suitableproduct in the market.


Reserve Management Objectives andCoordination

983. United Kingdom official holdings of inter-national reserves are owned by Her Majesty’sTreasury (HMT) and comprise gold, foreign cur-rency assets, International Monetary Fund (IMF)Special Drawing Rights (SDRs), and the U.K.’sReserve Tranche Position (RTP) at the IMF. Withthe exception of the RTP, these reserves are held inthe Exchange Equalization Account (EEA). TheBank of England manages the reserves as agent forHMT, as well as providing advice on reserves man-agement issues, including liability management.

984. The EEA was established in 1932 as afund for stabilizing the exchange value of sterling.Any U.K. government exchange rate interventionwould therefore be conducted through the EEA.54

The EEA also provides foreign currency services toGovernment Departments and Agencies, i.e., salesof foreign currency to Departments with foreigncurrency obligations and purchases of foreign

currency from Departments with foreign currencyreceipts.

985. The U.K. Government has published aService Delivery Agreement (SDA) target to mini-mize the cost of holding reserves while reducingrisk. The performance relative to this target isreported in detail in HMT’s annual report on theexpenditure plans of the Chancellor of theExchequer’s Departments.

Institutional framework—the annual Remit

986. The Bank of England manages thereserves in accordance with criteria set out by HMTin an annual Remit, the main text of which is pub-lished in the Debt and Reserves ManagementReport, which is published by HMT at the time ofthe Budget. The Remit summarizes the bench-marks that the reserves are actively managedagainst; the investment constraints within whichthe Bank operates; the framework for risk control;and the arrangements for the audit of the EEA.The Bank is also set a profit target, net of manage-ment costs, for active management against thebenchmark; this target is not published.

Administration and control

987. The Bank reports to HMT on investmentperformance at a monthly meeting chaired by thehead of HMT’s Debt and Reserves Management

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54In addition to the United Kingdom’s Official Reserves, theBank of England manages its own holdings of foreign cur-rency assets and gold. As set out in the Chancellor of theExchequer’s letter of 6 May 1997 to the Governor of the Bankof England, the Bank can intervene in support of its monetarypolicy objective using the Bank’s own resources rather thanthose of the EEA. The Bank of England Act 1998 sets out rulesgoverning the disclosure of any such intervention.

team. The Bank’s Foreign Exchange (FED) andRisk Analysis and Monitoring (RAMD) divisionsaccount for the returns made, and for market andcredit risks incurred. Any outstanding operationalor policy issues are also discussed. Every sixmonths, there is a meeting at which the EEAAccounting Officer and the Bank of England’sExecutive Director for Market Operations or dele-gated senior officials review investment perfor-mance, discuss strategy, and agree upon analysis tobe commissioned by HMT and undertaken by theBank. Meetings to discuss individual issues, includ-ing changes to the Remit, may be proposed at anytime by HMT or by the Bank.

988. Every quarter, an independent opinion ofthe adequacy and effectiveness of the system ofinternal and financial control is provided to theBank’s Executive Director for Market Operationsby the Head of the Bank’s Internal Audit. TheBank’s Executive Director sends these reports tothe EEA Accounting Officer. At the same time, theExecutive Director provides the AccountingOfficer with a management report on the opera-tion of the control framework. Separately, the U.K.National Audit Office undertakes an external auditof the EEA on an annual basis.

Bank of England reserves managementstructure

989. The reserves management operation isultimately headed by the Executive Director forMarket Operations, to whom the heads of FED andRAMD report. It is an important principle that nei-ther the middle office (RAMD) nor the back officereport to the front office (FED).

990. FED and RAMD senior management areresponsible for implementing and reporting theresults of the strategy agreed between HMT andsenior management at the Bank. Decisions on spe-cific investments and the degree of latitude for indi-vidual portfolio managers, in addition to generalstaffing and budget issues, are taken at this level.

991. Dealers and portfolio managers withinFED provide active day-to-day management of theforeign exchange and asset portfolios, involvingtactical positioning and direct contact with marketcounterparts. Market positions and overall invest-

ment performance are formally reported to seniormanagement and to HMT on a monthly basis.

992. This delegation of responsibilities anddecision making is captured within the formalbenchmark process, where higher levels of man-agement shape the benchmark for the next leveldown. This approach enables the attribution ofoverall returns to the decisions taken at each leveland provides a direct and highly visible link betweendecisions made and profits earned. This gives essen-tial feedback in analyzing performance and acts asan important motivator for reserves managers.

993. As well as reporting directly to theExecutive Director for Market Operations, RAMDhas a reporting line to the Deputy Governor forFinancial Stability in the latter’s capacity ofChairman of the Bank’s Asset and LiabilityCommittee. This reinforces the independence ofthe middle office. The operational independenceof RAMD is considered to be an important pre-requisite for its effectiveness.

994. RAMD is responsible for legal, regula-tory, and ethical issues of compliance (externalcontrol) as well as risk measurement and moni-toring (internal control). It ensures that detailedbenchmarks, limits, and controls are in place thatare consistent with the risk limits set by HMT inthe Remit. It also establishes the compliance andreporting procedures that managers should fol-low and sets up all the necessary legal agreementsand documentation.

995. Operational procedures are documentedin a handbook that is frequently updated andmade available to all staff involved in the manage-ment of reserves. These include new products pro-cedures, to ensure that investment managers anddealers trade only in instruments that can be han-dled by settlement, risk, accounting, and IT sys-tems. The rules governing insider dealing and thedeclaration of personal financial transactions arealso circulated. All staff employed in the manage-ment and control of the reserves are required tosign these declarations on a frequent basis.

996. RAMD is responsible for ensuring thatinvestments are correctly recorded and for moni-toring any breach of limits, controls, or other ele-ments of compliance. All breaches are reported tosenior management. In addition, RAMD calculates


the profit and loss figures, which are reported tosenior management and HMT.

Training and retaining staff

997. The Bank of England devotes consider-able resources to training its staff in the specialistskills required for reserves management. Thisincludes regular participation in internal andexternal courses in finance and portfolio manage-ment techniques. Like other bank employees, staffinvolved in reserves management have their basicsalary structure enhanced by a flexible package offinancial and nonfinancial benefits, and individualeffort is rewarded through a system of discre-tionary bonuses (though as a considerably smallerproportion of total remuneration than in the pri-vate sector).


998. The presentation and accounting basis ofthe U.K. reserves has changed radically in recentyears. The United Kingdom has been at the fore-front internationally in promoting openness andtransparency in reserves data. In September 1997the Chancellor of the Exchequer announced thathe was “opening up the books” on the U.K.reserves of foreign currency and gold. The ensu-ing quarterly report, which was initially publishedwith a two-month lag, provided a breakdown ofassets and liabilities into broad currency blocs,SDRs, and gold. Since April 2000, reserves datahave been published on a monthly basis in accor-dance with the IMF/G10’s Special DataDissemination Standard (SDDS). Data from July1999 onward can be found on the Bank ofEngland website. These data record the value andcomposition of the U.K.’s gold and foreign cur-rency assets, liabilities, and derivatives on a“marked-to-market” basis (that is, using currentmarket valuations). The press release also reportsthe size(s) and date(s) of any intervention in theforeign exchange markets, either by the EEA orby the Bank of England, and gives an explanationof any intervention carried out.

999. As a further enhancement of trans-parency, in January 2000, the first set of EEA

annual accounts was published, covering1997–98; these financial statements are audited bythe National Audit Office. HMT now has a statu-tory obligation, as set out in the Finance Act 2000,to publish a full set of financial accounts for theEEA every year and, after examination and certifi-cation by the Comptroller and Auditor General,to lay the accounts before each House ofParliament by the January 31 following the end ofthe financial year to which the accounts relate.The financial accounts for 2000–01 were the firstto be published within this framework. Althoughthis is the fourth year for which the accounts havebeen published, it is the first time they have beenpublished under accruals accounting consistentwith U.K. Generally Accepted AccountingPractice (U.K. GAAP).


An asset/liability approach

1000. HMT’s foreign exchange assets and lia-bilities are managed jointly on a day-to-day basis bythe Bank of England. However, whereas the assetsare held in the EEA the liabilities are liabilities ofthe National Loans Fund (NLF), which funds theEEA’s assets through a combination of sterling andforeign currency borrowing. The ExchangeEqualization Account Act does not permit the EEAto borrow.

1001. Any NLF exposures relating to the foreigncurrency reserves are managed alongside those ofthe EEA by the Bank of England, which also acts asHMT’s agent for foreign currency liability manage-ment. For example, when the NLF borrows in a for-eign currency to fund the reserves it assumes thecurrency and interest rate risk as it sells the foreigncurrency to the EEA for sterling. Through its invest-ments the EEA will take an offsetting currency andinterest rate position so that the government’s expo-sures as a whole are hedged.

1002. EEA reserves fall into two differentlyfunded categories: “borrowed reserves” on whichthe currency exposures have been hedged and“net reserves,” which are funded out of un-hedged sterling.

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Funding the borrowed reserves

1003. The “borrowed” reserve assets arefinanced both by foreign currency and sterling-denominated liabilities, the latter swapped intoforeign currencies. Cost is the main determinantof whether the foreign currency reserves arefunded by issuing foreign currency liabilities or bysterling swapped into foreign currencies. Theleast-cost method of funding can be determinedby comparing, on a swapped basis, the cost of issu-ing bonds of a given maturity and nominalamount in dollars, euros, and yen with the cost ofissuing a similar bond in sterling. The EEA seeksto control the exposure in these borrowedreserves by matching the risk characteristics, forexample maturity, of its foreign currency assets tothose of the foreign currency liabilities. Any resid-ual risk is managed by swapping the exposure ofthe asset into that of the liability through cur-rency or interest rate swaps.

Recent trends in financing the borrowed reserves

1004. Since March 2000 a program was imple-mented that replaced maturing foreign currencydebt issues with sterling debt swapped into foreigncurrencies to finance the reserves. At prevailinginterest rates and swap rates this offered a morecost-effective means of financing than borrowingdirectly in foreign currency. As central governmentnet cash requirements for 2000–01 were reviseddown substantially, further swaps were undertakento prefinance some of the foreign currency debtmaturing in 2001 to 2003. This policy continuedthrough 2001–02.

1005. Prefinancing led to a temporary rise inthe gross reserves but did not increase the U.K.’snet foreign currency exposures, because all trans-actions were hedged. As the prefinanced liabilitiesare redeemed, the level of gross reserves will fallback. Redemption of the longest-dated prefi-nanced foreign currency obligation in January2003 is expected to bring the level of gross reservesdown to $35 billion by the end of March 2003,from a recent high of $43 billion at the end ofSeptember 2001.

Net reserves

1006. The net currency reserves are effectivelyfinanced by unhedged sterling, and by the EEA’snet SDR liability. HMT sets a benchmark for netcurrency exposures that takes into account pastpatterns of risk and return, as well as other macroe-conomic factors such as trade flows and the likelycurrencies used in any intervention. In 2001–02,this was 40 percent U.S. dollars, 40 percent euros,and 20 percent Japanese yen (excluding SDRs),which has been unchanged since accounts werefirst published in 1997–98.

1007. Interest rate risk in the net reserves haslargely been managed by investing in short-datedinstruments. Recently, however, the duration ofsome of the net reserves benchmark has beenextended to reflect a revised view about the besttrade-off between risk and return.

Composition of reserve assets

1008. Under the Exchange Equalization Act,funds in the EEA may be invested in any assetsdenominated in the currency of any country; in thepurchase of gold; or in the acquisition of SDRs.

1009. In May 1999, the Government announceda restructuring of the reserves involving a programof gold sales by auction to achieve a better balancein the portfolio by increasing the proportion held incurrency. This program continued until the end of2001–02. Following each auction, the proceeds ofgold sales were invested in foreign currency interestbearing assets and retained in the reserves broadlyin the proportion of 40 percent dollars, 40 percenteuros, and 20 percent Japanese yen.

Securities and other eligible instruments

1010. The statutory obligation of the EEA dic-tates that investments must be highly liquid, so theymay be made available quickly for interventionpurposes if necessary. They must also carry accept-able credit risk. Essentially this means that the bulkof the assets are securities issued by the nationalgovernments of the United States, euro area coun-tries, and Japan.


1011. The EEA also makes use of other instru-ments, however, including:

(i) Bonds issued by highly rated suprana-tional organizations and selected officialsector agencies;

(ii) Foreign currency spot, forward, and swaptransactions;

(iii) Interest rate and currency swaps;

(iv) Bond and interest rate futures;

(v) Forward rate agreements;

(vi) Gold deposits, gold loco, and gold qualityswaps;

(vii) SDRs;

(viii) Certificates of deposit and bank and cor-porate commercial paper; and

(ix) Bank deposits.

1012. Options are not currently permissibleinvestments for the EEA.

Liquidity policy

1013. To determine the benchmark asset alloca-tion for the EEA, the Bank employs an asset alloca-tion model that explicitly trades off liquidity andreturn: the model determines an asset mix that max-imizes expected return for given levels of expectedliquidation costs. Potential liquidation costs includeboth bid-offer transaction costs, which are depen-dent on the size of liquidation, and price move-ments, which are primarily driven by marketconditions at the time of liquidation. Liquidationcosts are incurred only if there is a call on thereserves. A “call” on the reserves is defined by threeparameters: the size of the call, the probability of thecall occurring, and the length of time available tomeet the call. In the absence of such a call, thereserves are assumed to be held to maturity andyields between asset classes can be compared on aspread-to-LIBOR basis (taking into account the basisswap if assets are denominated in different curren-cies). Various call scenarios are assumed, based onhistoric events and future potential needs. A corelevel of liquidity is also specified in the model, lead-ing to minimum holding thresholds in particularasset classes such as U.S. Treasury bonds.

1014. The results of the liquidity model areused to determine the neutral position of the bor-rowed reserves, and this forms the benchmark foractive management.

Active management benchmarks

1015. The Bank actively manages both the bor-rowed and net reserves in order to enhancereturns relative to benchmarks. Deviations frombenchmarks are capped by the VaR limits set eachyear by HMT in its annual Remit. The benchmarkreturns on borrowed reserves comprise the returnsto the hedge portfolios held against the NLF for-eign currency and returns generated by the ster-ling swaps program.

1016. The benchmarks for active managementare adjusted for any positions taken by higher lev-els of management such that the returns to activerisk taking are properly identified for each portfo-lio. Such management positions count against theoverall VaR limits.

Active management

1017. Portfolios are divided into major cur-rency blocs—dollars, euros, and yen—and portfo-lio managers establish tactical positions by buyingand selling securities against their individual cur-rency benchmarks. They are also permitted toestablish positions using derivatives includingfutures and swaps although not, currently, options.

1018. A range of positions including outrightlongs and shorts, curve positions, spread switches,and relative value switches are taken at the activelevel. The decision to take profits on trades and tounwind loss-making positions, in most instances,belongs to the portfolio manager although, excep-tionally, senior management may ask for positionsto be closed in order to avoid a buildup of unac-ceptable risks. Positions are monitored on a fre-quent basis by the direct line management of theactive traders.

Market risk

1019. Market risk is the exposure to move-ments in market variables. For the EEA, these vari-

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ables are primarily interest rates and exchangerates. Since 1999 the Bank has monitored and con-trolled market risk using a VaR model, which pre-dicts, at a specified confidence level, the maximumlikely loss for the portfolio over a certain timeperiod. The Bank applies a 99 percent confidenceinterval and a ten-day holding period, which pre-dicts that in 99 ten-day periods out of a hundred,losses should not exceed those suggested by themodel. These VaR estimates are based on the pastvolatility of returns on different asset classes andon how the returns on each asset class are corre-lated with other positions held in the portfolio.

1020. The Bank measures the EEA’s VaR expo-sure on a regular basis throughout the day. It alsocalculates the Delta exposure at the same fre-quency. Delta measures the change in value of theportfolios for each one-basis-point shift in the rele-vant yield curve. It supplements the VaR measure,and helps to test the sensitivity of the portfolio tochanges in interest rates. Market risk reports areproduced daily.

1021. Furthermore, the Bank conducts regularstress tests, to explore the vulnerability of the EEAto hypothetical severe market movements and toestimate the potential losses in these extreme con-ditions. The results of these tests are reported tosenior management.

Credit risk

1022. The management of the reservesinvolves exposure to the creditworthiness of banks

and of the issuers of sovereign, supranational, orcommercial paper. The creditworthiness of thesebanks and issuers is subject to regular scrutiny bythe Bank. Although the Bank takes account of pub-lished Agency ratings, it sets its own internal limits,which limit the maximum exposure to each bankand issuer in terms of both amount and maturity.Such exposures are monitored in real time againstthe limits. A report of any limit excesses is sent toHMT each month. In addition, there are limits tocontain exposure to each country’s banking systemand on instrument types.

1023. Where bonds are owned by the EEA, butheld by custodians, these custodians may be autho-rized to use them in their bond lending programs.These programs involve lending the bonds againstcollateral consisting of either other bonds or cash.The authorized custodians are permitted to investcash collateral in money market instruments. Theinvestment of this cash collateral is subject to creditlimits determined by the Bank. The amounts dele-gated to the custodians are deducted from the limitsavailable to the Bank for its own EEA managementactivities. Any maturity mismatch between the col-lateral held and the corresponding investments isstrictly limited. Daily reports are received by theBank, which allows compliance with the investmentconstraints to be checked.

1024. The EEA also exercises its right to callcollateral each time exposures to swap or repocounterparties rise above contractually definedthresholds. Unsecured credit risk on such transac-tions is thereby kept to a minimum.


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